An active and robust stock market for flotations or initial public offerings (IPOs) is viewed as one of the most important drivers for encouraging entrepreneurship and innovation.
There are two reasons for this. First, an IPO market provides capital to high-potential start-up companies. Second, a vibrant stock market is crucial for venture capitalists investing in these entrepreneurs, since it provides the opportunity to exit investments and, at the same time, realise strong positive returns.
According to the 2011 Global Trends in Venture Capital survey by accountant Deloitte and several national venture capital (VC) associations, IPOs are crucial to the success of the VC industry. To see this, we can examine the VC cycle, which typically starts with the creation of funds to raise capital from both institutional and private investors interested in backing innovative start-ups.
The funds select promising firms, which they nurture and support by contributing the money and services these companies need to reach the next stage in their development. Ideally, this continues until the funds decide to exit their portfolio companies and reap the fruits of their investments.
A significant part of the returns are then distributed to the initial investors, enabling the beginning of a new VC cycle.
Several other exit mechanisms are available, including trade sales, secondary sales and buybacks. However, the survey indicates the lack of an IPO market seriously disrupts the VC cycle, and as a result institutional investors lose faith in the VC industry. More worrisome, investors’ lack of trust has depressing consequences for the total number of VC funds.
This trend is particularly evident in Europe. This year, Earlybird Venture Capital found in a study – Turning Venture Capital Data into Wisdom – that the number of VC funds in Europe decreased from about 1,600 in 1999 to 711 this year, a decrease of 63%, leading to a substantial VC supply gap. How can this gap be bridged?
In recent years, European VC funds have outperformed their US counterparts in terms of exit multiples even without a Nasdaq-type stock market. The Earlybird study shows there are several reasons that returns in Europe were better.
The VC supply gap allowed existing funds to be more selective, focusing only on the best start-ups. Moreover, the scarcity of VC resulted in lower entry valuations. But the Earlybird study also shows the importance of large corporations in the VC cycle. Indeed, they play a dominant role in the VC industry by putting themselves in the market as an attractive partner providing important exit opportunities, but also one willing to provide additional funding through their corporate venturing (CV) organisations.
The involvement of CV units in the VC cycle is not new.
Corporations introduced venturing initiatives in the 1980s and 1990s, focusing on later-round investments. But recently, we see a change in the scope of such initiatives towards early-stage, and even seed, investments. Increasingly, corporations seek to be more creative in their efforts to attract and integrate outside innovations.
On the whole, there is a keen awareness of the need for investing in high growth start-ups that could spur the corporation’s own innovation efforts and lead to greater growth.
It is, therefore, unsurprising that CV activities have a positive impact on the corporation’s stock price. We looked at data from company websites and commercial databases to analyse the stock market impact of CV announcements from 36 of the largest CV organisations across the world from 2005 to 2010. We found those announcements considered strategic are met with better-than-average stock market reactions.
We can distinguish several options corporations often employ simultaneously in their strategic open innovation efforts. Corporations make, for example, direct investments in other, mostly entrepreneurial or high-growth, companies. But they also follow a more indirect investment approach by increasingly acquiring limited partnership (investment) interests in independent VC funds. It is here that CV units offer VC funds most advantages. Besides exit opportunities, corporations provide venture capitalists with funding support, thereby bridging the VC supply gap.
In addition, corporations could, as an anchor investor, assist in the fund’s due diligence and selection processes, and acquaint portfolio companies with a multinational’s affairs and operations, particularly in the area of international marketing, sales and distribution.
How should CV activities be structured?
The limited partnership agreement – often complemented by sideletters – will govern three relationships: the relationship between the venture capitalist and the corporation as a strategic investor, the relationship between the venture capitalist and other financial investors, and the relationship between strategic and financial investors.
In certain situations, such as when the VC raises funds from a strategic investor, traditional investors will probably seek further restrictions and covenants relating to the management of the fund, conflicts of interest and restrictions on the type of investment the fund can make. The restrictive nature of covenants, which must make sure all investors are treated equally, will correspond to the uncertainty, information asymmetry and agency costs resulting from the strategic investor’s participation.
However, the use of restrictive covenants can entail the erosion of value, as they limit the venture capitalist’s ability to benefit from the knowledge, resources and investment opportunities of the strategic investor. It will, therefore, be common practice that corporations, in conjunction with the venture capitalist, endeavour to obtain more favourable terms than other investors with respect to dealflows, portfolio selection and monitoring, investment decisions and co-investment rights.
The reputation of the venture capitalist and the corporation – as a strategic investor – will, of course, affect other investors’ willingness to accept more favourable terms for one of their co-investors.
At this point, we focus on the task for governments. When incentives in a VC transaction are badly aligned – as could be the case if a strategic corporate investor enters the scene – it is arguably appropriate for governments to attempt to align the incentives between the parties in order to stimulate CV investments. One way to do this is by giving subsidies in the form of tax breaks to the corporations or the funds or both.
However, government sponsorship could crowd out the supply of VC if it does not encourage all players in the VC industry. To the extent that government intervention is needed to stimulate partnerships and alliances in the VC industry, governments could seek to co-invest in established VC funds and become a limited partner themselves.
Such a strategy will, certainly in the long run, lead to networking benefits for these VC alliances involving corporations, venture capitalists and governments. More importantly, the more passive signalling role of governments arguably makes their investment and support less dependent on political institutions and changes than directly government-sponsored programmes or initiatives.
Certainly the effort of government, as a facilitator of CV activities, could foster entrepreneurship and VC, and promote long-term growth similar to that experienced in Silicon Valley some decades ago.