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«LAW AND ECONOMICS RESEARCH PAPER NO. 01-04 A Cross-Country Comparison of Full and Partial Venture Capital Exit Strategies Douglas J. Cumming Jeffrey ...»

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UNIVERSITY OF TORONTO

Faculty of Law

LAW AND ECONOMICS

RESEARCH PAPER NO. 01-04

A Cross-Country Comparison of

Full and Partial Venture Capital Exit Strategies

Douglas J. Cumming

Jeffrey G. MacIntosh

This paper can be downloaded without charge at:

The Social Science Research Network Electronic Paper Collection:

http://papers.ssrn.com/abstract=268557 A Cross-Country Comparison of Full and Partial Venture Capital Exits ∗ Douglas J. Cumming School of Business University of Alberta Edmonton, Alberta Canada T6G 2R6 Tel: (780) 492-0678 Fax: (780) 492-3325 E-mail: Douglas.Cumming@ualberta.ca Http://www.bus.ualberta.ca/dcumming Jeffrey G. MacIntosh Toronto Stock Exchange Professor of Capital Markets Faculty of Law University of Toronto 78 Queen's Park Toronto, Ontario Canada M5S 2C5 Tel: (416) 978-5785 Fax: (416) 978-6020 E-mail: j.macintosh@utoronto.ca First Draft: October 1999 This Draft: May 21 2002 We owe special thanks to Stefanie Franzke, Aditya Kaul, Paul Halpern, Gary Lazarus, Ted Liu, Mary ∗ Macdonald, Frank Mathewson, Vikas Mehrotra, Corrine Sellars, Kashi Nath Tiwari and Ralph A. Winter and an anonymous referee for helpful comments and discussions. We are also grateful for comments from seminar participants at the University of Alberta Institute for Financial Research Workshop (October, 1999), the ABN AMRO International Conference on Initial Public Offerings, Amsterdam (July, 2000), the Canadian Law and Economics Association Annual Conference, Toronto (September, 2000), the Eastern Finance Association, Charleston (April, 2001), the University of Western Ontario, ASAC (May 2001), the Multinational Finance Society, Lake Di Garda (June, 2001), the University of Frankfurt Center for Financial Studies (CFS) (July, 2001), the University of Hamburg Institute for Law and Economics Workshop (July, 2001), and the Australasian Banking and Finance Conference (December, 2001). Parts of this paper appear in an earlier and different version entitled “The Extent of Venture Capital Exits: Evidence from Canada and the United States,” in J. McCahery and L.D.R. Renneboog, eds., Venture Capital Contracting and the Valuation of High-Tech Firms (Oxford University Press, 2002, forthcoming).

A Cross-Country Comparison of

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This paper considers the issue of when venture capitalists (VCs) make a partial, as opposed to a full exit, for the full range of exit vehicles. A full exit for an IPO involves a sale of all of the venture capitalist's holdings within one year of the IPO; a partial exit involves sale of only part of the venture capitalist's holdings within that period. A full acquisition exit involves the sale of the entire firm for cash; in a partial acquisition exit, the venture capitalist receives (often illiquid) shares in the acquiror firm instead of cash. In the case of a buyback exit (in which the entrepreneur buys out the venture capitalist) or a secondary sale, a partial exit entails a sale of only part of the venture capitalist's holdings. A partial write-off involves a write down of the investment. We consider the determinants of full and partial venture capital exits for all five exit vehicles. We also perform a number of comparative empirical tests on samples of full and partial exits derived from a survey of Canadian and U.S. venture capital firms. The data offer support to the central hypothesis of the paper: that the greater the degree of information asymmetry between the selling VC and the buyer, the greater the likelihood of a partial exit to signal quality. The data also indicate differences between the U.S. and Canadian venture capital industries, and highlight the impact of legal and institutional factors on exits across countries.

Key words: venture capital; partial exits; regulation JEL classification: G24, G28, G32, G38, K22

1. Introduction Much theoretical research has focused on the role of venture capital financial contracts in mitigating agency costs and informational asymmetries between venture capitalists and entrepreneurial firms (e.g., Sahlman, 1990; Cornelli and Yosha, 1997; Trester, 1998; Marx, 1998; Hellmann, 1998; Bergmann and Hege, 1998; Trester, 1998; Amit et al., 1998; and Kirilenko, 2001). Empirical research along these lines may be classified into one of two categories: studies that use industry data with many observations (e.g., Gompers and Lerner, 1999a), and studies that use more detailed hand-collected data with up to 200 observations (e.g., Gompers, 1997; Trester, 1998; Kaplan and Strömberg, 2000; Hellmann and Puri, 2002).

A second type of research in venture capital focuses on mitigating agency problems between entrepreneurial firms and their new owners upon venture capital exit. The ability to make a profitable exit lies at the heart of venture capital [“VC”] investing (Sahlman, 1990; Gompers and Lerner, 1999a). There are 5 principle types of VC exits (MacIntosh, 1997): an initial public offerings [“IPO”], in which a significant portion of the firm is sold into the public market; an acquisition exit, in which the entire firm is bought by a third party; a secondary sale, in which only the VC’s shares are sold to a third party (again, typically a strategic acquiror); a buyback, in which the VC’s shares are repurchased by the entrepreneurial firm; and a write-off, in which the VC walks away from the investment.





Barry et al. (1990), Megginson and Weiss (1991), Ljungqvist (1999), Gompers and Lerner (1999a), Franzke (2001), Lee and Wahal (2002) and others have considered the role of venture capitalists in the going public process. MacIntosh (1997) analyzed factors that affect the choice of the complete class of venture capital exits (IPOs, acquisitions, secondary sales, buybacks, and write-offs); this work has been extended and the factors that affect the selection of different exits have been empirically tested by Cumming and MacIntosh (2000, 2002) using a hand-collected data set from venture capital exits in Canada and the United States. Recent papers by and Schweinbacher (2002) and Cumming (2002) analyze exits in Europe;

Fleming (2002) considers Australian data. Petty et al. (1999) provide U.S. case studies on harvesting venture capital investments for different types of exits. Smith and Smith (2000) discuss aspects of IPOs, acquisitions and buybacks. Black and Gilson (1998) introduced the notion of implicit contracting over exit. Hellmann (2000) and Smith (2000) analyze control over exit. Cochrane (2001) significantly adds to this research by considering a large sample of U.S. industry data.

This paper extends previous research on the complete class of venture capital exit vehicles and the associated selection effects for measuring the risk and return to venture capital investing. We distinguish between full and partial exits for the complete class of venture capital exits. We provide empirical tests of the factors that the choice of a full or partial venture capital exits over the complete class of exits, and provide evidence that the risk and return to venture investing differs by the extent of exit for each exit vehicle. Partial exits are typically associated with a higher risk and return, which is consistent with the proposition that partial dispositions are more common among exits whereby informational asymmetries are more pronounced.

We use hand-collected data on 248 VC exits from Canada and the United States. This data was collected using our own surveys and distributed with the assistance of the Canadian Venture Capital Association, and Venture Economics in the U.S. The trade-off in collection more detailed private VC exits information is in the comparatively smaller data set; nevertheless, our descriptive statistics are comparable to the available U.S. industry data described by Cochrane (2001) and the Venture Economics Annual Reports, and the available Canadian industry data from the Canadian Venture Capital Association Annual Reports (see section 6). Our hand-collected data involves a number of distinguishing features from available U.S. industry data employed by Cochrane (2001). For example, the U.S. industry data does not distinguish between selection among the full class of private exits (acquisitions, secondary sales, and buybacks), and it does not distinguish between selection of full and partial exits over the five distinct different types of exits, among other things (see section 6 below).

In the spirit of Black and Gilson (1998), Jeng and Wells (2000), and Mayer et al. (2002), we also provide an analysis of international differences in venture capital. We find significant differences in exit behaviour and the risk and return to venture capital as between Canada and the United States. We find a lower risk and return to venture capital investing in Canada. These differences are likely attributable to a combination of market and regulatory factors that differ between the two countries.

This paper is organized as follows. Section 2 of this paper recaps the types of exits used by venture capitalists. Section 3 distinguishes between full and partial exits for each exit vehicle. Section 4 considers the determinants of full versus partial exits. Section 5 documents institutional and legal differences between Canada and the United States that may affect exit. The data is described in section 6. Comparison tests across the data from Canada and the United States are provided in section 7. Empirical tests on factors that affect the extent of exit are presented in section 8. The last section concludes.

2. Types of Exit Vehicles Employed by Venture Capitalists In general, VCs will exit their investments by one of the following five methods. In an initial public offering (IPO) the firm sells shares to members of the public for the first time. The VC will typically retain its shares at the date of the public offering, selling shares into the market in the months or years following the IPO. Alternatively, following the IPO the VC may dispose of its investment by making a dividend of investee firm shares to the fund's owners. Despite the fact that the VC will not usually sell more than a small fraction of its shares at the time of the IPO (if any at all), exits effected by sales subsequent to the IPO are (following common usage) classified as IPO exits.

The VC may also sell the entire firm to a third party, which we refer to below as an acquisition exit.

Typically, the buyer is a strategic acquiror – a larger entity in the same or similar business to the acquired firm that wishes to meld the firm’s product or technology with its own (either vertically or horizontally).

Strategic acquisitions often involve the merger of two corporations with some prior contractual relationship, such as in the supply of inputs or the licensing of a particular technology (MacIntosh, 1994).

This form of exit may be effected in a number of different ways. For example, the transaction may be structured as a sale of all the shares in return for cash, shares of the acquiror, or other assets.

Alternatively, the transaction may be structured as a sale of the firm's assets or as a merger between the investee firm and purchasing firm (or a subsidiary thereof).

In an exit effected by way of secondary sale, the VC will sell its shares to a third party – typically a strategic acquiror, and in some cases another VC. A secondary sale differs from an acquisition exit in that only the shares of the VC are sold to the third party; the entrepreneur and other investors will retain their investments. Where the purchaser is a strategic acquiror, it will usually be seeking a window on the firm’s technology, with a view to possibly effecting out a complete acquisition of the firm sometime in the future.

In a buyback exit, the VC will sell its shares to the entrepreneur and/or the company.

A write-off typically involves the failure of the entrepreneurial firm. The VC may continue to hold shares in a non-viable or barely profitable enterprise in the case of a write-down, as discussed below.

3. Full and Partial Venture Capital Exits An exit may be full or partial. A full exit for an IPO involves a sale of all of the venture capitalist's holdings within one year of the IPO; a partial exit involves sale of only part of the venture capitalist's holdings within that period. A full acquisition exit involves the sale of the entire firm for cash; in a partial acquisition exit, the venture capitalist receives (often illiquid) shares in the acquiror firm instead of cash. In the case of a secondary sale or a buyback exit (in which the entrepreneur buys out the venture capitalist), a partial exit entails a sale of only part of the venture capitalist's holdings. A partial write-off involves a write down of the investment.

In the case of IPOs, the VC will rarely sell its holdings at the date of the IPO, for reasons explored further below. By convention (and recording of industry data by the Canadian Venture Capital Association and Venture Economics in the U.S.; see section 6 below), a full exit is defined as one in which the VC fully disposes of its holdings within one year of the date of the IPO. A partial exit involves a sale of at least some of the VC’s holdings within one year of the IPO, with retention of some of its holdings beyond the one-year period.

In a write-off exit, the VC makes a decision to spend no further time or effort bringing the investment to fruition, and essentially walks away from it. Indeed, many write-offs involve the bankruptcy and consequent disappearance of the firm. Given that a partial exit is one in respect of which the VC disposes of some of its holdings, by common usage there are no partial write-offs. Nonetheless, the Canadian Venture Capital Association and Venture Economics define a partial write-off as a situation in which the VC takes a write-down of the investment on its books. When this occurs, it is virtually certain that the investment is a “living dead” investment – i.e., one involving a viable but marginally profitable enterprise which lacks sufficient upside potential for the VC to continue to devote time and attention to it. While distinguishing between full write-offs and partial write-offs thus provides useful information, partial write-offs are distinct from partial exits in the case of IPOs, secondary sales and buybacks. We thus segregate the sample of write-offs from the other exit types in our empirical analysis.



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