1. Venture Capital Exits in Canada and the United States*
Douglas J. Cumming
School of Business, University of Alberta
Edmonton, Alberta, Canada T6G 2R6
Tel: (780) 492-0678
Fax: (780) 492-3325
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
First Draft: September 1997
This Draft: February 2002
* Cumming: University of Alberta School of Business; B.Com. (Hons.) McGill University; M.A.
Queen’s University; J.D./Ph.D., University of Toronto. MacIntosh: Toronto Stock Exchange Professor of
Capital Markets, University of Toronto Faculty of Law; B.Sc., MIT; LL.B., University of Toronto; LL.M.,
Harvard Law School. The authors thank Varouj Aivazian, Paul Halpern, Vijay Jog, Aditya Kaul, Frank
Mathewson, Vikas Mehrotra, Michael Patry, Tom Ross, Corrine Sellars, and especially Ralph A. Winter for
helpful comments and suggestions. We are also grateful for comments from the seminar participants at the
ABN AMRO International Conference on Initial Public Offerings (2000, Amsterdam), ASA Conference at
the University of Western Ontario (2001, London), Australasian Banking and Finance Conference (2001,
Sydney), Canadian Law and Economics Association (1998, Toronto), Center for Financial Studies at the
University of Frankfurt (2001), Eastern Finance Association (2001, Charleston), Financial Management
Association (2001, Toronto), Law & Entrepreneurship Research Conference Sponsored by the
Northwestern School of Law of Lewis & Clark College (2000, Portland), Multinational Finance Society
(2001, Garda, Italy), Northern Finance Association (2000, Waterloo), University of Alberta Finance
Workshop (1999, Edmonton), University of Hamburg Law and Economics Workshop (2001), and the
University of Toronto Institute for Policy Analysis (1997). This paper is scheduled for presentation at the
Babson Conference on Entrepreneurship (2002, Colorado).
Venture Capital Exits in Canada and the United States
Venture capital exit vehicles enable, to different degrees, mitigation of informational asymmetries
and agency costs between the entrepreneurial venture and the new owners of the firm. Different exit
vehicles also affect the amount of new capital for the entrepreneurial firm. Based on these factors, we
conjecture the efficient pattern of exits depending on the quality of the entrepreneurial venture, the nature of
its assets, and the duration of venture capital investment. We empirically assess the significance of these
factors using a multinomial logit model. Our comparative results between Canada and the U.S. provide
insight into the impact of different institutional and legal constraints, and suggest such constraints have
distorted the efficient pattern of exits in Canada.
I. EXIT VEHICLES…………………………………………………………………………………………...6
II. A GENERAL THEORY OF VENTURE CAPITAL EXITS…………………………………………………….8
III. EXCEPTIONS TO THE GENERAL THEORY: FACTORS AFFECTING THE VENTURE CAPITALIST’S TIMING OF EXIT AND
CHOICE OF EXIT VEHICLE ………………………………………………………………….12
A. Ability of the New Owners to Resolve Information Asymmetry and Value the Firm……...……13
B. Ability of New Owners to Monitor the Investment Post-Exit and Discipline the Managers…….20
C. Black and Gilson’s Implicit Contract Theory……………………………………………………29
D. The Transaction Costs of Effecting a Sale of the VC’s Interest……………...………………….29
E. Ongoing Costs of Operating as a Public, As Opposed to a Private Firm……………………..….34
F. Liquidity of Investment to Buyer………………………………………………………………...35
G. The Liquidity of the Consideration Received by the VC: The VC’s Cash Preference………..…...36
H. Managerial Incentives……………………………………………………………………………42
1. Incentive compensation and Stock Ownership as Managerial Motivators……………...42
2. The Corporate Control Market…………………………………………………………..46
I. Transaction Synergies..…………………………………………………………………………..47
J. Capital Raised, Scale of Acquisition, and Ability to Meet Future Capital Requirements……….51
K. Risk Bearing Considerations……………………………………………………………………..56
L. Common Exit Strategies as a Factor in Promoting Teamwork………………………..…………58
M. The Cyclicality of Valuations in IPO Markets………………………….……………………..…62
N. The Life Cycle of a Venture Capital Fund: The Fire Sale Problem…….. ………………………64
O. Reputational Incentives…………………………………………………………………………..65
P. Agency Costs of Debt…………………………………………………………………………….67
Q. Public Profile……………………………………………………………………………………..69
R. Governance Mechanisms…………………………………………………………………………69
S. A Rank Ordering of Exit Preference by Investee Firm Quality………………………………….70
IV. TESTABLE HYPOTHESES………………………………………………………………………………73
A. Firm Quality……………………………………………………………………………………...74
B. Investment Duration and Exit Strategy…………………………………………………………..75
C. Exit Strategies for High-Technology Firms……………………………………………………...77
V. LEGAL AND INSTITUTIONAL FACTORS…………………………………………………………………79
A. Type of Venture Capital Fund……………………………………………………………………79
B. Tax Factors……………………………………………………………………………………….83
C. Securities Regulation…………………………………………………….……………………….83
D. Market Liquidity………………………………………………………………………………….88
E. Underwriting Support for IPOs…………………………………………………………………..89
VI. EMPIRICAL EVIDENCE………………………………………………………………………………...90
B. Multinomial Logit Analysis……………………………………………………………………...94
Venture capital investing is primarily equity investing. Many entrepreneurial firms (“EFs”) are
young firms lacking the cash flow and profitability that would enable them to pay interest or dividends.
Thus, most of the venture capitalist's return arises in the form of capital gains. For this reason,
understanding the means by which venture capitalists (VCs) exit (i.e., dispose of) their investments is vital
to an understanding of the venture capital process. Indeed, there is evidence that the prospective suitability
of the various exit vehicles (initial public offering, acquisition, company buyback, secondary sale, and
write-off, each defined below) is considered by VCs to be an important factor in deciding whether to invest
in a firm.1
In addition, once an investment is taken on, the VC will structure its deal with the entrepreneur
to maximize the probability of exiting on favourable terms. Various common features of the typical VC/
entrepreneur deal, such as “piggyback” rights,2 “go-along” (or “carry-along”) rights, 3 and put options are
inserted with a view to facilitating exit.4
While previous research has explored the role of venture capitalists (“VCs”) in the going-public
process,5 the complete class of venture capital exits (IPOs, acquisitions, secondary sales, buybacks, and
Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks
versus Stock Markets, 47 J. FIN. ECON. 243 (1998); J. WILLIAM PETTY, JOHN D. MARTIN, AND JOHN W. KENSINGER,
HARVESTING INVESTMENTS IN PRIVATE COMPANIES (1999); Ian C. MacMillan, Robin Siegel & P.N. Subba Narashimba,
Criteria Used by VCs to Evaluate New Venture Proposals, 1 J. BUS. VENTURING 119 (1985); Richard B. Carter &
Howard E. Van Auken, Venture Capital Firms' Preferences for Projects in Particular Stages of Development, 32
J. SMALL BUS. MGMT. 60 (1994); Arshad M. Kahn, Assessing Venture Capital Investments with Non-Compensatory
Behavioral Decision Models, 2 J. BUS. VENTURING 193 (1987); Albert Bruno & Tyzoon Tyebjee, The
Entrepreneur's Search for Capital, 1 J. BUS. VENTURING 61 (1985).
A piggyback right enables the holder to require that she be bought out at the same time and on the same
terms as another shareholder. Where there is such a right, it helps the ensure that the parties work toward a
common exit, since neither party can unilaterally exit.
The holder of a go-along right can insist that the other owner(s) subject to the right sell her shares at the
same time and on the same terms as the holder of the right. The venture capitalist will typically hold the right,
which is designed to enable the VC to deliver one hundred percent of the EF’s shares to an acquiror.
PAUL A. GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE (1999); William A. Sahlman, The Structure
and Governance of Venture Capital Organizations, 27 J. FIN. ECON. 473 (1990).
Gompers & Lerner, Id.; Paul A. Gompers & Josh Lerner, Conflict of Interest in the Issuance of Public
Securities: Evidence from Venture Capital, 42 J. LAW & ECON. 1 (1999); William C. Megginson & Kathleen A.
Weiss, Venture Capital Certification in Initial Public Offerings, 46 J. FIN. 879 (1991); Christopher Barry, Chris
Muscarella, John Peavy & Michael Vetsuypens, The Role of Venture Capital in the Creation of Public Companies:
Evidence from the Going Public Process, 27 J. FIN. ECON. 447 (1990).
write-offs) has not previously been the subject of theoretical or empirical investigation.6
Previous research has dealt extensively with agency problems that arise in venture capital
investing.7 As initially identified by Sahlman, three types of agency relationships have been the focus of
discussion.8 First, venture capital firms have incentives to favour their interests over those of their
investors, and thus can be viewed as agents of the investors. Second, the entrepreneur has an incentive to
favour her interests over those of the VC, and hence can be considered to be an agent of the VC. Third, a
venture capital firm sometimes has the incentive to act at odds with the best interests of the entrepreneur,
and thus may be characterized as an agent of the entrepreneur.
In this paper, we suggest that there is a fourth type of agency problem that has received scant
attention. When the VC exits its investments, agency issues arise as between the sellers of the firm's equity
Black & Gilson, supra note 1, convincingly argue that IPOs are a superior form of exit to the alternatives,
and that an active IPO market is strongly correlated with the health of the venture capital industry in different
countries. They also put forth an implicit contract theory discussed infra section III.C. They do not, however,
rigorously explore alternative forms of exit. Petty et al., supra note 1, provide an analysis of case studies on
harvesting venture capital investments. D. Gordon Smith, Control Over Exit in Venture Capitalist Relationships,
Northwestern School of Law of Lewis and Clark College, mimeo (2000), considers whether the entrepreneur or
venture capitalist should have control over the exit decision. Thomas Hellmann, IPOs, Acquisitions and the Use of
Convertible Securities in Venture Capital, Stanford University, mimeo (2001), considers control over exit in the
choice of IPOs versus acquisitions. A new paper by Armin Schweinbacher, An Empirical Analysis of Venture
Capital Exits in Europe and in the United States, mimeo (February 2002), considers similar tests introduced in our
paper with data from Europe and the United States. Schweinbacher’s tests are based on our paper, and the results are
similar: exit patterns are most efficient in the United States. In contrast to our data (see infra section VI), however,
Schweinbacher’s data uses averages exit frequency across funds and does not provide a project specific investment-
by-investment analysis of exits.
William A. Sahlman, The Structure and Governance of Venture Capital Organizations, 27 J. FIN. ECON.
473 (1990); Josh Lerner, The Syndication of Venture Capital Investments, 23 FIN. MGMT. 16 (1994a); Josh Lerner,
Venture Capitalists and the Decision to Go Public, 35 J. FIN. ECON. 293 (1994b); Anat R. Admati & Paul
Pfleiderer, Robust Financial Contracting and the Role of Venture Capitalists, 49 J. FIN. 371 (1994); Eric Berglöf, A
Control Theory of Venture Capital Finance, 10 J. LAW, ECON. & ORG. 247 (1994); Francesca Cornelli & Oved
Yosha, Stage Financing and the Role of Convertible Debt, London Business School Working Paper No.253-1997
(1997); Dirk Bergmann & Ulrich Hege, Venture Capital Financing, Moral Hazard, and Learning, 22 J. BANKING
& FIN. 703 (1998); Jeffrey J. Trester, Venture Capital Contracting Under Asymmetric Information, 22 J. BANKING &
FIN. 675 (1998); Thomas Hellmann, The Allocation of Control Rights in Venture Capital Contracts, 29 RAND J.
ECON. 57 (1998); Gompers & Lerner, supra note 4; Paul A. Gompers, Grandstanding in the Venture Capital
Industry, 42 J. FIN. ECON. 133 (1996); Raphael Amit, James Brander and Christoph Zott, Why do Venture Capital
Firms Exist? Theory and Canadian Evidence, 13 J. BUS. VENTURING 441; Paul A. Gompers, Ownership and Control
in Entrepreneurial Firms: An Examination of Convertible Securities in Venture Capital Investments, Harvard
University, mimeo (1997); Douglas J. Cumming, The Convertible Preferred Equity Puzzle in Canadian Venture
Capital Finance, University of Alberta, mimeo (2000); Mark Garmaise, Informed Investors and the Financing of
Entrepreneurial Projects, University of Chicago Graduate School of Business, mimeo (2000); Steven N. Kaplan &
Per Strömberg, Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital
Contracts, University of Chicago Graduate School of Business, mimeo (1999).
(the VC and other investors in the EF) and the purchasers. We hypothesize that the choice of exit vehicle
and the timing of exit are strongly influenced by a desire to minimize these agency problems (in addition to a
variety of other hypothesized factors). The theme that unifies the paper is that the VC’s goal is to maximize
the proceeds resulting from the exit of its investments. We identify a variety of factors that influence the
exit price associated with various forms of exit, and hence the VC’s choice of exit vehicle.
Not all of these factors are empirically testable, either because it would be difficult to devise an
appropriate empirical test, or because of limitations in our data set. For this reason, in our empirical tests, a
variety of factors are subsumed under the rubric of a variable that we simply style firm “quality”, which is
proxied by the ratio of the proceeds of exit to the cost of investment. We hypothesize that, when arrayed by
quality (from high to low), VC investments will be exited by, in rank order, IPOs, acquisitions, secondary
sales, buybacks, and write-offs (Hypothesis 1).
We also hypothesize that the longer the duration of the VC’s investment, the less the degree of
information asymmetry between firm insiders (including the selling VC) and outsiders (i.e. potential
purchasers of the VC’s interest). We posit a rank ordering of exits arrayed by investment duration (from
high to low) in the following order: IPOs, secondary sales, acquisitions, buybacks, and write-offs
Finally, we hypothesize that technology investments (when compared to non-technology
investments) will be associated with greater information asymmetry between insiders and outsiders, a
greater likelihood of moral hazard problems, higher growth potential, and a greater likelihood that
transaction synergies can be generated by combining the EF with another firm. We posit a rank ordering of
preferred exit vehicles for technology investments as follows: IPOs and acquisitions, secondary sales,
buybacks, write-offs (Hypothesis 3).
We test these hypothesized relationships using multinomial logit methodology, on data derived
from a survey sent to Canadian and U.S. VCs. In our results, we find little support for Hypothesis 2, more
support for Hypothesis 3, and perhaps the strongest support for the central hypothesis of the paper,
We find evidence that exit preferences differ as between Canada and the United States. In
particular, our theoretical framework appears to have more predictive power in the United States. We
suggest that this is due to economic, legal and institutional factors that distort the efficient pattern of exits in
Canada. We also suggest that these various constraints have led to a lower level of VC skill in Canada,
introducing noise into our Canadian data, as well as lower returns to venture capital investing in Canada
relative to the United States.
The paper is organized as follows. In section I we begin with a basic description of alternative exit
vehicles. Section II summarizes a general theory of venture capital exits derived from related work.
Section III enumerates and discusses factors that push toward or away from particular exit choices. This
section supplies the theoretical core of the paper. In section IV we generate the three hypotheses that link
firm quality, investment duration, and the nature of the firm's assets to choice of exit vehicle. Section V
discusses legal, institutional and economic differences that arise between the U.S. and Canadian markets
that impact on the choice of exit. In Section VI, we empirically test the three hypotheses using survey data
collected from Canadian and U.S. VCs. Section VII is the conclusion.
I. EXIT VEHICLES
In general, VCs will exit their investments by one of the following five methods: initial public
offering (IPO), acquisition, buyback, secondary sale, or write-off. In an IPO, the firm embarks upon a sale
of its shares to public investors. The VC will typically not sell all (or even a part of) its shares into the
public market at the date of the public offering, for reasons discussed below. Rather, securities will be sold
into the market (or distributed to investors) over a period of months or even years following the public
offering. Whether the VC sells at the time of the IPO or later, by common convention we denominate IPOs
as a form of exit, since it will precipitate an exit at some point in the future.
Sometimes a VC will exit via an acquisition exit in which the entire firm is purchased by a third
party. There are a variety of means for effecting an acquisition exit, including a sale of shares, a merger, and
sale of the firm’s assets. However the transaction is effected, potential buyers in a strategic acquisition can
assume a variety of identities. In some cases, the purchaser will be another VC. A sale from one VC to
another can be motivated by the relative skill sets of the selling and purchasing VC. The purchaser may be
more familiar with the firm’s technology or markets, for example, than the seller. Such a sale might also be
motivated by differences in the confidence of the two VCs in the future of the firm’s product or technology.
In the majority of cases, however, the purchaser will be a strategic acquiror. A strategic acquiror is a
business entity that is in a business that is the same as, or similar to that of the target firm.
It may be a competitor of the target firm, or a supplier or customer.9 It is typically larger, and often much
See, e.g., VENTURE ECONOMICS , EXITING VENTURE CAPITAL INVESTMENTS (1988).
larger than the target firm. Following the acquisition, it may leave the target firm as a wholly owned
subsidiary or a separate division, in order to preserve the management/entrepreneurial team responsible for
the firm’s past success. Alternatively, it may integrate the company's technology with its own following the
acquisition. In either case, a major motivation for the transaction will often be to meld the target’s products
and/or technology with its own, in order to produce synergistic gains.
This is not to say that a strategic fit exists in every case. Gompers and Lerner’s investigations of
corporate VC funds, for example, demonstrate that the closeness of fit between the corporation’s business
and the target firm varies substantially.10 Corporate VC funds that lack a strategic focus do comparatively
poorly and tend to be wound up sooner than funds with a strong strategic focus. It would be surprising if
the same was not also true for corporate acquirors acquiring other than through an in-house VC fund.
Although references below to strategic acquirors should be understood to encompass variation in closeness
of fit, for analytical purposes we deal mainly with the case of a strategic acquiror with a close fit with the
In an exit effected by way of secondary sale, the VC sells its shares to a third party – again
typically a strategic acquiror, and in some cases another VC. A secondary sale differs from an acquisition
exit in that only the VC sells to a third party; the entrepreneur and other investors 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 a 100% acquisition of the firm at some point in the future.
In a buyback, the entrepreneur and/or firm managers or the company (collectively referred to
simply as "the entrepreneur" below) will repurchase the shares held by the VC. In many cases, the buyback
will be triggered by the exercise of contractual rights taken by the VC at the time of initial investment.
Such rights will often include, for example, the ability to “put” its shares to the entrepreneur after the elapse
of stated periods of time, such as two or five years, the failure to achieve performance targets, or the failure
to go public.
A write-off occurs where the VC walks away from its investment. While a write-off will often
involve the failure of the company, the VC may continue to hold shares in a non-viable or barely profitable
Gompers and Lerner, supra note 4, 95-123.
II. A GENERAL THEORY OF VENTURE CAPITAL EXITS
Elsewhere, we provide a general theory of VC exits. 11 This theory builds on research into the nature
of venture capital investing, which may be summarized as follows. The VC’s special skill set as an investor
is engaged in all three phases of an investment: entry (i.e. investment), building value with a view to exit,
and exit.12 At the point of entry, the VC exercises expert judgment in winnowing the wheat from the chaff.
During the build up phase, the VC is an active, or value-added, or relational investor. The VC intensively
monitors managers and participates in strategic decision-making (including hiring and firing managers).
During this phase, the VC also provides ancillary services to the entrepreneurial EF, such as providing advice
on legal and accounting assistance, identifying other sources of financing or arranging financing, identifying
suppliers and customers, etc. Finally, the VC exercises expert judgment in relation to the exit decision,
determining when and by what means and for what consideration the investment will be exited. In the
build-up (second) and exit (third) stages, the VC lends its reputational capital to the EF. This makes it easier,
for example, for the firm to source high quality professional assistance, source high quality suppliers, and
locate customers. In all three phases (at least with respect to relatively early stage companies), the VC’s
skills are sui generis,13 and are not – at least in the development stages at which VCs invest - replicated by
other types of investors.14
Our general theory begins with a theory of venture capital duration. This theory contains a
number of admittedly unrealistic assumptions and assumes away any differences in the types of exits that the
VC might choose, in order to isolate those elements of the choice of exit that are endogenous to VC
Douglas J. Cumming & Jeffrey G. MacIntosh, Venture Capital Investment Duration in Canada and the
United States, 11 J. MULTI. FIN. MGMT. 445 (2001); see also Douglas J. Cumming & Jeffrey G. MacIntosh,
Economic and Institutional Determinants of Venture Capital Investment Duration, in Gary Libecap, ed., ADVANCES
IN THE STUDY OF ENTREPRENEURSHIP , INNOVATION AND E CONOMIC GROWTH, Vol.13 forthcoming (2002).
See generally Black & Gilson, supra note 1, at 252-255.
See Black & Gilson, supra note 1; Michael Gorman and William Sahlman, What Do Venture Capitalists
Do? (1989) J. BUS. VENTURING 231 (1989); WILLIAM D. BYGRAVE & JEFFREY A. TIMMONS , VENTURE CAPITAL AT THE
CROSSROADS (1992); Josh Lerner, Venture Capitalists and the Oversight of Private Firms, 50 J. FIN. 301 (1995);
Thomas Hellmann & Manju Puri, Venture Capital and the Professionalization of Start-up Firms: Empirical
Evidence, J. FIN. (forthcoming 2002).
The skill sets of merchant bankers and mezzanine financiers overlap those of VCs, but these financiers
typically finance firms in more mature stages of development, and focus more of their efforts on MBO and LBO
financing. They also provide a range of advisory and other services not offered by venture capital firms. The
skill set of angel investors also overlaps with that of VCs, but angels have historically invested prior to VC
involvement. VCs typically will not invest below certain thresholds (e.g. in Canada, typically $500,000 or
$1,000,000 per investment) because there is a significant fixed cost element to investigating new investment
possibilities, generating economies of scale in VC investing. See Jeffrey G. MacIntosh, Venture Capital Exits in
Canada and the United States, in PAUL J.N. HALPERN, ED., FINANCING GROWTH IN CANADA, 279-356 (1997).
investing (and not influenced, for example, by information asymmetries that arise on exit between the VC
and potential buyers of its interest). Once these elements are identified, we relax our assumptions and bring
a variety of “real world” constraints on VC exit to bear, to gain a fuller understanding of the range of
dynamics that drive VC exit choice.
The theory of duration thus assumes that the investment has been made and focuses on the second
element in the VC’s skill set – the ability to add value to the EF by offering managerial and strategic
guidance in addition to a variety of ancillary services. The general insight is that as the duration of the VC’s
investment increases, its ability to add value to the enterprise diminishes. The starting assumptions are:
1. The VC has a unique ability to add value to the enterprise by functioning as an active
investor (i.e. there are no other value-added investors).
2. At any given point in time, the VC’s investment in the firm can be sold to a third party for a
price which represents the best estimate of the true value of the firm (i.e. there is no
3. The exit price is thus not dependent upon the form of exit.
4. The fund has an infinite life span, so that the VC’s choice of when to exit is made
independently of any need to exit investments in order to return both invested capital and
profits to the fund’s investors.
5. The VC can freely re-deploy capital harvested from one investment into other investments.
Under these assumptions (which are relaxed in the analysis and discussion that follows), a VC will
exit from an investment when the projected marginal value added (PMVA) resulting from its stewardship
efforts, at any given point in time, is less than the projected marginal cost (PMC) of these efforts. By
"effort" we mean all of those things that VCs can do to add value to an enterprise. By "cost" we mean all the
direct and overhead costs associated with creating value, as well as the opportunity cost associated with
alternative deployments of capital. By "projected" we mean to suggest that the VC will take into account not
merely present cost and effort, but a summation of all future costs and efforts. By "point in time", we refer
to all of those points in time at which the VC formally or informally reassesses its continued commitment to
an investment, whether quarterly, yearly, or otherwise. We refer to the projected marginal costs of
maintaining the investment as the “maintenance costs”. These relationships are illustrated in Figure I.
[FIGURE I ABOUT HERE]
If, at any given time the maintenance costs exceed the marginal value generated, then the VC will be
better off selling the investment to a third party (or parties). That way, it can maximally exploit its
comparative advantage over other investors – i.e. its ability to create value by actively managing each firm
within its portfolio.
In this general theory of investment duration, we suggest that an exit will generally be precipitated
by one of three different types of events.
1. The marginal value and maintenance cost curves cross: the exhaustion of the VC’s skill set
We posit that VC value added will decline over time until it is equal to or less than maintenance
costs. VC value added will be greatest at the start of the investment relationship, when the VC is most likely
to be able to bring managerial and financial discipline to the enterprise, help identify and implement product
development strategies, identify legal, accounting and marketing expertise, and so on. However, the ability to
add value will decline over time as the firm matures, management becomes more seasoned, the most
pressing product development and marketing issues have been worked out, and the firm’s various business
contacts (including legal, accounting, investment banking, marketing channels, suppliers, and customers)
have been put in place.
We also posit that maintenance costs will decrease over time. That is, the effort expended by the
VC will be front-end loaded, for the reasons given in the preceding paragraph.
Finally, we posit that maintenance costs contain a significant fixed cost element, since the VC must
perform some baseline level of monitoring in respect of each of its investments, whether in need of active
management or not. Thus, the maintenance costs curve will decline more slowly than the marginal value
curve. Thus, at some point in time the two functions will cross, at which point the VC will be unable to add
further value to the enterprise, and will exit the investment.
2. Internal or external shocks change the location of the marginal value added and/or
maintenance cost curves
A variety of internal or external shocks (both systematic and unsystematic in nature) can shift either
the marginal value added curve, the maintenance costs curve, or both, causing the exit criterion to be
satisfied. For example, if the firm’s technology proves unworkable, this will presumably relocate the
marginal value added curve. Other events that might relocate either or both of the curves include: the
firm’s technology is rendered obsolete by external technological developments; the firm’s product is
displaced in the market by those of competitors; a recession dries up demand for the firm’s product;
complementary technological developments in the marketplace greatly increase the value of the firm’s
3. The VC receives new information about the location of the marginal value or maintenance
Upon entering into an investment, the VC will, at least at an intuitive level, draw marginal value
added and maintenance cost curves. These curves may subsequently be revealed to have been drawn
incorrectly. For example, the maintenance cost curve may have to be re-drawn because the entrepreneur
turns out to be far more difficult to work with than originally forecast. Once re-drawn, the curves may
intersect at a new location, causing the exit condition to be satisfied. The effect of re-drawing either or both
curves is illustrated in Figure I.
III. Exceptions to the General Theory: Factors Affecting the Venture Capitalist’s Timing of Exit and
Choice of Exit Vehicle
The general theory of venture capital exits described above is based on a number of unrealistic
assumptions. For example, at any given point in time, it is likely that there will be a host of potential value-
added investors other than the VC. Foremost among these is the strategic acquiror. A strategic acquiror – a
firm in the same or similar business – will often have unique abilities to resolve information asymmetries
between managers and investors, and to monitor the investment. If so, that strategic acquiror will place a
higher value on the assets than the VC. 15 In such a case, maintaining the investment rather than selling it to
the strategic acquiror results in an opportunity cost for the VC. Acting rationally, the VC will sell the
Research by Gompers & Lerner supports the view that strategic acquirors are better able to select
investments and to provide value-added services. They find that corporate VC funds with a strong strategic focus
(which are in essence a type of strategic acquiror) perform both the screening and monitoring functions better than
private funds. See Gompers & Lerner, supra note 4, at 95-123.
investment, even if the value-added that the VC can generate exceeds the investment’s maintenance costs.
Similarly, severe information asymmetries arise at the time of exit, as between the selling VC and
whomever purchases the VC’s interest. These information asymmetries will affect the timing of exit, the
choice of exit vehicle, and the proceeds that result from exit.
Thus, the general theory must yield to a set of exceptions (based on real world constraints) that we
posit are the key determinants of the VC’s choice of when, and by what means, it will exit a particular
investment. These are enumerated and discussed in this section, and summarized in Table I.
These exceptions are all tied together by a single thread. All of them impact in one way or another
on the VC’s exit value. Under the assumption that the VC will generally choose the timing and form of exit
that will maximize the proceeds of exit, examination of the exceptions helps to illuminate why VCs exit their
investments as they do.
[TABLE I ABOUT HERE]
A. Ability of the New Owners to Resolve Information Asymmetry and Value the Firm
When the time comes for the VC to exit, the degree of information asymmetry between firm
insiders and outsiders will be less severe than when the VC initially invested in the firm. Older firms
that have benefited from VC guidance will tend to have a proven product, an established market,
relatively experienced management, and more elaborate internal control and information systems than
when the VC's first investment was made. This will attenuate many of the risks that confront investors in
the earlier stages of the firm's existence.16
Nonetheless, the degree of information asymmetry may still be significant, especially when
compared with that of a typical public company. A public company will have a lengthier operating history,
resulting in the production of a stream of publicly available issuer-specific information. In addition to the
beefier information record resulting from mandatory disclosure, public companies attract the private
information gathering activities of both buy-side (i.e. institutional) and sell-side (i.e. brokerage) analysts.
Even if held privately, this information will work its way into the share price, reducing the risk that buyers
Sahlman, supra note 7. See also Jeffrey G. MacIntosh, Legal and Institutional Barriers to Financing
Innovative Enterprise in Canada, monograph prepared for the Government and Competitiveness Project, School
of Policy Studies, Queen's University, Discussion Paper 94-10 (1994).
will make investment mistakes.17 Lacking the informational base resulting from the operation of
mandatory disclosure and private information gathering activities, the securities or private firms are
inherently subject to an information discount reflecting the comparative paucity of information.
The severity of the information asymmetry confronting the firm will be a factor in the choice of exit,
because it will influence the willingness of a variety of potential buyers to pay for the VC’s interest. In
investing, what you don’t know can hurt you. The lower the quantum and quality of information concerning
the EF, the higher the information discount.
This means that those potential buyers (“new owners”) who are best able to overcome these
information asymmetries will tend to be the highest valuing purchasers. Since different forms of exit result
in sales to a heterogeneous variety of buyers possessing differing abilities to resolve information
asymmetries, the existence and magnitude of information asymmetry associated with the EF will influence
the VC’s choice of exit.
IPOs involve the sale of shares of a company to public investors, typically (but not always)
accompanied by a listing on a stock exchange. We hypothesize that this form of exit will be
accompanied by the greatest information asymmetry between the firm and its new owners. Historically,
about three-quarters of all VC investments have been in high technology companies, and this has risen to
about 90% in recent years.18 High technology firms are the most likely to be characterized by severe
information asymmetries, particularly when the firm’s technology is novel.19 There will thus be a
significant difference in willingness to pay between sophisticated investors (i.e. those with the ability to
resolve information asymmetries) and unsophisticated investors.
We posit that public investors are relatively unsophisticated.20 While all but the smallest IPOs are
See generally Ronald J. Gilson and Reinier J. Kraakman, The Mechanisms of Market Efficiency, 70 VA.
L. REV. 549 (1984); Avner Arbel, Giraffes, Institutions, and Neglected Firms, F. ANAL. J. 57 (May-June 1983).
CANADIAN VENTURE CAPITAL ASSOCIATION, VENTURE CAPITAL IN CANADA: ANNUAL STATISTICAL REVIEWS
1993-2001; VENTURE ECONOMICS, VENTURE CAPITAL ANNUAL REVIEWS 1993-1996; Gompers & Lerner, supra note 4.
See infra, Part IV, C.
Thomas Chemmanur & Paolo Fulghieri, Information Production, Private Equity Financing, and the
Going Public Decision, Columbia University, mimeo (1994).
sold mainly to institutional investors, institutional money managers do not possess a high degree of
expertise in evaluating any particular technology. Moreover, public buyers suffer from well-known
collective action problems resulting from the relatively high degree of dispersion of share holdings.
Because share ownership is atomized, each owner has an incentive to allow other shareholders to gather
information.21 Attempts to spread the cost of information gathering by pooling resources are also
characterized by free rider problems. By contrast, as discussed below, exits via acquisitions, secondary
sales, and buybacks all result in considerable concentration in post-exit shareholdings, mitigating free rider
The standard answer to the comparative lack of sophistication of public buyers is that the skill and
knowledge deficit is abridged by investment bankers, lawyers, accountants, and other market professionals.
These individuals gather and process information concerning the IPO firm and ensure that the new issue is
correctly priced. Because they are repeat players in capital markets, their reputations are at stake with
respect to every new issue brought to market. Thus, they have an incentive to price new issues
The certification role played by investment intermediaries has been empirically documented. The
more reputable the investment banker associated with a new issue, for example, the lower the degree of
short-term underpricing of the issue (i.e. the more potent the signal of quality, hence the lesser the need to
underprice to attract purchasers).22 Similarly, the better the reputation of the firm’s accountants, the lower
the degree of underpricing.23
The certification role extends to VCs as well. VC-backed firms (i.e. those that have had VC
involvement prior to going public) also exhibit a lesser degree of short-term underpricing.24 VCs are able to
ADOLF A. BERLE & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY , revised edition
(New York: Harcourt, Brace and World, Inc., 1967); Bernard S. Black, The Value of Institutional Investor
Monitoring: The Empirical Evidence, 39 U.C.L.A. LAW REV. 986 (1992)
Megginson & Weiss, supra note 5.
See, e.g., Richard B. Carter, Frederick H. Dark, and Alan K. Singh, Underwriter Reputation, Initial
Returns, and the Long-Run Performance of IPO Stocks, 53 J. FIN. 285 (1998).
Megginson & Weiss, supra note 5.
bring firms to the public market sooner than non-VC-backed firms, 25 with lower ratios of revenues to
assets,26 and with less established earnings records.27 Moreover, the older the VC firm, and hence the
greater its reputation, the lower the degree of short-term underpricing.28 This evidence is all consistent with
the certificatory role played by VCs in public market offerings, and the proposition that the better the VC’s
reputation, the more potent the signal of quality.
Problems of information asymmetry are also partly addressed by VC ownership retention. As
explored further in Part III F, VCs do not typically sell their shares at the time of the IPO. Ownership
retention conveys a signal of quality to the market in addition to providing an assurance that the VC will
continue to monitor management post-IPO. Ownership retention and VC reputation are at least partly
substitutable, so that sales by VCs with established reputations do not affect the offering price as adversely
as sales by VCs lacking good reputations.29
Despite this evidence, we hew to our assertion that information asymmetry is highest in the case of
IPOs. Buyers in IPOs mostly rely on market intermediaries to price a new issue appropriately. By contrast,
in an acquisition exit, a secondary sale, or a buyback, the purchaser will have direct access to firm
information in addition to a degree of sophistication at least matching that of the most sophisticated market
intermediaries. In an acquisition exit or a secondary sale, the new owner will typically be a strategic
acquiror - a firm in the same or a similar line of business that will often seek to meld the firm’s
technology with its own. It will possess a keen understanding of the firm’s technology and its potential
marketability. In a buyback, the purchaser will be the entrepreneur, who is obviously well situated to
resolve information asymmetries (although will perhaps lack the ability of the strategic acquiror to
evaluate the information30).
We also note that, while investment bankers clearly play an important role in accurately pricing a
new issue, like institutional money managers, they tend to be generalists (although in the U.S. there are a
Megginson & Weiss, Id.; Timothy H. Lin and Richard L. Smith. Insider Reputation and Selling
Decisions: The Unwinding of Venture Capital Investments During Equity IPOs, 4 J. CORP. FIN. 241 (1998).
Megginson & Weiss, Id.; Lin & Smith, Id.
Barry et al., supra note 5.
Gompers, Grandstanding in the Venture Capital Industry, supra note 7.
Lin & Smith, supra note 25.
See infra, note 36 and accompany text.
variety of highly specialized technology underwriters).31 Because of this, they rely heavily on their
technology analysts both in determining whether to underwrite a particular offering and in pricing the
offering. Despite their specialized skills, these analysts are unlikely to be able to replicate the knowledge
and experience of a strategic acquiror or the firm’s insiders.
Even an experienced VC may lack the acumen of a strategic acquiror in valuing the firm, although
it may possess an evaluative capability superior to the entrepreneur effecting a buyback. Daines and
Klausner present direct evidence that VCs fail to maximize the value of the firm when it goes public.32 The
find that firms with VC involvement are just are likely to adopt value-reducing anti-takeover provisions as
firms without VC involvement.
Moreover, evidence relating to the reduction of short-term underpricing in the presence of reputable
market intermediaries (including VCs) is not evidence that information asymmetries are fully resolved.
Short-term underpricing is the market’s reaction to information asymmetry. While the presence of
reputable market intermediaries reduces IPO underpricing, it does not eliminate it. While admittedly we
cannot directly observe (and hence compare) discounting in private companies to reflect information risk,
underpricing even with expert intermediaries remains substantial.33
For this reason, in Table 1 we rank the comparative ability of public markets to resolve information
asymmetries as somewhat disfavouring an exit via a public offering.
As noted, in a sale of the entire firm to a third party, the buyer will often be a strategic acquiror. A
strategic acquiror will usually be a large company in the same or similar business as the purchased firm,
either as competitor, supplier, or customer, and will often integrate the company's technology with its own
Almost all underwriters in Canada are generalists. Even Yorkton securities, the investment banker with
perhaps the best claim to be a technology boutique, still does approximately 30% of its business in traditional
industries. Moreover, it does not specialize in any one segment of the technology market. By contrast, in the
United States, boutique underwriters such as Hambrecht and Quist and Robertson, Stephens and Co. focus entirely
on technology offerings, and even particular types of firms in the technology spectrum.
Robert Daines and Michael Klausner, Do IPO Charters Maximize Firm Value? Antitakeover Provisions
in IPOs, J, LAW, ECON., & ORG. (forthcoming) (2002).
Megginson & Weiss, supra note 5.
following the acquisition.34 That strategic acquirors are usually the same or a closely related business to
the acquired firm is not merely accidental. Just as VCs are specialists at resolving information asymmetries
in the earlier stages of investing, so strategic acquirors, by virtue of their understanding of the firm’s market
sector and their ability to evaluate the firm’s technology, are expert evaluators of the firm’s business.
Because of its bargaining power, a strategic acquiror will be able to demand and receive access to inside
information about the firm (and better access than in connection with a secondary sale). Thus, in Table 1,
we rank the ability of strategic acquirors to resolve information asymmetries as strongly favouring the
Purchasers in secondary sales are usually strategic acquirors. However, the purchaser of a secondary
block will usually lack the bargaining power of a 100% acquiror to obtain inside information. Clearly, there
will be a great deal of fact-dependency. If the vendor is selling a majority or controlling block, it will usually
have access to inside information that can be provided to potential purchasers. If a minority is being sold,
the situation is more parlous; the VC may not be able to count on the support of the board in obtaining and
using corporate information to sell its interest. More than likely, however, no secondary purchaser would
consider buying into an enterprise without the support of the entrepreneur and the other owners. Where this
is the case, the information flow may be comparable to a situation in which a controlling interest is being
Nonetheless, because there will be cases in which access to information will be restricted, the
comparative inability of a secondary purchaser to resolve information asymmetries and value the firm is
ranked as slightly disfavouring a secondary sale.
Whether the corporation or a group of insiders actually purchase the VC's shares, the entrepreneur-
insiders are the true buyers. For obvious reasons, the problem of access to information disappears. The
insiders know as much or more about the enterprise than anyone else. They clearly have better knowledge of
their own activities (and proclivities) than anyone else.
Supra, note 9 and accompanying text.
It is more than simply access to information that is important in valuing an enterprise, however.
Evaluative skill is also important. Because of lack of business savvy, experience, financial acumen, or
market knowledge, the entrepreneur may not be as capable of evaluating information as a VC or even
knowledgeable outsiders. For this reason, the problem of information asymmetry may persist even in the
face of unfettered access to firm information. Nonetheless, we suggest that the entrepreneur’s access to
information greatly attenuates the problem of information asymmetry, substantially reducing valuation risk.
A complete analysis of the ability to overcome information asymmetries cannot, however, ignore a
constituent that will usually play a major “ownership” role following a buyback –the firm’s lenders. A
buyback will typically involve substantial borrowing to retire the VC’s shares. The post-buyout firm will
thus be re-capitalized with a much higher level of debt than prior to the VC exit. The effect of information
asymmetry on the debt holders will be substantial. Banking officers who oversee the administration of
commercial lending facilities are generalists who rarely possess the ability to effectively evaluate high
technology (and/or high growth) companies.35 Perhaps more importantly, lending officers have evaluative
abilities that are grossly inferior to those of VCs. Acting rationally, they will discount their ability to place
an accurate valuation of the enterprise. The result will either be that credit is made unavailable, or made
available only at premium prices.
Moreover, commercial lending has traditionally been based on the ability to take security over
tangible assets, which are often scarce in high tech businesses.36 It is true that a few banks have focused on
lending to high growth companies (sometimes, as in the case of the Silicon Valley Bank, in partnership with
VCs). Some mainstream banks have opened specialty-lending branches that cater to technology
businesses.37 These banks are willing to lend against receivables, and do not require tangible assets.
Nonetheless, in many geographic locales such cutting-edge lending is not available. Even when it is, it will
be restricted to firms with sufficiently generous cash flow to service regular interest payments and periodic
repayments of principal. If a firm does not have such cash flow, then the likelihood of securing debt
financing to retire the VC’s shares will be remote.
Jeffrey G. MacIntosh, The Banks and Innovative Enterprise: Opportunities and Constraints, in RICHARD J.
BRAUDO AND JEFFREY G. MACINTOSH, EDS., COMPETITIVE INDUSTRIAL DEVELOPMENT IN THE AGE OF INFORMATION (1999).
See Paul A. Toriel, The Role of Banks in the Financing of Knowledge-based SMEs, in RICHARD J. BRAUDO
AND JEFFREY G. MACINTOSH, EDS., COMPETITIVE INDUSTRIAL DEVELOPMENT IN THE AGE OF INFORMATION (1999) at 156.
Banks like the Silicon Valley Bank of California, which essentially partner with a VC to overcome these
evaluatory deficiencies, are still the exception.
Merchant bankers, mezzanine financiers, and leveraged buyout specialists clearly possess a much
higher level of sophistication in evaluating and monitoring their investments. However, such lenders favour
companies both with cash flow and at least moderate growth prospects. They are very unlikely to lend to
living dead or lifestyle investments, which we argue elsewhere in this paper make up the great bulk of share
buybacks. Moreover, such lenders lack the technology focus of VCs, and will in general possess inferior
evaluative capabilities in relation to the types of firms that VCs invest in. In addition, merchant bankers,
mezzanine financiers, and leveraged buyout specialists focus their attention on companies that are much
larger than the typical buyback firm.
Even when cash flow exists, debtholders will be concerned that the concentration of equity holdings
in the hands of a small number of insiders will furnish the equity holders with a greater incentive to
appropriate wealth from the debt holders, leading to a higher agency cost of debt. 38 Agency costs are
enhanced by information asymmetry,39 leading to an even lower post-buyout firm valuation, and hence a
lower exit price.
Thus, our entry in Table 1 for the effect of information asymmetry on the ability of the new owners
to resolve information asymmetries and value the firm shows separate entries for equity and debt. The new
equity holders will be highly capable of resolving information asymmetries, while the new debt holders will
do so with great difficulty.
B. Ability of New Owners to Monitor the Investment Post-Exit and Discipline the Managers
The willingness of potential new owners to pay to acquire the VC’s interest (or the entire firm) will
depend on the degree to which the new owners are capable of mitigating managerial agency costs.40 The
higher the prospective agency costs, the lower the firm’s valuation by prospective investors, 41 and the lower
the VC’s exit value.
AMIR BARNEA, ROBERT A. HAUGEN AND LEMMA W. SENBET, AGENCY PROBLEMS AND FINANCIAL CONTRACTING
(1985); Paul J. Halpern, Michael Trebilcock, and Stuart Turnbull, An Economic Analysis of Limited Liability in
Corporation Law 30 U. TOR. L. J. 117. (1980).
Barnea et al., Id.
Michael H. Jensen & William H. Meckling, Theory of the Firm, Managerial Behaviour, Agency Costs
and Ownership Structure, 3 J. FIN. ECON. 305 (1976).
The ability to resolve information asymmetry is closely connected with monitoring capability.
Knowledgeable buyers who can critically evaluate the information they receive from management can better
determine when the managers are not performing adequately (i.e. can more readily recognize moral hazard
The ability of the buyer(s) to monitor managers will also depend not only on the identity of post-exit
shareholders and their ability to resolve information asymmetries, in addition to the post-exit configuration
of shareholdings – and in particular whether there are significant block holders and/or controlling
shareholders. In general, managers will be disciplined more effectively by a controlling (and non-
managerial) shareholder than by an unrelated group of small shareholders.42
While information asymmetry is mitigated at the IPO stage by the certificatory force of professional
and VC participation, the involvement of these parties either terminates or is attenuated following the IPO.
The investment bank and the firm’s lawyers will conduct intensive due diligence at the time of the offering,
but, barring a major follow-on corporate transaction, will exercise a much lighter hand following the IPO.
The auditors will perform an annual audit, but this does not distinguish the IPO from any other form of exit,
given that most private companies in which VCs invest will also perform an audit.
While VCs usually retain significant post-IPO ownership interests, and often retain a board seat,43
their ability to monitor will be impaired following the IPO. The VC’s ability to supply useful monitoring is
limited by its skill set; VC investors specialize in bringing fledgling private companies to maturity, and then
exiting. The skill set associated with providing useful guidance to a public company clearly contains
overlapping elements, but is sufficiently distinct that great expertise in the former does not guarantee great
expertise in the latter.
The VC’s ability to monitor is also reduced by the disappearance of the VC’s pre-IPO contractual
Black, supra note 21; Ronald J. Gilson & Reinier J. Kraakman, Reinventing the Outside Director: An
Agenda for Institutional Investors, 43 STAN. L. REV. 863 (1991); John C. Coffee, Jr., Liquidity Versus Control: The
Institutional Investor as Corporate Monitor, 91 COL. L. REV. 1277 (1991); Bernard S. Black and John C. Coffee, Hail
Britannia?: Institutional Investor Behaviour Under Limited Regulation, 92 Mich. L. Rev. 1997 (1994); Jeffrey G.
MacIntosh, The Role of Institutional and Retail Shareholders in Canadian Capital Markets, 31 OSGOODE HALL L.J. 371
(1993); Jeffrey G. MacIntosh & Larry Schwartz, Do Institutional and Controlling Shareholders Increase Corporate
Value?, in RONALD J. DANIELS & RANDALL MORCK, EDS., CORPORATE DECISION-MAKING IN CANADA (1995) 303.
Lin & Smith, supra note 25.
levers, such as the entitlement to be on the board of directors and a veto power over board decisions.44
The VC’s incentive to monitor on a going-forward basis will also be impaired by its reduced
shareholdings45 and the availability of a market exit option.46 This option is not available prior to an IPO –
thus enhancing the comparative attractiveness of exit over voice. The VC’s incentives to monitor will also be
reduced to the extent that stock market analysts will also supply monitoring services. 47 Moreover, the VC
will not anticipate being a long-term investor (i.e. it will reduce and ultimately liquidate its holdings in the
firm, usually prior to the elapse of three years following the IPO48) reducing its incentive to participate in
long term strategic decision-making.
Thus, the impact of shareholder collective action and free rider problems will be more profound
following, than at the time of the public offering.49 These well known problems will adversely affect the
value of the enterprise at the time of the IPO, and hence the price that the public market is willing to pay for
shares in the company.
Skilful underwriters and legal counsel will create governance mechanisms that will combine
restraints and incentives to reduce managerial agency costs post-exit. These may include, for example,
providing for the election of a majority of independent directors, restricting those transactions that may be
consummated without shareholder approval, creating incentive compensation arrangements, and opting out
of anti-takeover provisions in the statute of incorporation.50 Such measures may also include not adopting
value-reducing charter restraints such as cumulative voting and other anti-takeover measures.51 However, it
is clear that none of these restraints operate seamlessly. For example, the empirical link between the
Black & Gilson, supra note 1, at 261.
Id. at 260.
See Part III F.
See generally Lucian Bebchuk, Federalism and the Corporation: The Desirable Limits on State
Competition in Corporate Law, 102 HARV. L. REV. 1435 (1992).
Daines & Klausner, supra note 32.
percentage of independent directors and firm value is tenuous.52 Creating charter restrictions on
managerial activity, or incorporating in states with strict fiduciary duties in order to curb opportunism may
actually reduce firm value.53 Incentive compensation schemes enhance managerial incentives, but
Daines and Klausner produce empirical evidence that charter restrictions crafted at the IPO stage are
frequently sub-optimal.55 An overwhelming majority of VC-backed firms in their sample adopted some
form of anti-takeover protection (“ATP”), and many of these adopted the most virulent forms of ATP.
Daines and Klausner empirically reject possible efficiency explanations for the inclusion of ATP in IPO
firms. They also produce empirical evidence that the presence of a VC does not materially alter the
probability of that the IPO firm will adopt takeover protection.
Even with optimal charter provisions (and underlying statutory law, embodied in the corporate code
of the jurisdiction of incorporation),56 collective action and free rider problems remain. These problems are
addressed, but far from perfectly remediated by the presence of institutional investors, whose more
substantial shareholding interests create a heightened incentive to monitor. 57 A variety of legal and economic
factors blunt institutional oversight, such as cooption of institutional investors by corporate managements. 58
The empirical link between institutional shareholder activism is still tenuous.59
Sanjai Bhagat & Bernard Black, 2000, Board Independence and Long Term Firm Performance,
Columbia Law School, The Center for Law and Economic Studies, February, 2000; download available at
Roberta Romano, Law as a Product: Some Pieces of the Incorporation Puzzle, 1 J. LAW, ECON. & ORG.
225 (1985); Robert B. Daines, Does Delaware Law Improve Firm Value? J. FIN. ECON. (forthcoming) (2002).
Michael C. Jensen & Kevin J. Murphy, Performance Pay and Top Management Incentives, 98 J. POL. ECON.
225 (1990); Jeffrey G. MacIntosh, Executive Compensation: The Importance of Context, in VALUE FOR
MONEY:EXECUTIVE COMPENSATION IN THE 1990s (1996).
Daines & Klausner, supra note 32.
ATPs, for example, may be found in the IPO firm’s charter, or furnished by the corporate code in the
firm’s state of incorporation. Thus, ATP may be adopted by the appropriate choice of jurisdiction of
Black, supra note 21.
See Coffee, supra note 42; Black & Coffee, supra note 42, Edward Rock, The Logic and (Uncertain)
Significance of Institutional Shareholder Activism, 79 GEO. L. REV. 445 (1991), and MacIntosh, supra note 42,
for a theoretical and practical discussion of the shortcomings of institutional oversight.
Another factor tending to the remediation of agency costs is that an IPO generally involves the sale
of a minority interest to public investors,60 leaving a controlling shareholder or coalition of shareholders in
place.61 The existence of a controlling shareholder(s) will result in enhanced discipline of managers, because
the controlling parties will possess the unilateral power to discipline the managers. The extent of this
discipline, however, will depend on whether control is split between a variety of shareholders, in addition to
the identity of the controlling shareholder(s).62 Following the IPO, control will often reside not in a single
shareholder, but in a coalition of shareholders.63 The control coalition may be subject to coordination,
collective action and defection problems.
Perhaps more importantly, the managers themselves will usually form a significant part of the
controlling coalition,64 or may indeed control the firm themselves.65 This may exacerbate, rather than
ameliorate agency problems.66 While the empirical evidence is not entirely consistent, it appears that there is
no simple linear relationship between managerial share ownership and firm value. For example, one
frequently cited study suggests that as managerial ownership increases, the value of the firm rises, falls, and
then rises again.67 Another suggests that it rises, levels off, and then decreases.68 In both cases, the studies
Following a typical offering, only about 30 per cent of the shares will be in the public float. Gompers &
Lerner, supra note 4, at 272; Daines & Klausner, supra note 32.
Barry et al., supra note 5 at 491 (Table 6), found that following an IPO, the holdings of all venture
capital investors had a mean of 24.6% and a median of 22.6% of the firm’s shares. They also found that prior to
the IPO, VCs in the aggregate held (on average) one-third of all board seats, and that they mostly continued to
hold their board seats following the IPO. The findings of Daines & Klausner, supra note 32, are broadly similar.
They find that following an IPO, VC investors had a mean of 37.5 percent of the firm’s equity, and the top five
managers 18.9%. The total post-IPO director and officer holdings were 45.4%. However, Gompers & Lerner
found that employees and management on average retained only between about seven and 12% of the equity of
firms going public; see Gompers & Lerner, supra note 4, at 224. See also Marco Pagano, Fabio Panetta, & Luigi
Zingales, Why Do Companies Go Public? An Empirical Analysis, 53 J. FIN. 27 (1998).
See infra, Part III G.
Supra note 38.
Randall K. Morck, Andrei Shleifer & Robert W. Vishny, Management Ownership and Market Valuation,
20 J. FIN. ECON. 293 (1998)
John J. McConnell & Henri Servaes, Additional Evidence on Equity Ownership and Corporate Value, 27
J. FIN. ECON. 595 (1990).
suggest that the enhanced alignment of managerial and shareholder interests that is created by increasing
managerial share ownership is offset by management’s ability to entrench itself in power.
In addition, a consistent finding in the finance literature is that, on average, firm profitability falls
following an IPO.69 While this finding cannot unambiguously be attributed to monitoring problems (it may
extend, for example, from reduced managerial incentives resulting from reduced managerial shareholdings 70),
it is certainly suggestive. In Table 1, we thus suggest that the ability of new owners to monitor and
discipline the managers will either slightly or strongly disfavour the use of an IPO exit.
In an acquisition exit, the acquiror obtains 100% of the equity of the firm. Thus, it has both the
incentive, and the ability (through its control of the board, and the ability to pass shareholder resolutions) to
monitor the managers closely. In Table 1, we thus suggest that the strategic acquiror’s heightened ability to
monitor and discipline management favours an acquisition exit.
Purchasers in secondary sales will usually be strategic acquirors (and sometimes venture capitalists).
These entities have a high level of sophistication in evaluating high growth companies. Nonetheless, they
will not have the same ability to monitor and discipline the managers as in the case of a 100% acquisition.
Very often, the vendor will be a minority shareholder. Hence the buyer will not acquire either de jure or de
facto control of the board. This removes from the acquiror’s control a variety of informational, investigative
and disciplinary tools that are available to a controlling shareholder or single owner. For example, a
minority shareholder has no formal access to directors’ meetings or the minutes of such meetings. A
minority shareholder will have limited ability to investigate the performance of management, absent the
cooperation of the controlling shareholders. A minority shareholder will be unable, by itself, to remove
management. Depending on the size of its holding, a minority shareholder may also lack a power of
negative control; that is, the power to block resolutions requiring supra-majority confirmation.
Pagano et al., supra note 61; Francois Degeorge & Richard Zeckhauser, The Reverse LBO Decision and
Firm Performance: Theory and Evidence, 48 J. FIN. 1323 (1993); Bharat A. Jain & Omesh Kini, The Post-Issue
Operating Performance of IPO Firms, 49 J. FIN. 1699 (1994); Wayne H. Mikkelson, Megan Partch, & Ken Shah,
Ownership and Operating Performance of Companies that Go Public, 44 J. FIN. ECON. 281 (1997).
An offset will be an enhanced ability to craft compensation arrangements. See infra, section III.G.1.
Added to this, a non-controlling VC will have carefully nurtured a relationship with the
entrepreneur and other shareholders. In a successful venture capital investment, the VC will seldom if ever
have to resort to its formal powers as a shareholder or director; it will exercise informal powers of persuasion
by virtue of its amicable relationship with the entrepreneur. This relationship will ensure that powers not
formally granted to the VC will nonetheless be available informally, such as access to information and
management’s ear on matters of policy and management.
By contrast, the purchaser of the VC's shares will have no pre-existing relationship with the firm’s
non-selling shareholders. It will thus not - at least immediately - have the same leverage over management
as the departing VC. Even if it negotiates a contractual novation of the selling VC’s levers over management,
such as the power to veto board decisions, it will not immediately command the same informal persuasive
powers as the departing VC (although the VC may be departing either because it failed to negotiate suitable
contractual levers, or was dissatisfied with its ability to exercise informal powers of persuasion over the
These factors account for the buyer’s usual preference for a 100% acquisition rather than a secondary
purchase of the VC's shares alone. Thus, in Table 1, we suggest that monitoring and disciplinary
considerations operate to slightly or strongly disfavour a secondary sale.
On its face, the buyback gives the firm’s new owners both the incentive and the ability to monitor
managers, because the new equity owners are the managers. This greatly attenuates the agency costs of
equity and creates a potent incentive for the entrepreneur/managers to manage the firm’s assets profitably.
Further, the entrepreneur and/or firm will usually have to borrow money to purchase the VC'S
shares, substantially enhancing the debtload. High levels of fixed payments of interest and principal act as a
discipline on management.71
However, a complete analysis of the new owners’ monitoring capabilities cannot ignore a number of
additional factors. One is that the buyback jettisons a specialized monitor (the VC), and substitutes a non-
specialized and much less skilled monitor – the firm’s banker. As noted earlier, commercial banking officers
Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 AMER. ECON.
REV. 323 (1986).
have limited skill in monitoring their debtor companies.72 This may allow the entrepreneur to indulge a
taste for leisure in a manner that she was unable to do while the VC was on board. Indeed, anecdotal
evidence accumulated from our discussions with VCs suggests that a buyback often evidences a fundamental
breakdown in the entrepreneur/VC relationship. A buyback is frequently triggered by the VC pursuant to put
rights reserved in the original deal documentation.73 It will typically exercise such rights when it is of the
view that the investment no longer has significant upside potential. The underlying cause may purely be a
function of the nature of the firm’s technology and the market in which it competes, but it may also be a
function of the differing preferences of the entrepreneur and VC. Post-buyback, the entrepreneur may be in a
position to indulge a taste for leisure in a way that she was unable to do when the company had active
minority investors. Put somewhat differently, she may be less interested in becoming fabulously wealthy
than in running a "lifestyle" company; i.e. one that furnishes profits that are adequate to pay the interest on
the firm's debt and provide a reasonable return without the extraordinary commitment generally demanded
by a VC. Needless to say, the VC’s preference is quite different; a VC seeks to groom the firm for a “home
run” – a huge upside payoff. The occurrence of a buyback is evidence that the entrepreneur’s and VC’s
objective functions have parted company, perhaps because the VC initially failed to appreciate the
entrepreneur's work/leisure preferences. If so, the managers may be less motivated after the buyout than
The departure of the VC may not be the end of external monitoring, however. Other VCs may
retain their interests. There may be a variety of other active investors, including angel investors. When VCs,
angels or other active investors remain on board, the entrepreneur’s ability to indulge a leisure preference
will be constrained. Alternatively, if some active investors remain aboard, but they are less demanding than
the departing VC, the buyback may constitute a middle ground between a VC-dominated firm (in which the
leisure preference is constrained) and an independent, management-owned firm (in which it is not).
A buyback exchanges equity for debt financing. Because the firm’s debt/equity ratio will be high
following the buyback, it is important to examine the governance properties of debt in addition to equity.
We suggested earlier that the ability of debt financiers to monitor and discipline the managers will be no
better than their ability to resolve information asymmetries and value the firm.74
Supra notes 35-39 and accompanying text.
Barry et al., supra note 5.
Thus, we suggest in Table 1 that the governance properties of equity strongly favor a
buyback, while the governance properties of debt strongly disfavor a buyback.
Public markets are characterized by well-known collective action and free rider problems,
exacerbating agency problems. By contrast, following an acquisition exit, the purchaser possesses both
the incentive and the means to monitor and discipline management. We thus suggest in Table 1 that the
post-exit governance properties attending an acquisition exit will favor an acquisition, while slightly or
strongly disfavoring an IPO, as compared to other means of exit.
In a secondary sale, the identity of a significant blockholder changes. We suggest that, lacking
the VC’s long-standing relationship to the entrepreneur, it will be comparatively more difficult for the
buyer to use its blockholding to effectively monitor and discipline managers. We thus suggest that
governance issues slightly or strongly disfavor a secondary sale.
Buybacks present a more difficult case. A buyback essentially eliminates information
asymmetries and concentrates equity ownership in the hands of the managers, providing the managers
good incentives to lower agency costs. Moreover, the buyback typically involves adding significantly to
the firm’s debt burden, which operates as a discipline on management. However, we also suggest that
specialty lenders like merchant bankers, mezzanine financiers, and LBO specialists will be unlikely to
supply debt financing, leaving commercial banks as the most likely source of additional debt. However,
commercial lending officers are neither specialized nor highly skilled monitors. Moreover, banks are in
the business of making low-risk loans to borrowers that have either tangible assets or receivables as
collateral, and unless the firm is a cash cow, it may be expensive or impossible to secure debt financing
to replace the VC’s equity. Added to this, the concentration of equity holdings increases the agency costs
of debt. Thus, on balance, the governance properties of a buyback neither favor nor disfavor a buyback.
C. Black and Gilson’s Implicit Contract Theory
In a very interesting paper, Black and Gilson75 show IPOs facilitate an implicit contract of
transferring control back to the entrepreneur. This is also true in the case of buybacks, where the
entrepreneur repurchases the venture capitalist’s interest. In an acquisition exits, however, the entrepreneur
Supra, note 1.
does not regain control, suggesting that acquisitions may be a less attractive exit vehicle from the
perspective of an entrepreneur. Transfer of control is indeterminate in the case of secondary sale exits.
D. The Transaction Costs of Effecting a Sale of the VC’s Interest
The transaction costs of effecting a sale of the VC’s shares will be a factor that influences the exit
price. Whether the seller or the buyer bears the burden in the first instance, all transaction costs will be
passed back to the seller, since they either diminish the value of what is being sold, or increase the buyer’s
purchase price. Thus, higher transaction costs are associated with lower proceeds of sale.
In general, transaction costs will fall under some or all of the following headings: the cost of
identifying potential purchasers and marketing the shares; the cost of assembling information to enable the
buyer(s) to evaluate the purchase; the cost of negotiating contractual arrangements ancillary to the sale; the
cost of amending the firm’s constating documents to enable the sale (e.g. in order to recast governance
arrangements); the cost of changing the default law that applies to the firm by changing the jurisdiction of
incorporation; the cost of board deliberations in respect of any or all of the above or of other matters (such as
debating discretionary share transfers in the case of private corporations). At the risk of double counting, 76
we also include the price discount associated with information asymmetry. Some of these costs are
unavoidable, such as negotiating a price. Other costs, such as those associated with amending the firm’s
constating documents, or reincorporation in another jurisdiction, are elective.
Transaction Costs of Selling Following an IPO
A sale of shares in a public company entails three forms of transaction costs; the cost of brokerage,
the cost of price pressure on the price received for the shares, and the cost of any signalling effect on the
price of the shares. The sum of these costs can vary enormously. While brokerage costs are minimal, price
pressure and signalling costs can be substantial.
Price pressure results when the seller’s broker must lower the price below the posted market price to
attract enough buyers to liquidate the seller’s holdings. The likelihood of price pressure depends on the size
of the block being liquidated relative to the public float of shares. If the ratio is high, price pressure can be
See supra, Part III.A.
Gompers & Lerner, supra note 4, at 263-287.
Signalling costs arise when the market attributes informational content to a sale of shares by an
insider; i.e. the market believes that the insider is selling because it is in possession of negative information,
which lowers the price at which purchasers are willing to buy.78 These too can be substantial.79
A full enumeration of the transaction costs of a sale of public firm shares, however, must take into
consideration the transaction costs of effecting the IPO. These costs are necessarily incurred to facilitate the
post-IPO sale of the VC’s shares. They have the effect of diminishing the value of the firm, and hence the
price that the VC will receive for its shares. These costs include:
1. the underwriter’s commission, which will probably be no less than 4% of the issue
proceeds, and may be 8% or more for an IPO issuer;80
2. the accounting costs necessary to put the firm’s information systems into a “market
3. the legal, accounting, printing and other associated costs of producing the registration
statement and other documents required by securities regulators;
4. the cost of marketing the issue;
5. listing fees;
6. in Canada, the cost of translating the prospectus into French, if the offering is to be
made in Quebec.
Stuart C. Myers & Nicholas Majluf, Corporate Financing and Investment Decisions When Firms Have
Information that Investors Do Not Have, 13 J. FIN. ECON. 187 (1984).
A key reason for the success of electronic trading networks is that they allow large block traders in
general, and institutional traders in particular, the opportunity to unwind their positions without significant
signaling effects. See generally Jonathan R. Macey & Maureen O’Hara, Regulating Exchanges and Alternative
Trading Systems: A Law and Economics Perspective 28 J. LEG. STUD. 17 (1999).
There is a danger of double counting, insofar as the underwriter’s commission will reflect many of the
other costs discussed infra. However, those further items noted immediately below reflect costs borne by the
selling shareholder either directly, or indirectly through the cost borne by the issuing corporation. For the issuer,
the opportunity cost resulting from diversion of management and employee talent almost certainly exceeds the
direct cost. See generally MacIntosh, supra note 42.
7. the indirect cost that results from underwriter underpricing of the issue, which averages
15.3% in the U.S. and 9.3% in Canada;81
8. the set-up cost of hiring new staff to deal with public company requirements such as
compliance with continuous disclosure requirements and investor relations, etc.;
9. the opportunity cost that arises as a result of the diversion of management and other
personnel away from business matters, including time spent meeting with lawyers,
accountants, and others to assist in the preparation of the registration statement,
participating in road shows, etc.
Note that other costs associated with running a public company (as opposed to a private company), both
transactional and otherwise, are dealt with in the immediately following section.
Transaction Costs of Selling Shares in a Private Company: A Comparison
A special set of interrelated problems inheres in selling shares of private companies. Shares of
private companies are far less liquid than shares in public companies, because of the absence of a ready-made
market for the firm’s shares. This illiquidity is enhanced by virtue of the fact that share transfers in private
companies must typically be approved by the board of directors. Relatedly, small corporations are often
characterized as incorporated partnerships. That is, while nominally organized as corporations, a close
working relationship between the various shareholders – akin to a partnership - is typically important to the
success of the enterprise. This is in part a consequence of the fact that shareholder and managerial roles
overlap to a considerable degree, so that the shareholders must work together as managers. Even when this
is not the case, it is important that management and non-management shareholders share a strategic vision
for the corporation and be able to work cooperatively, failing which the enterprise may disintegrate in
acrimony and litigation. Thus, the decision of whether to admit new owners (and the decision of potential
new owners to seek admission) involves interpersonal factors that are not implicated (or implicated at a
lower level of intensity) in the case of public corporations.
The requirement for board approval of share transfers discourages trading in small lots. Thus,
Tim Loughran, Jay Ritter and Kristian Rydqvist, Initial Public Offerings: International Insights PACIFIC
BASIN FIN. J. 165 (1994).
investment in a private company typically involves a higher level of committed capital than investment in
a public company. Thus, the universe of potential buyers is restricted to those who are wealthy enough to be
able to fully diversify the risk of a relatively large holding. This further impairs liquidity, which is an
important component of share value.82
In addition, securities laws frequently restrict the sale of shares in private companies to designated
categories of exempt purchasers; i.e. purchasers who are permitted to buy securities without the requirement
that the issuer prepare a registration statement. 83 The resale of shares in private corporations is also restricted
so as to reduce the danger of a “backdoor underwriting”, in which the issuer uses an exempt purchaser to
funnel securities to non-exempt purchasers. In the United States, resale restrictions typically extend two
years beyond the date of issuance.84 In Canada, they can be even more onerous. In Ontario, for example,
while the “hold period” for restricted shares was recently reduced to a maximum of 12 months, 85 it does not
start to run until the issuer goes public. Prior to the elapse of the pertinent hold period, securities may only
be resold to other exempt buyers. This greatly reduces the liquidity of private company shares and hence the
potential market for these shares (and the price at which they can be sold).
Overall, however, we do not believe that the transaction costs of selling an interest in a private
company will be comparable to those experienced in an IPO. Aside from liquidity factors described above,
all the elements of selling shares in a private company are replicated in the going public process – but on a
grander scale. The issuer’s and underwriter’s legal counsel, junior and senior officers, accountants, auditors
etc. will be engaged in an intensive process that will last at least several weeks and possibly several months.
Going public will generally require much more disclosure than will be required on a private sale and
extensive massaging of the company’s information systems (including preparation of historical accounting
records), and other changes to the company’s constating documents and structure that are either not required
on a private sale, or required at a lower threshold.
Moreover, once the company has been public for several months or years, the purchaser’s
See infra parts III.E and F.
See e.g. Rule 144, 17 C.F.R. § 230.144; Securities Act (Ontario), R.S.O. 1990, c.S.5, s.72, as augmented
by Ontario Securities Commission Rule 45-501 ((2001) 24 OSCB 7011) and Multilateral Instrument 45-102
((2001) 24 OSCB 7029) (neither of the latter instruments, however, being in force in Ontario during the period
covered by our data).
Rule 144, id.
Ontario Commission Rule 45-501, Multilateral Instrument 45-102, supra note 82.
information risk will be considerably lower than in respect or a private company. In the public market,
share prices reflect the heterogeneous opinions of different market traders.86 In an efficient market, the price
is the best estimate of the intrinsic value of the firm. Buyers of public firm shares thus free ride on the
efforts of other shareholders in determining value. By contrast, in a private company, the buyer must rely on
its own resources in valuing the firm. Private company valuations are thus inherently more risky.
In Table 1, we thus suggest that transaction cost considerations will favour a private sale of the VC’s
interest, rather than a public sale. We make no distinction in the transaction costs attaching to various
different forms of private sale (secondary sale and buybacks). This is not because we believe that no
material differences exist. For example, a negotiated buyback involves only one seller and one buyer, thus
raising bilateral monopoly problems that will complicate negotiations. By contrast, a secondary sale that
involves one seller but many possible buyers will not. However, we believe that the transaction costs of
various forms of private sale will be highly fact contingent, and will depend on such factors as the
configuration of shareholdings, the personalities of the negotiating parties, the existing nexus of contracts
binding the various parties, and other factors. Thus, we decline to speculate on the relative transaction costs
attending different forms of private sale.
E. Ongoing Costs of Operating as a Public, as Opposed to a Private Firm
The IPO is the only form of exit that results in the company operating as a public firm. This results
in costs that are not borne by private firms. These costs will be capitalized and factored into the price at
which the firm sells its shares to the public, and will thus affect the VC’s exit value. They include:
1. the ongoing costs of regulatory compliance for public issuers, including both direct costs
(e.g. maintaining dedicated staff) and opportunity costs (e.g. diversion of managerial time);
2. loss of confidentiality as a result of regulatory requirements to disclose material
information in the registration statement, and to disclose material developments in the life
of the firm on an ongoing basis;
3. slowed decision making, especially with respect to corporate fundamental changes
requiring shareholder approval and/or stock exchange, regulatory or court approval;
Ronald J. Gilson & Reinier Kraakman, The Mechanisms of Market Efficiency, 70 VIR. L. REV. 549
4. exposure to strike suits designed to extort a settlement from the firm,87 and to other forms
of frivolous or vexatious litigation;
5. adverse changes in the firm’s opportunity set as a result of pressure from analysts and
institutional investors to achieve short-term results.88
Clearly all of these costs make the IPO a less favourable form of exit than would otherwise be the
case, when compared to a private exit.
F. The Liquidity of the Investment to the Buyer
In the strict sense, liquidity refers to the ability of a buyer or a seller to effect a sale at or near the last
transaction price.89 Immediacy refers to the ability of the buyer or seller to effect a sale quickly. 90 Liquidity
is also frequently used, however, as an overarching term that embraces both liquidity, in the strict sense, and
immediacy. It is the broader sense that we use the term in this article.
Liquidity is of value to investors;91 recent empirical work confirms that it is a priced attribute of
securities.92 An exit that provides an investor with a relatively liquid investment will thus enhance the value
of the investment to the buyer, and derivatively increase the VC’s exit price.
Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43
STAN. L. REV. 497 (1991). But see also Joseph A. Grundfest, Disimplying Private Rights of Action Under the
Federal Securities Laws: The Commission's Authority, 107 HARV. L. REV. 961 (1994); Joel Seligman, The Merits
Do Matter: A Comment on Professor Grundfest's "Disimplying Private Rights of Action Under the Federal
Securities Laws: The Commission's authority" 108 HARV. L. REV. 438 (1994).
Whether pressure from analysts and institutional investors leads to management myopia is a subject of
some controversy. See e.g. Ronald M. Giammarino, Patient Capital? R&D Investment in Canada, in RONALD J.
DANIELS & RANDALL MORCK EDS., CORPORATE DECISION-MAKING IN CANADA (1995) 575.
Macey & O’Hara, supra note 78.
Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. FIN. ECON. 223 (1986);
Yakov Amihud & Haim Mendelson, The Effects of Beta, Bid-Ask Spread, Residual Risk, and Size on Stock
Returns, 44 J. FIN. 479 (1989).
Michael J. Brennan, Tarun Chordia & Avanidhar Subrahmanyam, Alternative Factor Specifications,
Security Characteristics, and the Cross-Section of Expected Stock Returns, 49 J. FIN. ECON. 345 (1998).
Of the different exit techniques, only the IPO provides the new owner(s) with a high degree of
liquidity. Shares of a public firm (with some variation depending on the depth and breadth of trading) can be
freely sold into the public market at or near the last transaction price, and with speed relative to the sale of
shares of a private company. As noted in Part C above, the shares of private companies are typically illiquid
by comparison. In sum, the factor of liquidity to buyer favours sale via an IPO.
G. The Liquidity of the Consideration Received by the VC: The VC’s Cash Preference
VCs often say that "Cash is King". This homily expresses the VC's preference for an exit that yields
cash consideration. In this section, however, we use the word “cash” to refer not merely to currency, but
near-currency as well; i.e. interests that can readily be converted into currency, such as the shares of a liquid
public company (although we note that a slightly different usage is employed in Table 1 to conform to the
manner in which our data was collected).
A cash exit is preferable for a number of reasons. When the fund termination date arrives, the
limited partners will prefer to receive their returns in a liquid form, giving them maximum flexibility in re-
deploying the proceeds of their investment (or in paying out the proceeds to their own owners).
In addition, prior to the termination of the fund, a cash exit allows the VC to re-deploy the capital.
In some circumstances (and particularly where the exit is made early in the life of the fund) re-deployment is
more attractive than holding cash, because VCs bring value to their investments by engaging in active,
hands-on management. They have no particular advantage in acting as cash custodians or in administering
purely passive investments. Once the VC's skill set has been exhausted, it makes sense to cash out and move
on to further active investments.93
Reinvestment is sometimes constrained, however, by the VC’s contract with its limited partners,
which may forbid re-investment save with the approval of the advisory board or the limited partners, or
within a restricted period of time following the fund’s inception. 94 Such provisions are designed, in part, to
ensure that the VC does not re-invest late in the fund’s life cycle, with the result that the investment cannot
be harvested at the termination date and the VC has no choice but to seek an extension of the partnership, sell
Lin and Smith, supra note 25.
Gompers and Lerner, supra note 4, 39 and 43 (Table 3.1).
the investment on disadvantageous terms, or distribute illiquid securities to its limited partners.95
An IPO exit is generally a superior way for the VC to dispose of its interest for cash, although most
“cash” distributions following IPOs consist of distributions of shares of the public company, rather than the
cash proceeds of sale96. The VC will not generally sell its shares at the time of the IPO97 by means of a
secondary offering qualified under the prospectus. Lin and Smith, for example, find that only slightly more
than a quarter of lead VCs sell any shares at the time of the IPO. When they do, they sell an average of
only 20.4% of their shares.98 Post-IPO, they continue to hold substantial interests in the firm. Lin and
Smith find that the average post-IPO holding of all VCs is 20.7%, and 17.7% when the lead VC sells shares
in a secondary offering at the time of the IPO.99 Other studies produce similar results.100
It is in the mutual interest of the VC and the underwriter that the VC not sell shares into the IPO.
Sale of shares might convey a signal that the VC lacks confidence in the firm’s prospects, and/or believes
that the sale price is too high.101 In addition, if the VC resiles from the firm at the time of the public market
offering, public investors will be deprived of the benefit of the VC’s continued monitoring of management.102
Gompers and Lerner provide a number of reasons why the VC might opportunistically reinvest late in the
fund’s life cycle. These are: a distribution of profits might reduce VC fees by reducing capital under
administration; reinvested capital may yield greater profits; extension of the limited partnership will result in the
VC continuing to earn fees from the fund. Id., note 11, at 39. The first and third seem to be genuine instances of
opportunistic behaviour. However, the second may in fact merely evidence an alignment of interest between the
VC and the limited partners.
Such distributions in kind are effected for a variety of regulatory, tax, and economic reasons. See
Gompers & Lerner, supra note 4, 263 et seq. While the extent to which a share distribution mimics cash will
depend on the depth and breadth of the trading in the company’s shares, an IPO will generally supply the VC (and
derivatively its limited partners) with consideration that is liquid compared to other forms of exit.
Lin & Smith, supra note 25.
See supra note 61.
Lin & Smith, supra note 25; Gompers & Lerner, id. at 266; Megginson & Weiss, supra note 5; Douglas
Cumming & Jeffrey MacIntosh, The Extent of Venture Capital Exits: Evidence from Canada and the United
States, in JOE MCCAHERY & LUC RENNEBOOG, VENTURE CAPITAL CONTRACTING AND THE VALUATION OF HIGH TECH FIRMS
Barry et al., supra note 5.
The VC and the underwriter will thus typically enter into a “lockup” arrangement that contractually
restricts VC sales at the time of, and for some period of time following the IPO. This contract legally
enforces, and therefore makes credible the VC’s promise not to sell. In the United States, the contractual
lockup period is typically six months following the offering, although it may be as long as two years.103
Even after the elapse of the escrow period, however, many VCs hold their shares for months or
years.104 Barry et al, for example, found that while the post-IPO mean holding of the VCs in their sample
was 24.6% (with a median of 22.6%, one year after the offering, the mean holding was 17.8% (and the
In Canada, regulatory hold period and escrow requirements have historically been more restrictive
than those in the U.S., and may prevent the VC from selling its shares into the market for a period that
ranges from six months to in excess of five years, although the norm is within a range of six months to two
years.106 Anecdotal evidence suggests that regulatory approvals are often granted to permit sales prior to the
elapse of the escrow period. Because, as noted, many U.S. VCs continue to hold even after the expiry of the
escrow period, it is not clear to what extent the added layer of regulation in Canada makes it more difficult
for Canadian VCs to liquidate their investments following the IPO.107
Canadian VCs are sometimes able to do an end run around the escrow requirements by causing their
investee companies to go public via an American exchange such as NASDAQ, thus taking advantage of the
shorter escrow period. This will not, however, affect the duration of applicable hold periods, if the shares
were initially issued pursuant to an exemption from the prospectus requirement under Canadian legislation.
To the extent that an American IPO results in the issuer reincorporating in the U.S. – a factor that is said to
enhance marketability – potentially onerous tax liabilities are triggered.108 These factors limit the
Gompers & Lerner, supra note 4, at 209; Lin & Smith, supra note 25.
Gompers & Lerner, id., at 266; Lin & Smith, id.; Barry et al., supra note 5; Megginson & Weiss, supra
Barry et al., id.
MacIntosh, supra note 14. The Canadian Securities Administrators, an informal body consisting of all of
the provincial and territorial securities administrators, has recently agreed upon a uniform national hold period
ranging from four to twelve months after (with some oversimplification) the later of the date upon which the
company went public, and the say on which the exempt securities were initially sold. This has now been enacted
into law in Ontario, the focal point of Canada’s capital market. See MI 45-102, supra, note 82.
Cumming & MacIntosh, supra note 100.
A reincorporation outside of Canada results in a deemed disposition of assets, resulting in the levying of
attractiveness of the end run. Indeed, it would appear that the vast bulk of Canadian firms effecting IPOs
do so in Canada.109 On balance, our best guess is that the added regulatory burden in Canada results in a
lower degree of liquidity for VC holdings.
Why might a VC choose to hold, even following the elapse of escrow and hold periods? If the
market for the firm’s securities is illiquid, the VC may effectively be locked in because of potentially serious
price pressure (lowering the sale price below the posted market price) should it choose to sell. 110 In an illiquid
market, the market is also more likely to attribute informational content to the sale (i.e. that the seller is
selling on bad information), given that illiquid markets are characterized by relatively poor information, and
any given quantum of new information will be accorded enhanced importance by market traders.111
As noted above, even in a liquid market, reinvestment of the proceeds of sale of the VC’s shares
may be impossible under the terms of the VC-limited partner contract, attenuating the incentive to exit.112
Even in the absence of such contractual restrictions, a VC concerned to maintain a good reputation will be
concerned that reinvestment will convert a liquid asset fit for distribution into an illiquid asset unsuitable
either for exit or distribution.
Finally, the VC may simply choose to hold shares when it believes that the prospective stock market
gains outweigh the gains from reinvestment. Consider, for example, a situation in which the stock market is
rising rapidly, and the VC believes that, although stock market values are inflated and divorced from
underlying fundamentals, psychological factors will continue to drive the market higher. If the VC also
believes that the price of new investments is correspondingly inflated, then the wisest course might be to
maintain the existing investments, and attempt to sell these investments at or near the market peak.
Empirical evidence explored further below suggests that VCs are indeed good at exiting their portfolio firms
capital gains taxes. See Income Tax Act (R.S.C. 1985, c. 1 (5th Supp.)), s.232.
While no precise data appears to be available on this issue, our discussions with investment bankers
suggest that this is in fact the case.
Gompers & Lerner find that distributions of shares to investors are associated with substantial drops in
share prices, which they attribute to price pressure. See Gompers & Lerner, supra note 4, at 263-287.
See e.g. Avner Arbel, Generic stocks: an old product in a new package (Summer 1985) J. of Port. Man. 4
(1985); Avner Arbel, Steven Carvell and Paul Strebel, Giraffes, Institutions, and Neglected Firms, (May-June
1983) Fin. Anal. J. 57 (1983).
Supra, notes 91-92 and accompanying text.
at market peaks.113
We indicated above that VCs start to unwind their interests in the first year after the IPO but
nonetheless retain substantial blocks. What happens to the VC’s ownership interests after a year? Lin and
Smith find that by three years following the IPO (or such longer period as was necessary to locate a publicly
filed proxy statement), most VCs in their sample were completely disinvested. Lead VC investors were still
listed as blockholders in proxy statements only 12.3% of the time, and in these cases they held only 1.4% of
the shares outstanding (compared to 12.1% immediately after the IPO).
Thus, while many VCs remain invested for a period of some months, or even a year or two
following the IPO, these interests will then be unwound. Initial VC ownership retention is thus not
inconsistent with the view that the IPO yields a relatively liquid exit for the VC. It merely emphasizes that
liquidity is constrained by a variety of factors, including the VC-limited partner contract, legislative
requirements, stock exchange rules, and other factors such as the life cycle of a VC fund. Thus, in Table 1
we suggest that an IPO is favoured for liquidity reasons (keeping in mind that this is in comparison to other
forms of exit).
In some circumstances, an acquisition exit will supply the selling VC with liquidity that exceeds that
realized following an IPO. Consider, in particular, a case in which the acquiror pays in cash for the shares
(or the assets) of the EF, in the broad sense noted above - meaning either currency or shares of a highly
liquid public company (typically shares in the acquiror itself). In this case, the selling VC either receives
currency directly, or can readily sell the shares it receives for currency without significant price pressure
(depending on the size of its holding) or signalling impact.114 Hold periods and escrow requirements do not
typically come into play.115
See infra, section III.L.
Since the acquiror will typically wish to acquire 100% of the EF (i.e. it will rule out VC ownership
retention), it will be more difficult for the market to interpret the VC’s immediate exit as a lack of confidence in
the firm. Indeed, any negative signal arising from the sale of the VC’s shares is counterbalanced by the positive
signal emanating from the strategic acquiror’s purchase of the firm.
For example, in Ontario, during the period covered by our data, shares received by the VC in an
acquisition effected by a merger between the acquiror and would be freely tradable as long as the acquiror had
been a “reporting issuer” in Ontario for a year. OSA s.72(5). A public firm that had not filed a prospectus with
Ontario regulators and was not listed on the Toronto Stock Exchange might not qualify as a reporting issuer in
Ontario. However, since the shares received by the VC and other corporate insiders would not be legended, as a
practical matter such shares would effectively be freely tradable.
The acquiror, however may not be a liquid public company, and thus unable to supply liquid shares
as consideration. It may also be a private company without a public market for its shares. Thus, the ability
of an acquisition exit to supply cash will depend on the characteristics of the acquiror. For this reason, in
Table 1 we suggest that while an acquisition exit may provide the greatest liquidity, the ability to supply cash
is subject to considerable variation.
It is noteworthy that Canadian Labour Sponsored Venture Capital Corporations,116 which administer
approximately half of the venture capital funds in Canada, are constrained under their governing legislation
to invest only in “eligible investments”, which excludes shares in a foreign (including U.S.) corporation.
This can have the effect of reducing the VC’s exit price by forcing it to accept consideration in currency that
is less than the nominal amount of corporate shares that it might otherwise have received.
In a secondary sale, the purchaser will usually be a strategic acquiror. Thus, for the reasons explored
in the immediately preceding section, secondary sales may or may not supply cash.
The purpose of a buyback is to cash out the VC; definitionally, the EF will thus not offer the VC
share consideration. It will borrow money to effect the buyback, replacing equity with debt. Thus, on its
face, a buyback will yield a cash exit.
This statement must be qualified, however, given that buybacks are frequently only partial in nature;
i.e. they involve the purchase of only part of the VC’s interest.117 Moreover, payment is often staged over a
period of months or years. This again suggests that the EF is often a living dead investment, and the
entrepreneur will have limited resources (including borrowing capacity) to effect the buyback. Thus, in
reality, most buybacks promise only partial liquidity.
See infra Section V.A. for a description of Labour Sponsored Venture Capital Corporations.
Cumming & MacIntosh, supra note 100.
In the U.S., the VC’s quest for cash points to the IPO as a preferred means of exit, although U.S.
VCs will experience greater liquidity than Canadian VCs. Acquisition exits may in some circumstances
offer even greater liquidity, if the acquiror pays cash. However, this is subject to considerable variation
depending on the nature of the acquiring firm. In both the U.S. and Canada, secondary sales are similar to
acquisition exits in their ability to yield cash. While a buyback supplies only currency, many buybacks are
only partial, and payment will occur only over a period of months of years. Thus, the reality is that
buybacks supply only partial liquidity.
H. Managerial Incentives
1. Incentive Compensation and Stock Ownership as Managerial Motivators
Another factor that a buyer will take into account in determining its willingness to pay for the VC’s
shares is the extent to which management’s incentives are aligned with shareholder interests following the
purchase. The extent of this alignment (or misalignment) will be factored into the buyer’s willingness to
pay, and hence into the VC’s exit price. In what follows, we compare the ability to craft appropriate
incentive arrangements following different types of VC exit.
It is now well understood that managerial incentives can be enhanced by incentive compensation
devices such as stock options.118 Another factor that aligns management’s interest with that of shareholders
is managerial share ownership. 119 However, there is conflicting evidence on the nature of the relationship
between share ownership and managerial incentives. Morck, Schleifer and Vishny present evidence that as
managerial ownership increases, the value of the firm rises to the 5% ownership threshold, falls between 5%
and 25%, and then rises again.120 McConnell and Servaes,121 however, present evidence suggesting that the
value of the firm rises to something in excess of 50% ownership, and then falls as management ownership
Jensen & Murphy, supra note 54; Jeffrey G. MacIntosh, Executive Compensation: The Importance of
Context, C.D. HOWE INSTITUTE, VALUE FOR MONEY: EXECUTIVE COMPENSATION IN THE 1990'S (1996), 88-123; Stephen
Bryan, Lee-Seok Hwang & Steven B. Lilien, CEO Stock Option Awards: An Empirical Analysis and Synthesis of the
Economic Determinants, SSRN Working paper series, abstract id 157548, March 1999.
Morck, et al., supra note 67; Karen H. Wruck, Equity Ownership Concentration and Firm Value, 23 J.
FIN. ECON. 3 (1988).
John J. McConnell & Henri Servaes, Additional Evidence on Equity Ownership and Corporate Value, 27
J. FIN. ECON. 595 (1990).
increases. Whichever of these relationships holds, the non-linear relationship between management
ownership and firm value is a consequence of two opposing effects. With increasing ownership, managers’
pecuniary interests are increasingly aligned with other shareholders (the “alignment effect”). However,
increasing ownership also enhances management’s ability to ward off a hostile takeover bid, and hence to
preserve their jobs and/or indulge non-pecuniary preferences (the “entrenchment effect”). The strength of
these effects changes at differential and non-linear rates over the full range of ownership interests. Thus,
over some part of the range of ownership, the entrenchment effect will dominate. Over the other parts of the
range of ownership interests, the alignment effect will dominate.
Different forms of VC exit will tend to be associated with different post-exit managerial
shareholdings. However, without consistent evidence as to the nature of the relationship between
management ownership and share value, it is difficult to predict how ownership changes associated with the
VC's exit will affect firm value. Our comments below are thus subject to wide confidence intervals.
The IPO is the only form of exit that allows the firm (post-exit) to pay its managers partly in share
options or other forms of compensation linked to market price. While not a perfect motivator, the use of
options and other incentive devices linked to market price enhances managerial alignment with shareholder
On the other hand, while IPOs generally leave the existing management in place, the IPO will
significantly dilute managerial shareholdings, resulting in a diminished alignment effect. But, as the above
discussion makes clear, the IPO will also result in a diminished entrenchment effect. Thus, the effect of the
change in ownership configuration on the value of the firm cannot be predicted with precision.
Baker and Gompers suggest that VCs have the incentive to craft post-IPO compensation contracts
for CEOs that provide an appropriate trade-off between incentives and ability to consume private benefits
that might flow from control. 123
They find evidence in support of this proposition. While CEO share
ownership decreased post-IPO, incentive compensation contracts replicated the sensitivity of CEO wealth to
firm performance that prevailed prior to the IPO, while other limitations on managerial actions served to
See supra notes 38, 67 and accompanying text.
Malcolm Baker & Paul Gompers, Executive Ownership and Control in Newly Public Firms: The Role of
Venture Capitalists, Harvard Business School, mimeo (1999).
limit manager opportunism. Thus, in Table 1 we suggest that the compensation factor strongly favours a
public company exit.
Because a strategic acquisition involves the purchase of the entire firm, the managers will be left
with no direct equity interest in the EF’s assets. Nonetheless, the managers will often receive shares of
the acquiror as consideration for selling their shares in the EF, especially if the acquiror is a cash-starved
technology company.124 Thus, assuming that they stay on board, the managers will retain an indirect
share interest in the EF’s assets. Even if a new management team is hired, management can be given
shares or share options in the acquiring firm.
If the acquiror is not a public company, then it cannot use incentive compensation arrangements
based on the public market price to motivate the managers. If it is a public company, it will be able to do
so. However, a strategic acquiror is typically larger, and often much larger than the EF. Thus, whether the
purchased firm is maintained as a wholly owned subsidiary or rolled into the operations of the acquiror
company, its operations will constitute only a part – perhaps a very small part – of the acquiror’s business.
In these circumstances, there may be a tenuous link between the success of the purchased operations and that
of the firm as a whole. The ability to use the acquiror’s shares (or options) as currency to motivate
executives is thus significantly abridged, when compared to an IPO. The acquisition exit may also be
inferior in this dimension to other forms of private VC exit in which the managers retain a larger
proportional interest in the enterprise, as discussed below.
A secondary sale of the VC's interest alone will not affect managements' shareholdings, and
presumably will not affect incentive compensation contracts. Thus, it will not affect managerial incentives.
A buyback will not create any opportunity to put in place market-based incentive schemes, since the
firm will remain private. However, a buyback will almost always result in the insider/managers owning a
Cumming & MacIntosh, supra note 100.
large portion (and in many cases all) of the firm. At very high levels of ownership, the alignment effect is
likely to dominate the entrenchment effect.125 Thus, on this score, a buyback is likely to enhance
management’s incentives and reduce the agency costs of equity.
In addition, because the entrepreneur and/or firm will usually resort to substantial debt financing in
order to retire the VC’s shares, the buyback will substantially enhance the entrepreneur’s or the firm’s
debtload. The higher level of fixed payments of interest and principal will act as an additional discipline on
However, after the buyback occurs, the entrepreneur will be free to pursue whatever maximand suits
her, and her pursuit of profits may be tempered by a taste for the consumption of non-pecuniary rewards,
particularly leisure. The presence of external investors will contain this leisure preference. However, the
buyback jettisons a specialized monitor (the VC) and replaces it with less effective monitor – the firm’s
lender. Indeed, as noted above, one of the objectives of the buyback, from the entrepreneur’s point of view,
may be to eliminate external monitors, in order to permit the indulgence of a taste for leisure that could not
be accommodated when the company had active external investors.
Nonetheless, lacking hard evidence that buybacks are typically motivated by the entrepreneur’s
revealed preference for leisure, we posit in Table 1 that enhanced managerial incentives favour the buyback
when compared to other forms of exit.
2. The Corporate Control Market
Public firms are subject to discipline from the market for corporate control.127 Easterbrook and
Fischel argue that the public price of a firm’s stock consists of two components. The first reflects the value
of the firm under existing management. The second reflects the value of the firm should a takeover bid
occur, with the installation of a superior management team.128 This is supported, in the case of public
corporations, by evidence that the more active the takeover market, the greater the degree of managerial
Supra notes 66-69 and accompanying text.
Jensen, supra note 71.
See e.g. Frank H. Easterbrook & Daniel Fischel, The Proper Role of a Target's Management in
Responding to a Tender Offer, 94 HARV. L.R. 1161 (1981).
turnover and managerial discipline.129
While in theory this will also be true for private corporations, informational asymmetries between
insiders and outsiders ensure that the set of interested acquirors will be much smaller for a private
corporation than a public corporation. Moreover, a hostile takeover of a private corporation is often difficult
or impossible. The concentration in shareholdings that is typical of private corporations effectively cedes a
veto over any hostile takeover to the controller(s). Added to this, the charter of most private corporations
will require that the board approve any transfer of shares, giving the board a veto as well. Thus, the control
market is far less active for private corporations.
Thus, this factor strongly favours the IPO exit; following an IPO, the managers are subject to the
discipline of the corporate control market. The only other exit in which there is an active corporate control
market is the acquisition exit – and then only in cases in which the acquiror is a public company. Typically,
however, even in such cases the EF assets will constitute only a small part of the acquiror’s total assets, so
that if the managers use these assets inefficiently, it may not produce a hostile takeover. Thus, this factor
favours the acquisition only weakly, and with significant variation.
I. Transaction Synergies
The products or technologies or some EFs will be more likely than others to exhibit
complementarities with products or technologies owned by other firms. Thus, the possibilities for
synergistic (and value-enhancing) union with other entities will vary across the spectrum of EFs. We
hypothesize that this will affect the choice of exit.
In an IPO, the firm is not combined with any other entity. An IPO will thus not result in the
direct realization of transaction synergies.
By creating a public market for the firm’s shares, however, an IPO will create or enhance the
probability of a consensual merger or hostile takeover in which transaction synergies are realized.
Wayne H. Mikkelson & M. Megan Partch, The Decline of Takeovers and Disciplinary Managerial
Turnover, 44 J. FIN. ECON. 205 (1997).
Although following the IPO the firm will usually have a de jure or de facto controlling shareholder,130
making a hostile takeover difficult, this controlling position will tend to disappear over time as the firm
grows (and issues more equity) and as early stage shareholders (including managers and VCs) sell off
their holdings.131 Thus, at the time of the IPO there will always be some positive probability that the firm
will be the subject of a premium takeover offer at some point in the future.132 In a market characterized
by rationale expectations, the act of going public will thus result in a takeover premium being
incorporated into the price of the shares.133
There is good empirical evidence that one of the more important reasons why acquirors pay
premia on takeovers is the expectation that the union of the acquiror and target will produce synergies.134
Thus, early stage shareholders (including VCs) selling into the public market will receive a payment that
reflects the likelihood that transaction synergies will be exploited in the future. This payment will be
incorporated into both the price at which the shares are initially sold to the public, and the market price
Indeed, an IPO may sometimes be viewed as a strategic prelude to a synergistic merger. When
the firm is private, the universe of potential acquirors is restricted both by information asymmetries
between the firm and potential acquirors, and the firm’s lack of a public profile. By remedying these
problems, an IPO will raise the probability of a control transaction – perhaps even an auction between
competing acquirors - in which shareholders will capture a share of the synergistic gains.
IPOs facilitate the potential realization of future transaction synergies not merely by facilitating
hostile acquisitions. They also facilitate acquisitions by the firm itself. Once the firm is public, its shares
can be used as currency to effect acquisitions of other firms. The ability to use the firm’s shares as
consideration in a merger or takeover bid is particularly important for the type of firms that venture
capitalists specialize in: rapid growth technology-based firms. Such firms are often cash starved, and the
ability to use shares as currency to effect acquisitions economizes on scarce cash resources. Again, in a
Supra, note 59 and accompanying text.
Supra note 46 and accompanying text.
Supra note 112 and accompanying text. See also supra note 48 and accompanying text.
Roberta Romano, A Guide to Takeovers: Theory, Evidence, and Regulation 9 YALE J. ON REG. 119 (1992).
market characterized by rational expectations, this advantage will be reflected in the IPO price and the
market price going forward. Particularly when the EF plans to grow partly or wholly by acquisition, the IPO
thus has a significant advantage over private forms of exit.
We noted earlier that not all strategic acquirors exhibit the same degree of closeness of fit between
the acquiror and the target.135 Even acknowledging this variation, the purchase of the firm by a strategic
buyer will very often result in the realization of transaction synergies. Indeed, this is frequently the whole
point of the acquisition. In some case, the decision to purchase the firm will be the outcome of a "make or
buy" decision.136 Such a decision arises where the buyer has reached a critical juncture at which it needs to
develop a specific product or technology to complete or complement an existing product line. Rather than
developing the product or technology itself, it will identify a firm that possesses what it needs and buy the
Acquisitions can also be motivated by the desire to capture the human capital of the target firm.
Since the human capital will often have its maximum value when members of the target’s entrepreneurial
group are kept together as a team, the best way to acquire the target’s human capital will be to buy the entire
firm. Again, synergistic gains can be realized by combining the target’s human capital with the acquiror’s.
Acquisitions are sometimes motivated by a desire to capture intellectual property rights held by the
target. The target may have patents, for example, that will assist it in defending intellectual property rights
against challenges from other firms - perhaps even from the target itself.
Synergies can also be realized by acquiring the target firm’s customer base, providing new
distribution channels for current and anticipated products or services.
Especially in the technology industries, strategic buyers will often place idiosyncratically high
values on the target firm. In many cases this will be due to the fact that the buyer has already spent
considerable sums of money developing similar or complementary products or technologies. Because of
Supra note 9 and accompanying text.
On the make or buy decision, see generally Oliver Hart, Norms and the Theory of the Firm, 149 UNIV.
PENN. L.R. 1701 (2001); Aaron S. Edlin & Benjamin E. Hermalin, Contract Renegotiation and Options in Agency
Problems, 16 J. LAW, ECON. & ORG. 395 (2000).
this, the buyer will be uniquely positioned to bring the product or technology to market without
substantial additional investment. The buyer may also possess distribution networks that are well adapted to
marketing the seller's product or technology. In some cases, a strategic buyer will be a high valuing
purchaser because it wishes to keep the firm's technology out of the hands of competitors. Any of these
factors can transform the strategic acquiror into a high-valuing purchaser.
Clearly, the acquiror’s anticipation of the realization of transaction synergies will affect its
willingness to pay to acquire the EF. Depending on the relative bargaining strengths of the buyer and seller
and the information they possess (and in particular, the extent to which the seller is aware of the magnitude
of the synergistic gains available to the buyer), the synergistic gains will be split between the buyer and
We surmise that in this respect the acquisition exit dominates the IPO exit. In Table 1, we suggest
that the ability to exploit transaction synergies strongly favours an acquisition exit.
Transaction synergies are far less likely to be realized in the case of secondary sales than
acquisitions, primarily because the buyer will usually be unable to combine the target's assets with its own.
Under pertinent corporate law, effecting a combination of assets generally requires both directors' and
shareholders' resolutions, whether the combination is effected by way of merger, a sale of the target's assets
to the purchaser, or by other means. 137 If the buyer possesses only a minority shareholding interest in the
target enterprise, securing such resolutions may be difficult or impossible, particularly in Canada, where a
resolution of two-thirds of the votes cast is required.138
Even when the buyer purchases a controlling interest from the departing VC, the buyer is necessarily
taking on as many partners as there are other shareholders. Attempts to transfer assets from the target to the
buyer may result in a suit by one or more of these shareholders for breach of fiduciary duty or oppression.
See e.g. Canada Business Corporations Act (CBCA), R.S.C. 1975, c.C-44, as amended, Part XV
(fundamental changes); Del. Code Ann. tit. 8.
See e.g. CBCA, Id. Note that Rule 61-501 of the Ontario Securities Commission, which requires a
valuation of the subject assets (or shares) and approval by a majority of the minority of shareholders (i.e.
excluding interested parties), does not apply to corporations that are not reporting issuers in Ontario (i.e. that are
private companies). See Rule 61-501, Insider Bids, Issuer Bids, Going Private Transactions and Related Party
Transactions, 23 O.S.C.B. 2719 (2000).
However, when a strategic acquiror makes a secondary purchase, it is often as a prelude to making a
future acquisition. The occurrence of a secondary sale to a strategic acquiror thus materially raises the
probability of a future acquisition in which transaction synergies will be realized. Thus, while ranking
behind acquisitions and IPOs, secondary sales contain some possibility for the future realization of synergies.
A buyback results in no direct transaction synergies. Moreover, the likelihood that future synergies
will be realized in a merger or takeover seems small. Not only will the firm will remain privately held – but
loaded up with debt as a result of the borrowing necessary to effect the buyback. In addition, as noted above,
shares of private corporations are difficult to use as currency to effect acquisitions, limiting the EF’s ability
to initiate a merger or takeover transaction. Nor, because of its already high debt level, will it be able to
borrow money to effect an acquisition. Finally, the likelihood that it will be either an acquisition target or a
suitable acquiror will be small if, as we have surmised, it is a living dead investment (or “lifestyle”
In summary, strategic acquisitions routinely result in the realization of transaction synergies. IPOs
incorporate some premium into the price reflecting the potential future realization of transaction synergies,
both through hostile takeovers of the EF and acquisitions by the EF itself. Secondary sales and buybacks
typically result in no direct transaction synergies, although secondary sales have a greater built-in potential
for the realization of future asset combinations that yield transaction synergies. In Table 1, we thus suggest
that this factor strongly favours the acquisition, favours the IPO, is neutral to positive with respect to
secondary sales, and strongly disfavours buybacks.
J. Capital Raised, Scale of Acquisition, and Ability to Meet Future Capital Requirements
Exit techniques differ in the extent to which they are associated with the raising of new capital for
the firm, the ability of the buyer(s) to digest the purchase, and the ability of the buyer(s) to meet future
capital requirements. These factors will all affect the choice of exit vehicle.
The purchaser will have to possess sufficient capital to effect the acquisition, whether of the VC's
shares alone or the entire company. An extraordinarily successful firm (or one with tremendous prospects
of future success) will command a high price. The buyer must have sufficient resources to pay this price.
Moreover, except in cases in which a short term “flip” is contemplated, the acquiror must be able to
anticipate that it will have sufficient capital (or the ability to bring further investors on board) to meet the
firm's future capital needs as it continues to grow.
An IPO is associated with a large infusion of fresh capital. Importantly, it is the only exit technique
that invariably has this result, and this sets the IPO apart from exits that leave the corporation private. Exit
while still private involves only a secondary sale of the VCs share (or its equivalent, such as a sale of assets).
Exit via IPO involves both a secondary sale and a primary market distribution. Thus, a VC may decide to
exit while the firm is still private without the constraint of having to convince new investors that the firm
warrants a cash infusion. When exiting via IPO, the firm must be able to justify its need for new funds to the
capital market; otherwise, the IPO – and hence the exit - will fail. This will tend to restrict the availability of
an IPO to firms surpassing a hurdle growth rate. In Table 1, we record this difference in the column “Must
New Capital Be Raised?”
Moreover, access to the public market tends to be restricted to firms that surpass a hurdle size – at
least if the firm hopes to attract a more reputable underwriter. 139
There are fixed costs associated with
marketing an issue of securities; the resulting economies of scale can be exploited by marketing only
comparatively large offerings. Thus, the most reputable underwriters tend to shy away from small offerings;
small firms may consequently either fail to gain access to the public market, or gain access only at a cost that
is unacceptable to the firm’s principals. Less reputable underwriters will be compelled to increase the degree
of IPO underpricing in order to market the issue.140
In addition, institutional funds – the primary buyers in most IPOs - are not bottom feeders. There
are fixed costs in investing institutional assets, and hence economies of scale associated with the investment
process. As a result, institutional fund managers prefer to make a smaller number of relatively large
The presence of a VC mitigates the size effect to some degree. Barry et al., supra note 5, present
evidence that small firms lacking VC participation effect IPOs with lower tier underwriters than similar firms with
Megginson & Weiss, supra note 5.
purchases of securities, rather than a larger number of relatively small purchases.141 For this reason, they
will tend to avoid participating in small IPOs.142
An additional factor that drives institutional investors away from small IPOs is that many
institutional investors prefer to invest in relatively liquid assets. The smaller the public offering, the less the
liquidity of the offered shares, the less the degree of institutional interest, and the greater the underwriter’s
cost in marketing the issue. All of these factors support the existence of a size hurdle in IPO markets.
Pagano et al. produce direct evidence of the existence of both growth rate and size hurdles.143 They
find that firms that grow faster and are more profitable are more likely to experience an IPO. They also find
that the most important factor explaining an IPO is the market to book ratio. A high market to book ratio
suggests that the market believes that the firm will grow rapidly. The second most important factor in their
study was the firm’s size.144
Other forms of exit have neither growth nor size constraints, although buybacks will often be
available only to smaller firms, as discussed elsewhere. This creates a selection bias that suggests that the
returns associated with IPOs will exceed those associated with other forms of exit. In Table 1, we record this
difference between IPOs and other forms of exit in the column headed “Size and Growth Rate Constraints?”
While the fund raising requirement is a constraint, it is also an opportunity, in the sense that the
public market is the deepest capital well from which the company may drink. The public market has the
greatest ability to digest large-scale purchases. It also has the greatest ability to furnish additional capital if
needed in the future. This is reflected in Table 1 in the column “High Growth Firms”. IPOs are particularly
well suited to high growth firms because of the depth of the capital pool available.
Institutional investors are usually precluded under applicable legislation from making large investments
in small firms, because of prohibitions against holding more than a stated percentage of a single issuer’s equity.
In addition, institutional investors will typically wish to avoid ownership thresholds that trigger public reporting
requirements. In the United States, the pertinent threshold is 5% (Hart-Scott-Rodino Act [cite]); in Canada, it is
10% (see e.g. Ontario Securities Act, ss.101 and 107). Finally, purchases of small firms generally preclude short-
selling because of the difficulty of borrowing shares to effect a short sale; this too limits institutional interest.
Again, the presence of a VC mitigates the inclination of institutional investors to avoid small issues to a
degree. See Megginson & Weiss, supra note 5.
Marco Pagano, Fabio Panetta, & Luigi Zingales, Why Do Companies Go Public? An Empirical Analysis,
53 J. FIN. 27 (1998).
On the face of it, an acquisition raises no fresh capital; it merely rearranges ownership interests (i.e.
transfers the company to new owners). However, this can be misleading. A strategic acquisition is
undertaken for the purpose of realizing transaction synergies. In some cases, the target will be left as a stand-
alone entity, with a fresh capital infusion from the acquiror. In other cases, other acquiror assets will be
fused with the target firm assets – perhaps in addition to a large fresh infusion of capital.
If the acquiror is large (e.g. Microsoft, Intel, or Cisco Systems), it will usually be able to digest a
large-scale acquisition without further capital raising, and will also handily be able to meet the firm’s future
capital requirements. Even if it is not, it may nonetheless have the ability to tap into the public market for
acquisition or project financing to further develop the EF’s assets. However, because some acquirors may
not be public or may not have favourable standing in the public market, in Table 1 we suggest that an
acquisition exit may not always be as well suited as an IPO in meeting the capital needs of high growth
A secondary market sale of shares will result in no new investment. It is also less likely than an
acquisition to presage the investment of new capital by the buyer (or the combination of the target assets and
the purchaser’s assets). This is because, as indicated above, strategic buyers often desire to obtain 100% of
the company before investing new capital.
However, even if the buyer will not immediately be investing fresh capital in the business, it will
sometimes purchase the VC's shares with a view to ultimately making an acquisition and investing new
capital. Clearly, however, a secondary sale is less likely to be well suited to rapid growth firms with good
prospects than an IPO or an acquisition exit.
The buyback raises no new capital. Rather, it will typically substitute debt for equity capital, in
order to finance the repurchase of the VC’s shares. In one sense, this is a benefit, since the buyback exit is
available for low growth firms that are not looking to raise new capital.
However, if the VC's investment has proven to be a winner, the corporation will have significant
value. In this situation, the company (and entrepreneur) will simply lack the resources (including borrowing
capacity) to repurchase the VC's interest. In essence, a buyback is good evidence that the entrepreneur and
VC agree that the firm lacks significant upside potential; it is a small scale “cash cow”, rather than a fast-
growing and cash-starved “gazelle”145. Thus, a buyback will support only a small scale of acquisition. In
addition, it both evidences, and adds to the EF’s comparative inability to raise present or future capital.
In summary, IPOs definitionally raise new cash for the firm. This adds a constraint to the IPO exit
decision in that the public market must be willing to support current capital raising: i.e. the firm must have
sufficiently attractive investment projects available to justify a fresh infusion of funds. This creates a
selection bias in reviewing the returns associated with VC exits, because only the most promising firms will
be able to tap the IPO market. The selection bias is exacerbated by the size and growth rate hurdles that the
EF must overcome before being admitted to the public markets. However, public markets are the deepest
capital well from which the EF may drink, making the public market particularly well suited to high growth
Strategic acquisitions are also a form of exit that both accommodate large scale acquisitions (at least
if the acquiror is large) and facilitate the infusion (or raising) of new funds. Thus, acquisition exits are also
well suited to high growth firms.
Secondary sales will normally result in no fresh infusion of capital. Because only the VC sells its
shares, they are definitionally associated with a lower scale of acquisition. They are less likely than IPOs or
acquisitions to support present or future fund raising activities, although they may be a prelude to a future
acquisition by a strategic acquiror.
Buybacks merely substitute debt for equity. In general, they accommodate only small-scale
acquisitions, and do not support significant future capital raising.
K. Risk Bearing Considerations
The terms are borrowed from Ronald J. Gilson, Evaluating Dual Class Common Stock: The Relevance of
Substitutes, 73 VIRGINIA L.R. 807 (1987).
In this section we focus on the efficiency of risk bearing by the purchaser of the VC’s interest (or,
if a corporate acquiror, its shareholders). In the Capital Asset Pricing Model, only systematic risk is
priced,146 although under more sophisticated models (such as Arbitrage Pricing Theory) a variety of risk
factors may be priced.147 At the risk of oversimplification, we discuss only the cost that results from a failure
to diversify unsystematic risk.
Different forms of exit involve different classes of purchasers, and some purchasers will be better
able to diversify unsystematic risk than others. The cost of a buyer’s underdiversification will be reflected in
the buyer’s willingness to pay for the investment, and hence the VC’s proceeds of exit.
In general, where the firm is purchased by an individual or a private corporation, the purchase may
result in underdiversification. Whether underdiversification occurs will depend on the size of the acquisition
relative to the wealth of the purchaser(s), and the degree to which the purchaser’s investment portfolio is
otherwise diversified. Bill Gates, for example, could presumably effect a billion dollar acquisition out of his
private wealth without incurring material underdiversification. Not many other individuals can make the
same claim. However, many individuals with low net worth can effect small purchases in the public market
without this leading to underdiversification.
In theory, underdiversification should not be of concern to an acquiror that is a public company (or
other tradable entity), since the entity’s owners may themselves diversify the unsystematic component of the
firm's risk by holding diversified portfolios of securities. However, as a practical matter, even managers of
public companies may have incentives to avoid high-risk investments, even if these investments have
significantly positive net present value. This will be true if the managers are underdiversified. They will be
underdiversified if their wealth is concentrated in the firm, when all sources of managerial wealth, including
remuneration, stock, stock options, and other incentive contracts are taken into account. Underdiversification
will lead the managers to avoid increasing the firm’s unsystematic risk, even though the firm’s shareholders
are indifferent to unsystematic risk (so long as the project has at least a zero net present value). 148
See e.g. FRANK J. FABOZZI & FRANCO MODIGLIANI, CAPITAL MARKETS : INSTITUTIONS AND INSTRUMENTS , 2d ed.
(1996) at 187-214.
See, e.g., Eugene Fama, Market Efficiency, Long-Term Returns, and Behavioral Finance, 49 J. FIN.
ECON. 283 (1998); Brennan et al., supra note 54; Bengt R. Hölmstrom & Jean Tirole, LAPM: A Liquidity-based
Asset Pricing Model, NBER Working Paper No. W6673.
John C. Coffee, Shareholders Versus Managers: The Strain in the Corporate Web, 85 MICHIGAN L.R. 1
IPOs spread risk better than any other form of exit save (potentially) an acquisition exit.
Institutional investors make purchases that are small relative to assets under administration, and are widely
diversified. Retail investors are obviously more prone to underdiversification, although there is no evidence
that the typical retail purchase results in underdiversification. In any case, all but the smallest IPOs are sold
mainly to institutional buyers.149 Thus, risk bearing considerations strongly favour an IPO.
A large strategic acquiror that is a public company will be as well positioned to bear risk as a firm
effecting an IPO. Indeed, for very large public firms (particularly conglomerates) the addition of the EF’s
assets to the acquiror’s stable of assets may not materially change the managers’ exposure to risk, even if the
managers are underdiversified.150 Thus, in some cases, the acquisition will dominate the IPO with respect to
Acquirors are not all large conglomerates, however. Some may be private corporations for whom
the shareholders and managers are both underdiversified. Thus, in Table 1, we suggest that risk bearing
factors will strongly favour the acquisition exit, but subject to variation.
Secondary sales may or may not result in efficient risk bearing. If the purchaser is an individual
who is underdiversified, then it will not. If it is a strategic acquiror that is a large public corporation, it will
spread risk widely. However, even in the latter case, it will not spread risk as widely as in the case of an IPO
of acquisition, since there may be other shareholders in the EF who are underdiversified. Thus, in Table 1
we list the risk bearing properties of a secondary sale as indeterminate.
See e.g. Gompers & Lerner, supra note 4; Vijay M. Jog, The Climate for Canadian Initial Public
Offerings, in PAUL J.N. HALPERN, ED., FINANCING GROWTH IN CANADA, 357-402 (1997).
This is not to say that conglomerate enterprise is efficient; the evidence suggests otherwise. See e.g.
Edward M. Miller, Why the Break-up of Conglomerate Business Enterprises Often Increases Value, 20 J. OF SOC.
POL’T AND ECON. STUD. 317 (1995).
Buybacks result in a concentration of the equity in the hands of the entrepreneur(s). Because the
manager’s income and wealth will both derive from the EF, this is almost certain to result in inefficient risk
bearing. Thus, risk bearing considerations strongly disfavour the use of a buyback exit.
Risk bearing considerations favour IPO and acquisition exits. The larger the firm and hence the
greater the scale of the exit, the greater the comparative advantage of IPOs and acquisitions in spreading risk.
Acquisitions are subject to variation, however, because the identity of the acquiror will vary. Secondary
sales have an ambiguous affect on risk bearing, while buybacks will usually result in inefficient risk bearing.
L. Common Exit Strategies as a Factor in Promoting Teamwork
In this section, we make two important distinctions. The first is between forms of exit that are
common, and those that are not. The second is between exit strategies that are common (at the time of the
VC’s first investment), and those that are not. The first is illustrated by an acquisition exit, which, as
discussed further below, represents a common form of exit. The second is illustrated by a buyback. A
buyback is a common form of exit, but is unlikely to form a common exit strategy, in the sense that neither
the entrepreneur nor the VC will aim to effect a buyback exit at the outset of the investment.
A venture capital investment is virtually by definition a relational investment, and a strong and
amicable working relationship between the VC and the entrepreneur is what distinguishes a successful from
an unsuccessful investment.151 We posit that the strategy of working toward a common form of exit tends to
cement the VC-entrepreneur relationship and prevent various forms of VC or entrepreneur opportunism.
Consider, for example, a situation in which the entrepreneur and the VC are at one in pursuing either
an IPO or an acquisition exit. In this case, they will work cooperatively to effect that result. If, however, the
entrepreneur anticipates that the VC will make a unilateral exit via a buyback, she has incentives to depress
the value of the enterprise in order to pay the VC as little as possible when it is cashed out. This she may do
by shirking, deliberately refraining from adopting value-added strategies (which can be implemented once
the buyback has been effected), or by misrepresenting the state of the firm to the VC (thereby depriving the
VC of knowledge not merely as to an appropriate exit value, but also regarding an appropriate set of policies
that will maximize the value of the firm).
Sahlman, supra note 7; Gompers & Lerner, supra note 4.
There is growing evidence in the literature of opportunistic forms of exit. Gompers, for example,
produces evidence of VC opportunism by young venture capital firms in prematurely exiting their
investments via IPOs in order to generate a track record for subsequent fund raising (a phenomenon that he
christens “grandstanding”).152 We produce evidence in related work that when abundant funds are available
to VCs, they will sometimes opportunistically effect an exit from some of their investments in order to re-
deploy their managers into new investment opportunities.153 The entrepreneur’s interest is clearly to avoid
opportunistic exits, whether taken unilaterally (as in a secondary sale) or jointly (as in an acquisition), and to
ensure that the VC is truly committed to maximizing the value of the EF - and not merely the aggregate
value of the firms in its portfolio. By the same token, the VC will be anxious that the entrepreneur, in whom
much of the value of the firm resides, does not opportunistically exit.
One significant and ongoing source of tension between the VC and the entrepreneur (and a potential
source of exit opportunism) arises from the differing risk preferences of the VC and the entrepreneur. A
well-diversified VC will act as a risk neutral party (barring agency issues that arise between the fund’s
managers and its own investors154). The entrepreneur, on the other hand, will routinely be underdiversified,
because both her income and the bulk of her wealth will derive from the EF. She will thus behave in a risk
averse manner. On the principle that “a bird in the hand is worth two in the bush”, she might be tempted to
engineer a premature exit (e.g. by secondary sale or acquisition) at relatively inferior consideration, locking
in her gain, to accommodating the VC’s preference to wait until the time is ripe for an IPO (with all its
attendant systematic and unsystematic risks).
Various contractual means are used to address these issues, and many of these contractual provisions
are designed to ensure that a common form of exit occurs.155 For example, “go along” rights enable all
shareholders to participate in an exit negotiated by only some of the shareholders. This discourages both the
VC and the entrepreneur from attempting to negotiate a unilateral exit. Similarly, “drag along” rights allow a
Gompers, supra note 7.
Cumming & MacIntosh, supra note 11.
There is some potential for VC managers to act like corporate managers due to underdiversification,
since the manager’s wealth will depend to a considerable degree of the performance of the fund. VC managers,
by their nature, however, are likely to be less risk averse (and perhaps even risk preferring) when compared to
corporate managers, attenuating this agency problem.
These issues are explicated at much greater length by Smith, supra note 6. See also Gompers & Lerner,
supra note 4, ch. 3.
super-majority of shareholders (typically 90%) to compel recalcitrants to participate in an exit.156
Even without such express stipulation, an experienced VC will often take the entrepreneur’s
preferences into account when choosing a form of exit, even if this results in a less profitable exit than might
otherwise have been the case. Cultivating the entrepreneur's interests protects and enhances the VC's
reputation in the entrepreneurial community, leading to a higher probability of investing in promising EFs in
IPOs are a form of exit in which the entrepreneur and the VC exit together. Because of the high
returns that often flow from an IPO, an IPO is regarded as a desirable form of exit. Hence, an IPO exit will
be both a common form of exit and a common exit strategy (excepting opportunistic IPOs, such as those
resulting from grandstanding). While the entrepreneur and the VC may not sell at precisely the same time
(indeed, they may sell months or even years apart), they will both have the same opportunity to sell once any
pertinent hold and/or escrow requirements (contractual or regulatory) have expired.
Acquisition exits, by definition, involve the sale of the entire firm, and so will necessarily entail a
common form of exit for the VC and the entrepreneur. Because acquisition exits, like IPOs, are usually
associated with high returns, an acquisition exit is also likely to form a common exit strategy.
At the time of the VC’s investment, both the VC and the entrepreneur will prefer either an IPO exit
or an acquisition exit. The IPO will often dominate as the preferred form of exit, because it tends to produce
the highest returns for both the VC and the entrepreneur.157 However, it will not be clear to the parties at the
time of investing whether an IPO will be feasible. The availability of an IPO will depend on a number of
variables that are difficult or impossible to forecast, such as the state of the public markets (and the economy)
at any given point in time, the fortunes of the firm, the array of products marketed by competitors, and so on.
As we argue elsewhere in this paper, for some firms an acquisition exit may dominate an IPO either at the
Id. Canadian corporate legislation typically supplies a de facto legislative drag along right even without
contractual stipulation. See e.g. CBCA s. 206 (which only requires that the acquisition be formally structured as a
takeover bid by the acquiror).
See infra Part VI; Bygrave and Timmons, supra note 13; John Cochrane, The Risk and Return to Venture
Capital, University of Chicago, mimeo; Gompers and Lerner, supra note 4.
time of investment, or at the time when the exit possibility ripens. Thus, both IPOs and acquisition exits
can be regarded as common exit strategies.
A secondary sale involves a sale of the VC’s shares alone. It is a non-cooperative form of exit, and
thus unlikely to represent a non-cooperative exit strategy. While a secondary sale (say, with the substitution
of a new VC) may represent an ad hoc cooperative strategy, given the way in which the investment has
developed, it is unlikely to form a cooperative strategy at the time of initial investment.
Buybacks are also a non-cooperative form of exit, involving the departure of the VC alone. Like
buybacks, they will not usually represent a preferred form of exit strategy at the inception of the parties’
relationship (although again, on an ad hoc basis, a buyback may become a cooperative exit strategy given the
company’s fortunes, an inability to utilize other sources of exit, and/or the state of the VC-entrepreneur
IPOs and acquisition exits are common forms of exit, as well as common exit strategies. Secondary
sales and buybacks are neither a common form of exit, nor a common exit strategy.
M. The Cyclicality of Valuations in IPO Markets
There is evidence that IPO pricing is subject to psychological factors, and not merely investment
fundamentals.158 The operation of these psychological factors may result in periodic overvaluations of IPO
firms. IPOs will be particularly attractive means of exit during these periods of overvaluation.
The best evidence that psychological factors operate in IPO markets is that in the longer term
Tim Loughran & Jay R. Ritter, Why Don’t Issuers Get Upset About Leaving Money on the Table in
IPOs? REV. FIN. STUD. (2002, forthcoming); Tim Loughran & Jay R. Ritter, The New Issues Puzzle, 50 J. FIN. 23
(1995); Jay R. Ritter, The Long-Run Performance of Initial Public Offerings, 46 J. FIN. 3 (1991); Mario Levis,
The Long-run Performance of Initial Public Offerings: The UK Experience 1980-1988, 22 FIN. MGMT. 28 (1993);
Tim Loughran, NYSE vs NASDAQ Returns, 33 J. FIN. ECON. 241 (1993); Jog, supra note 148; Gompers & Lerner,
supra note 4.
(typically defined as the five years following an IPO) IPOs are overpriced compared either to a relevant
market benchmark or a matched sample of public firms.159 Ritter’s pioneering study, for example, found that
"a strategy of investing in IPOs at the end of the first day of public trading and holding them for 3 years
would have left the investor with only 83 cents relative to each dollar from investing in a group of matching
firms listed on the American and New York stock exchanges.160 Ritter also found that "younger companies
and companies going public in heavy volume years did even worse than average”.161 Ritter concluded that
purchasers of IPOs were overoptimistic about the prospects of IPO firms, stating that "[t]he evidence
presented here is broadly consistent with the notion that many firms go public near the peak of industry-
Loughran, Ritter, and Rydqvist find further evidence supporting the view that investors cyclically
overprice IPOs and that firms time their offerings to coincide with 'hot issues' markets. 163 In 14 of 15
countries, they find a positive correlation between inflation-adjusted stock market prices and the annual
volume of IPO activity.
At first blush, this is not necessarily inconsistent with economic theory. In a strong economy, the
opportunity set of investment projects available to firms will widen, and the pool of positive net present
value opportunities will deepen. This will raise stock prices. It will also enhance both the demand for, and
supply of capital to fund new public companies. Thus, the correlation between rising stock prices and a
strong IPO market may be nothing more than a case of common causation. That is, each is a common
product of a strong economy.
As against this view, however, Loughran et al. find that the frequency of IPO offerings is much
more closely correlated with the stock market than with real economic factors.164 They conclude that "[t]he
evidence from around the world is consistent with the view that private companies have some success in
timing their IPOs to take advantage of misvaluations".
Id. See also Jay R. Ritter, The Long-Run Performance of Initial Public Offerings, 46 J. FIN. 3 (1991).
Ritter, Id., at 23.
See also Loughran et al., supra note 74.
Ritter, supra note 138, at 23.
Loughran et al., supra note 74.
There is also evidence that venture capitalists can time market cycles and take their EFs public at
just the right time to capture peaks in the market. Gompers and Lerner find that VCs “successfully time
IPOs by being more likely to take companies public when their valuations are at their absolute and short-
term peaks,” and that experienced VCs are better able to time the market than their less experienced
Interestingly, however, while psychological factors may account for the overvaluation of the
average IPO, long term overpricing appears to be concentrated among small, risky, young, and non-
venture-capital backed firms. As noted above, Ritter found that younger companies had the worst long-
term performance. In their multi-country review of IPO studies, Loughran et al. concluded that the worst
after-market performance was found in markets with an abundance of IPOs of risky firms. 166 Most
recently, Brav and Gompers find that "underperformance is almost entirely concentrated in the smallest
deciles of nonventure capital-backed issuers”.167
They note that purchasers of non-venture capital-backed IPOs tend to be retail, rather than institutional
investors, and speculate that such investors are more likely to be influenced by emotional, rather than purely
Although venture-backed IPOs may not therefore be prone to periodic overvaluations, there is
nonetheless good evidence that IPO valuations are cyclical in nature. Clearly, the attractiveness of an IPO
relative to other forms of exit will vary with the IPO pricing cycle.
N. The Life Cycle of a Venture Capital Fund: The Fire Sale Problem
In our general theory of exits, we assumed that venture capital funds are perpetual. In fact, most
venture funds are organized as limited partnerships that terminate ten years from inception, subject to the
Gompers & Lerner, supra note 4, at 213-14. See also Lerner, 1994b, supra note 7.
Loughran et al., supra note 80.
Alon Brav & Paul A. Gompers, Myth or Reality? The Long-Run Underperformance of Initial Public
Offerings: Evidence from Venture and Nonventure Capital-backed Companies, 52 J. FIN. 1791 (1997). See also
Gompers and Lerner, supra note 4, at 213-237. But see Lin and Smith, supra note 25, who find that venture-
backed IPOs experience significantly negative post-IPO price performance.
ability of the managers to extend the term with the permission of its unit holders. 168 We posit that exit
behaviour will be affected by the time horizon to fund termination. As the fund approaches the termination
date, there will be pressure to exit the fund’s investments in order to return to the limited partners their
capital contributions and associated profits in liquid form. This may lead the VC to exit an investment even
though the prospective net value added by staying involved is in excess of the investment’s maintenance
costs, and even if the VC is the highest value-added investor. We call this the “fire sale” problem, which is
essentially a problem of foregone opportunity (i.e. opportunity cost).
The fire sale problem will often entail both inferior exit valuations and inferior forms of exit.
With respect to the former, a firm may be brought to the public market a year or two earlier than optimal
in order to create liquid consideration to return to investors. With respect to the latter, a firm that in a
year or two might be suitable for the public market might instead be sold in an inferior acquisition exit.
Or, investments that might have been exited via acquisitions will be exited via secondary sales or
The fire sale problem is often contractually mitigated by provisions in the agreement binding the
VC to its investors that prevent re-deployment of capital harvested from old investments into new
investments.169 These constraints often allow reinvestment only in the first few years of the fund, or with
the approval of the unit holders. They are testimony to the potentially serious nature of the fire sale
problem, given the opportunity cost associated with holding cash for a period that might easily run into
In Table 1, we thus suggest that the fire sale problem will tend to favour inferior forms of exit
(save where the firm has already cleared the IPO size and growth hurdles), although what constitutes an
“inferior” form of exit will obviously be highly firm-specific.
O. Reputational Incentives
VCs, like other long-term players in capital markets, desire to maintain a favourable reputation in
the market. A good reputation will assist in attracting investors, developing and maintaining useful
working relationships with entrepreneurs, and forging relationships with lawyers, investment bankers,
Sahlman, supra note 4.
See supra, notes 91-93 and accompanying text.
auditors and others who are capable of providing useful services to investee companies.
That VC reputation has value in the market has empirical support. Megginson and Weiss170
demonstrate that venture-backed (“VB”) IPOs have less short-term underpricing than non-venture-backed
(“NVB”) IPOs. The difference is both statistically and economically significant; on average VB IPOs
were underpriced by 7.1%, versus 11.9% for NVB offerings. Since the degree of underpricing is a proxy
for the market risk of the issue, the presence of a VC clearly reassures public investors as to the quality of
the offering. Megginson and Weiss also found that underwriter compensation was lower for VB
offerings, suggesting that the underwriters believe that their risk is lower in VB offerings.171
Lin and Smith also find evidence of the value of the VC’s reputation. 172 A VC without an
established reputation is less likely to sell shares in a secondary offering at the time of the firm’s IPO.
VC’s with established reputations can afford to do so at lower cost; the VC’s reputation serves as a
“bond” that substitutes for ownership retention in reassuring investors that the VC is not selling merely
because it thinks that the stock is overvalued.
In this section, we suggest that reputational considerations are at work in the VC’s choice of exit.
In general, the VC’s desire to build a good reputation will lead it to prefer the form of exit that is
associated with the greatest returns for both itself and its investors; i.e. an IPO or an acquisition exit. As
we have already indicated, however, there may be situations in which the VC’s and entrepreneur’s exit
preferences (whether as to timing or form of exit) will diverge. 173 Gompers demonstrates that the desire
of younger VC firms to develop a good track record (in order to attract future funding) may lead them to
“grandstand” and bring firms to the public market prematurely.174
Megginson & Weiss, supra note 5.
See also Barry et al., supra note 5.
Lin & Smith, supra note 25.
Supra, Part III.K.
Gompers, 1996, supra note 7; Gompers & Lerner, supra note 4, at 239-261.
Gompers does not discuss forms of exit other than IPOs, and therefore does not opine on
whether grandstanding might involve exits by means other than an IPO. There seems to be no reason
why grandstanding might not also lead the VC to make a premature acquisition exit as well, if an
acquisition exit will yield the highest consideration for a given EF. One additional factor might be
important, however. IPOs receive more widespread coverage in the press than acquisitions, and attract
the interest of a wide spectrum of investors who might also be future investors in the VC’s future funds
offerings. IPOs are thus associated with much greater publicity for the VC. This publicity extends well
beyond the exit, since publicly traded firms that do well continue to attract the interest of the financial
press, analysts, and investors long after the IPO is concluded (while EFs sold in acquisitions may be
melded into the acquiror’s assets and disappear from public view). This might lead the VC to prefer an
IPO exit even in cases in which an acquisition exit would result in a higher payoff. We thus posit that
grandstanding will bias exit decisions in favour of IPO exits, particularly in hot issues markets in which
IPO valuations are high.
Because secondary sales and buybacks are generally not associated with very high returns, it
seems unlikely that grandstanding would manifest itself by exits taken by either of these means.
P. Agency Costs of Debt
The firm’s maximum value is achieved when the sum of the agency costs of debt, the agency
costs of equity, and residual loss is minimized. 175 Whether this optimum is achieved will affect the value
of the firm.
In this section, we focus exclusively on the agency costs of debt. While this abstracts away from
the agency costs of equity and residual loss, we suggest that when the agency costs of debt are extremely
high, the sum of the three constituent components of value is unlikely to be at a maximum. Thus, it is
important to determine the relative agency costs of debt associated with different forms of exit.
Different forms of exit will differentially affect the firm’s debt/equity ratio, and also the
concentration of equity holdings. In general, the lower the debt/equity ratio, the lesser the incentive of
equity holders to appropriate wealth from the debt holders, and the lower the agency costs of debt.176 In
Jensen & Meckling, supra note 40.
Jensen and Meckling, Id. See also Barnea et al., supra note 38; Halpern et al., supra note 38.
addition, the higher the concentration of equity ownership, the greater the incentive of the equity
holders to appropriate wealth from debt holders, and hence the greater the agency costs of debt.177
IPOs add a new layer of public equity on top of the existing equity, while not immediately
affecting the firm’s debt load. Thus, the debt/equity ratio is lowered, resulting in a lower agency cost of
debt. In addition, ownership concentration is reduced, which might again be expected to reduce the
agency costs of debt. An IPO will thus be expected to lower the agency costs of debt.
There is empirical support for this proposition. Pagano, Panetta and Zingales produce evidence
that firms experiencing an IPO experience a reduction in the cost of bank credit – even after controlling
for the reduction in leverage that results from going public.178
Because IPOs will thus not generally lead to an inefficient level of agency costs of debt (it will
generally lower the agency costs of debt), in Table 1 we suggest that this factor favours an IPO exit.
If an acquisition is effected by a purchase of shares, so that the target becomes a wholly owned
subsidiary (or nearly so) of the acquiror and retains a separate legal personality, equity ownership will be
highly concentrated. On its face, this will increase the agency costs of debt. However, if the acquiror is
a widely held public company, which will often be the case, then ownership of the target will in fact be
diffuse – and substantially more diffuse than prior to the VC’s exit. This points to lower agency costs of
However, the debt/equity ratio of the acquiror will also be important. An acquiror (particularly a
large one) with an extremely high debt/equity ratio may be unable to effect further borrowing against the
target’s assets, or will be able to effect borrowing only at a high cost. Thus, both the configuration of
equity holdings and the debt/equity ratio of the acquiror will play key roles in determining whether the
agency costs of debt increase or decrease post-acquisition. If the acquisition is effected by means of an
Pagano et al., supra note 61.
asset purchase, the analysis is much the same. Because of the factual dependence, in Table 1 we
record the effect of this factor on acquisitions as indeterminate.
Sale of the VC’s interest alone will simply substitute one equity holder for another, and thus will
not have any effect on the firm’s debt/equity ratio or on the concentration of equity holdings. It should
thus not affect the agency costs of debt.
The affect of a buyback on the agency costs of debt was discussed in the context of the effect of
information asymmetry on exit price.179 To briefly summarize, a buyback substantially increases the
debt/equity ratio and concentrates equity holdings in the hands of a few. Thus, we expect a buyback to
substantially increase the agency costs of debt.
Agency costs of debt are substantially increased by a buyback exit, and are lowered by an IPO
exit. They are not affected by a secondary sale, and are heavily fact-dependent in the case of an
acquisition. We thus suggest that this factor favours the IPO and disfavours the buyback.
Q. Public Profile
Going public can enhance a firm’s public profile in a manner that enhances the firm’s ability to
sell its products and to raise capital in the future.180 This is another advantage of the IPO over other
forms of exit, although once again if the acquiror in an acquisition exit is a public firm, similar benefits
may result. In a market characterized by rational expectations, these benefits will be reflected in the
VC’s exit price.
R. Governance Mechanisms
Supra section III.A.
See e.g. Paul E.C. Benson, The Going Public Decision, Insight Press (Toronto), June 22, 1993, at 3-6.
The exit price will be a function of the various contractual and extra-contractual mechanisms that
are put in to restrain agency costs post-exit.181 Since an exploration of the technology of contracting in
relation to various forms of exit is an undertaking in itself, we make no speculations on how the choice of
exit might be affected by such mechanisms.
S. A Rank Ordering of Exit Preference by Investee Firm Quality
The factors that we have suggested affect the VC’s exit decision are summarized in Table 1. The
best form of exit will thus be contingent on a variety of different factors to which it is difficult, a priori,
to ascribe particular weights. We nonetheless suggest that a general rank ordering of exit preference
(and/or availability) is possible.
The IPO appears to be the most desirable form of exit for high quality, rapid growth firms – the
“home runs” from which venture capitalists derive most of their returns. Public markets are unparalled in
their ability to supply capital on a large scale and to spread risk. They also give the firm an unparalleled
ability to adopt incentive compensation arrangements post-exit. By lowering the debt/equity ratio and
creating less concentration in shareholdings, IPO firms are unlikely to be characterized by inefficient
capital structures or to be constrained by high costs of debt. IPOs supply the VC with the most liquid
form of exit, save a subset of acquisition exits, and also furnish the new owners with unparalled liquidity.
It is true that IPOs take a back seat to acquisition exits with respect to the immediate realization of
transaction synergies. However, by exposing the firm to the possibility of a hostile takeover (and
elevating the probability of a friendly merger), the IPO facilitates the realization of future synergies, and
may facilitate the capture of a large share of those synergies by the new owners if a takeover auction
develops. IPOs maximally enhance the VC’s reputation, and also result in a public profile that will
facilitate sale of the company’s product and assist in future capital raising efforts. IPOs are not merely a
common form of exit for the VC and the entrepreneur, but are typically (with some exceptions, such as
grandstanding) also a common exit strategy from the inception of the investment. The IPO thus guards
against forms of opportunistic behaviour that result from either the pursuit or expectation of separate
IPOs do not, however, dominate all other forms of exit in all states of the world. As noted, they
are second to acquisitions in their ability to generate immediate synergies. Further, only firms that
Smith, supra note 6; Daines & Klausner, supra note 32; Hellmann, supra note 6.
surmount hurdle size and growth rates (and/or satisfy fad demands for particular types of firms) will
be saleable in the public market. VCs do, however, have an ability to time the IPO so as to maximize the
proceeds of sale in the public market, and this suggests that they may also have an ability to capture
windows of opportunity that allow otherwise unmarketable firms to be brought into the public market.
One of the more significant disadvantages of the IPO is the buyers’ collective inability to resolve
information asymmetries and value the firm at the time of sale. Underwriters and other intermediaries
(including the VC) will mitigate, but not fully resolve these difficulties. Other forms of exit are
characterized by lesser information asymmetries and greater buyer ability to value the firm.
Another significant disadvantage results from the comparative inability of public market buyers
to monitor and discipline the managers post-IPO. Well-known collective action and free rider problems
are not fully mitigated by the IPO “contract” crafted by the firm’s investment bankers and lawyers.
Again, other forms of exit appear to better address these problems.
Two other ways in which IPOs are inferior to other forms of exit arise from the comparatively
high costs of going public and of operating as a public company. In addition, IPO markets are highly
cyclical: valuations vary significantly depending on the general economic climate and the state of the
public market. In some periods of time, an acquisition exit may yield a higher multiple or may be
available when an IPO is not.
In general, we expect acquisition exits to be the second best form of exit. Strategic acquirors are
better placed than any other buyer to resolve information asymmetries and value the firm at the time of sale.
Moreover, because it will own the entire firm, a strategic acquiror will be uniquely well positioned (save
perhaps in a buyback) to monitor and discipline the managers. Thus, acquisition exit will be comparatively
attractive for EFs characterized by a high level of information asymmetry between insiders and outsiders.
This might be the case, for example, for biotech firms with long product development times, or more
generally firms anticipating a long R&D process prior to bringing a product to market, making it difficult for
the owners, analysts and potential investors to evaluate managerial performance.
Perhaps the greatest advantage of the acquisition exit is the ability to generate transaction
synergies. An acquisition exit will be comparatively attractive when the firm’s technology is highly
complementary to technologies possessed by strategic acquirors.
An acquisition exit will also be attractive when the firm fails to meet the hurdle growth rate
demanded by the public market, too small to be of interest to institutional investors, or insufficiently
“sexy” to be sold in the public market.
An acquisition will result in transaction costs that are low compared to an IPO, and will avoid the
ongoing costs that attend the running of a public company. It may supply the VC with liquidity superior
to an IPO, although it will not usually result in high liquidity in the hands of the acquiror. It may result
in comparable efficiencies in risk bearing to an IPO, and is second to the IPO in attracting press coverage
(and hence contributing to the reputation of the VC). Like the IPO, it represents a common form of exit,
and will often also represent a common exit strategy, mitigating VC-entrepreneur agency problems.
Our review of the theory suggests that the buyback is an inferior form of exit. Perhaps the point
most in favour of the buyback is that at the time of sale information asymmetries will be low. In
addition, post-exit managerial incentives will be high, although we have suggested that post-buyback the
managers may indulge a preference for the pursuit of non-pecuniary ends (and in particular, indulging a
leisure preference). On the negative side of the ledger, buybacks result in no transaction synergies. More
importantly, buybacks are contraindicated for investments of home run quality. Home runs are
associated with a large scale of acquisition, and in the usual case the entrepreneur will not have the
resources to effect such an acquisition. Nor will she have the borrowing capacity; a buyback will drive
the agency costs of debt so high that borrowing will either be unavailable, or available only at great cost.
Only specialist MBO lenders, merchant bankers or mezzanine financiers will have the expertise to
resolve information asymmetries and monitor the managers (especially with technology firms), but such
lenders are typically interested only in large scale (and often pre-IPO) companies.
Even if debt financing is arranged, high debt levels post-exit will make it difficult to effect
further expansion financings, or to expand through synergistic combination with other firms.
Buybacks are both a non-cooperative form of exit, and for this reason, will usually represent a
mutually non-preferred exit strategy. They result in inefficient risk bearing, and will fail to contribute to
the VC’s public profile (and hence reputation). Buybacks yield partial cash consideration for the selling
VC, but liquidity is typically constrained either because the buyback is partial or because the
consideration is paid over a period of time. For all of these reasons, we expect the buyback to be
associated with living dead investments rather than home runs or base hits.
We suggest that secondary sales are likely on average to be inferior to either IPO or
acquisition exits, but superior to buybacks. Because secondary buyers are usually strategic acquirors,
they will be able to overcome information asymmetries and value the firm - although not as effectively as
in a 100% acquisition. Nor will they have the same ability as in a 100% acquisition to monitor and
discipline the managers. Nor will they be able to freely mold the EF’s assets to their own uses, given the
presence of minority shareholder interests. Secondary sales will not immediately result in transaction
synergies, but may raise the probability that synergies will be realized in the future. The acquiror will
receive an investment with little liquidity. In addition, the buyback represents a non-cooperative form of
exit and a hence mutually non-preferred exit strategy. A buyback exit is unlikely to contribute to the
public profile or reputation of the VC.
Secondary sales have more capacity than buybacks to generate high returns, however. A
strategic acquiror will generally prefer to make a 100% acquisition, but may be unable to do so because
of an inability to convince all shareholders of the EF to sell. In such a situation, a high valuing acquiror
may be content to purchase the VC’s interest, and may be willing to pay a high multiple to effect the
purchase. Moreover, secondary sales will bring a new active monitor on board with specialized
knowledge, contacts, and/or monitoring capabilities, which will often enhance the value of the firm (and
hence increase the buyer’s willingness to pay to acquire the VC’s interest).
Acquisition, buyback and secondary sale exits are more likely to occur as a fund termination
deadline looms, at least if the firm cannot surmount the IPO hurdle rate and make an exit into the public
IV. TESTABLE HYPOTHESES
Given the limitations of our data, not all aspects of the above theory are testable. The following
describes the empirical tests that we were able to perform.
A. Firm Quality
Our first hypothesis is that firms of differing qualities will be exited via the rank ordering of exits
indicated in the last section; i.e. IPOs, acquisitions, secondary sales, buybacks, and write-offs. We use
the concept of “quality” as a proxy for the variety of factors digested in Table 1 (and discussed in the
previous rank-ordering) that have an influence on the VC’s exit price. We do not have the data to test all
of the factors in Table 1 that determine the firm’s quality (and because some of the hypotheses may
not in fact be testable). Thus, in our empirical analysis in section VI, we proxy firm quality by the
market/book ratio at the time of exit, where the “market” price is the exit or sale price, and the “book”
price is what was paid for the investment. This variable implicitly controls for scale effects. For
example, a large initial investment is likely to lead to a large exit price, even when the firm at exit is of
inferior quality and the VC’s rate of return is poor. By using the ratio of market to book, such as
investment will be ranked as inferior to a small investment that has a high exit price compared to the
VC’s initial investment.182 The market/book ratio is an indicator of how much the firm has increased in
value under the VC’s tutelage.
Hypothesis 1 Higher quality entrepreneurial firms will be exited, in decreasing order of likelihood) by
IPOs, acquisition exits, secondary sales, buybacks, and write-offs.183
This hypothesis gives rise to a potential for endogeneity. While we posit that firm quality affects
the choice of exit vehicle, it may be that causality runs in the opposite direction, and the choice of exit
vehicle is a prime determinant of exit value. In general, we think this unlikely, since the implication
would be that IPO exits (perhaps coupled with acquisition exits for some EFs and some states of the
world) would strictly dominate other forms of exit. However, we clearly observe all forms of exit.
Because of cyclical pricing in the IPO market, however, an IPO exit becomes relatively more or
less attractive depending on the state of securities markets at the time of the contemplated exit. Thus, in
section VI and in the Appendix, we empirically test for the presence of endogeneity.
We acknowledge limitations in the private information furnished to us by our VC respondents.
We would have preferred, for example, to have data on corporate governance mechanisms put in place at
the time of exit to control agency costs post-exit. To the extent that governance mechanisms restrain
agency costs, they have the potential of affecting exit price. Nonetheless, we feel that our data is
sufficient to enable us to perform the first empirical tests of factors affecting the full range of VC exits.
This is not perfect either. It may be that the larger investment has a higher net present value than the
smaller. However, there is no measure that is perfectly suited to proxy quality, given limitations that inhere in
calculating evaluating risk ex post (or even ex ante) and calculating net present values.
In other words, ∂(PIPO/PAcquisition)/∂(Quality) > 0 (i.e., the derivative of the probability of an IPO / the
probability of an acquisition with respect to entrepreneurial firm quality is positive). Similarly, Hypothesis 1
states that ∂(PAcquisition/PSecondarySale)/∂(Quality) > 0, and therefore ∂(PIPO/PSecondarySale)/∂(Quality) > 0, etc.
B. Investment Duration and Exit Strategy
VCs are more than merely sophisticated investors with the ability to separate good investments
from bad. While they do not run the EF on a day-to-day basis, there are hands-on investors whose various
activities add value to their EFs. VCs monitor and sometimes replace management, participate in strategic
decisions, and offer informal advice on decisions of lesser importance. Experienced VCs have webs of
contacts that assist the firm in sourcing materials, finding customers, building distribution networks, and
locating strategic partners. They offer expert advice on (and participate in) finding other sources of
funding. VCs also use their experience to help the firm find skilled lawyers, accountants, investment
bankers, and other professional advisors.184
We posit that, just as the acceleration imparted to a physical mass depends on the duration of the
external force applied, the increase in value of an EF will depend on the duration of the VC’s involvement
with the firm. Put in more concrete terms, firms that have benefited from lengthy VC guidance will be
more likely to have a proven product, an established market, relatively experienced management, and more
elaborate internal information and control systems than at the time of initial investment. Contacts between
the firm and suppliers, marketing experts, lawyers and investment bankers will be in place.185 These factors
attenuate many of the risks that confront investors in the earlier stages of the firm's existence.186
Empirically, VC involvement with an EF has been demonstrated to be a signal of firm quality to
the public market in relation to IPOs. Venture-backed firms experiencing an IPO are subject to less
underpricing than their non-venture-backed counterparts.187 In addition, venture-backed firms perform
better post-IPO than other IPO firms.188 This suggests that the longer the involvement of the VC, the
more potent the signal of quality.189
Supra, notes 11-14 and accompanying text.
Megginson & Weiss, supra note 5; Gompers, 1996, supra note 7.
These risks are described in Sahlman, supra note 4, at 489; see also MacIntosh, supra note 14.
Nonetheless, the degree of information asymmetry will be high compared with that of a typical public company.
A public company will have a lengthier operating history. Moreover, much more information about a public firm
will be on the public record, both as a consequence of the operation of private information gathering networks and
mandatory disclosure requirements.
Barry et al., supra note 5.
See Cumming & MacIntosh, supra note 11. This is similar to the model developed by Chemmanur &
Fulghieri, supra note 20, in which public offerings are better suited to older, more established companies in which
This hypothesis is testable. If duration is a signal of quality, the signal will have the highest value
where information asymmetry is the greatest. We have suggested that information asymmetry is at its
greatest in IPOs, followed by secondary sales, acquisitions and buybacks. 190 We thus conjecture the
following causal relationship:
Hypothesis 2 The longer the venture capitalist's investment duration, the more likely the following exit
vehicles will be used (in decreasing order of likelihood): IPOs, secondary sales,
acquisitions, buybacks, and write-offs.191
As with Hypothesis 1, Hypothesis 2 is tested in the Appendix for the possibility of endogeneity.
In addition, a variety of other factors appear to influence investment duration. Related research
indicates that investment duration is shorter when the exit is pre-planned or induced by an unsolicited
offer.192 Investment duration is also shorter for earlier stage (seed, start-up and expansion) investments. 193
In addition, VCs with large amounts of capital available for investment tend to exit their existing
investments sooner.194 In respect of IPOs, Gompers has shown that grandstanding affects investment
duration.195 Market liquidity may also affect investment duration. In order to take these factors into
account in our empirical analysis below we regressed various of these variables on duration and used the
residual explanatory variable [for what?]. Alternative specifications did not yield significant qualitative
moral hazard and adverse selection costs are less pronounced.
In addition, note that write-offs may be expected to be most frequent where investment duration is
shortest. Mitigating informational asymmetry between the firm and its future owners obviously is irrelevant to an
investment that will be written off. VCs will not actively contribute to an investee once they learn that its quality
is so low that it must be written off. While "living-dead" investments may exist (whereby VCs hang onto the
investment in hope of a turnaround) a strategy of supporting living-dead investments may diminish a VC firm's
reputation and its ability to signal quality to future owners through their active participation in the development of
In other words, ∂(PIPO/PSecondarySale)/∂(Duration) > 0 (i.e., the derivative of the probability of an IPO / the
probability of a secondary sale with respect to VC investment duration is positive). Similarly, Hypothesis 2 states
that ∂(PSecondarySale/PAcquisition)/∂(Duration) > 0, and therefore ∂(PIPO/PAcquisition)/∂(Duration) > 0, etc.
Cumming & MacIntosh, supra note 11.
Gompers, 1996, supra note 7.
differences in our results. Hence, in the analysis that follows, we use the total duration of the VC’s
relation with the entrepreneurial firm.
C. Exit Strategies and High-Technology Firms
High-technology firms (e.g., those in biotechnology, communications, computers, electronics,
energy, environmental technology, and medical related industries) are distinct from other entrepreneurial
firms in a number of important respects. First, information asymmetries are likely to be more pronounced
for technology firms. Such firms have assets that are intangible and transaction-specific.196 Further,
entrepreneurs' actions are difficult to monitor, and a greater proportion of the value of the investment is
concentrated in the hands of mobile human capital.197 Because of these factors, high technology firms are
more difficult to value.198 This raises the likelihood of an acquisition exit, since strategic acquirors are
better positioned than the public market to resolve information asymmetries and value the firm, and to
monitor and discipline managers post-exit.
Second, technology firms are probably better suited to the achievement of transaction synergies
than traditional firms. Since transaction synergies are better accommodated by an acquisition exit, this too
tends to push in the direction of an acquisition.
In short, as we noted earlier, for some firms and in some states of the world, acquisition exits may
dominate IPO exits – and this will be particularly true for technology firms. For this reason, in hypothesis
3 below, we hypothesize an equal probability of an IPO and an acquisition exit for technology firms.
The choice between secondary sales and buybacks is more difficult. Buybacks address problems of
information asymmetry better than secondary sales. However, secondary sales are more likely, in the long
run, to result in the realization of transaction synergies. We thus suggest that the presence of a technology
EF will raise the probability of a secondary sale compared to a buyback.
Hypothesis 3 High-technology entrepreneurial firms will be exited by (in decreasing order of likelihood)
Thomas H. Noe & Michael J. Rebello, Asymmetric Information, Managerial Opportunism, Financing and
Payout Policies, 51 J. FIN. 637 (1996).
Id. See also Oliver Hart & John Moore, A Theory of Debt Based on the Alienability of Human Capital, 109
QUART. J. ECON. 841 (1994); MacIntosh, supra note 14.
by IPOs and acquisitions, then secondary sales, buybacks, and write-offs.199
Summary of Hypotheses
Three factors were conjectured to affect the choice of exit vehicle: entrepreneurial firm quality
(Hypothesis 1), venture capital investment duration (Hypothesis 2), and whether the investee is a high
technology firm (Hypothesis 3).
Before proceeding with the empirical analysis of these three hypotheses in section VI, in the
following section we first consider how the Canadian and U.S. data may reflect legal and institutional
V. LEGAL AND INSTITUTIONAL FACTORS AFFECTING CHOICE OF EXIT VEHICLE; U.S. AND CANADIAN DIFFERENCES
This section briefly touches on a number of legal factors that affect exit strategy. 200 Subsection A
notes some differences between U.S. and Canadian VC funds, and the impact these differences might have
on exit data. Tax differences between Canada and the U.S. are noted in subsection B. Differences in
Canadian and U.S. securities regulation are discussed in subsection C, market liquidity in subsection D, and
underwriter support for IPOs in subsection E.
A. Type of Venture Capital Fund
The U.S. data examined in section VI is derived wholly from private venture capital funds. In
contrast, the Canadian data contains a mixture of types of VC funds. Macdonald & Associates classifies
In other words, ∂(PIPO/Psecondary sale)/∂(Technology) > 0 (i.e., the derivative of the probability of an
acquisition / the probability of an secondary sale with respect to binary indicator of whether it is a technology
entrepreneurial firm is positive). Similarly, Hypothesis 3 states that ∂(PSecondarySale/PBuyback)/∂(Technology) > 0, and
therefore ∂(PSecondarySale/PBuyback)/∂(Technology) > 0, etc. For reasons discussed in the text is difficult to predict, a
priori, the likelihood of an IPO over an acquisition for technology firms.
For a more detailed analysis, see MICHAEL ANDREWS, INITIAL PUBLIC OFFERINGS BY CANADIAN GROWTH
COMPANIES (1995); MacIntosh, supra note 14; Michael J. Robinson, Raising Equity Capital for Small and Medium
Sized Enterprises Using Canada's Public Equity Markets, in PAUL J.N. HALPERN , ED., FINANCING GROWTH IN CANADA,
the Canadian industry into 5 types of funds.201 The primary difference across funds arises in respect of
the source of contributed funds. "Private independent" funds are funded mainly by public and private
pension funds and wealthy individuals. "Corporate industrial" funds are wholly owned venture capital
subsidiaries of corporations, while "corporate financial" funds are wholly owned subsidiaries of financial
institutions. Together, these three types of funds, which correspond to those digested in the U.S. data, are
referred to below as "private" funds.
In addition, "government" or "public" funds are venture capital corporations owned and run by the
federal or provincial governments. Finally, hybrid funds are "funds which are formed in response to a
government incentive or an investment by government alongside private investors, or which have secured
more than 50% of their capital from another hybrid fund".202
The two types of funds that dominate the Canadian VC landscape are private funds and hybrid
funds. In turn, the most important type of hybrid fund is the Labour Sponsored Venture Capital
Corporation (LSVCC). LSVCCs controlled roughly half the total amount of venture capital under
management in Canada between 1992 and 1995, the years spanned by our data, and significantly more than
any other type of fund.203
The LSVCC is a venture capital corporation created pursuant to special legislation of either the
federal government or one of the five provinces that have passed enabling legislation for such funds. 204 The
impulse that led to the establishment of the LSVCC was a desire to encourage blue-collar ownership of
small and medium-sized enterprises. The province in which the fund is created provides a generous tax
credit to fund investors, and this credit is matched by the federal government (regardless of the jurisdiction
of incorporation).205 Only individual investors may contribute to LSVCC funds. Because of the underlying
MACDONALD & ASSOCIATES , VENTURE CAPITAL IN CANADA: A GUIDE AND SOURCES (1992).
Id., at 4, note 3; MACDONALD & ASSOCIATES, THE VENTURE CAPITAL MARKET IN CANADA: AN ANALYSIS OF 1993
VENTURE CAPITAL ACTIVITY (1994).
See MACDONALD & ASSOCIATES, CANADIAN VENTURE CAPITAL ASSOCIATION ANNUAL REPORT (1992-1996).
See generally Douglas J. Cumming & Jeffrey G. MacIntosh, Law, Finance and The Canadian Venture
Capital Cycle, University of Alberta and University of Toronto, mimeo (2001).
Prior to 1996, investors in LSVCCs received a 20% provincial tax credit plus a 20% federal tax credit on
an investment of up to $5,000. The $5,000 contribution was also eligible to be deducted from taxable income if
contributed through a Registered Retirement Savings Plan (“RRSP”) (similar to an American 401k plan). Under
the March 1996 federal budget, the government's tax credit was reduced to 15% on a maximum investment of
$3,500, and since that time the provinces have similarly reduced the provincial tax credit. The $3,500
contribution, however, is still eligible to be deducted from taxes if invested through an RRSP.
inspiration, a labour union must sponsor the fund, although anyone may invest in one.
In practice, LSVCCs investors are white-collar workers. 206 Even though the union will nominally
control the fund (all jurisdictions require that it appoint a majority of the board), its only substantive
involvement is, in essence, to “rent” its name to the fund. The professional managers hired under contract
by the union run the fund’s operations more-or-less autonomously.
LSVCCs operate under statutory constraints that do not apply to private funds. In particular,
LSVCCs are typically created with the dual mandate of creating jobs and investment in the sponsoring
jurisdiction. This difference between LSVCCs and private funds, however, is more apparent than real. In
the interests of attracting capital contributors, most funds207 operate in practice as profit maximizers, and a
number have publicly announced their intention to do so despite their statutory mandates.
Other statutory constraints may have a more real impact on exit strategy, via their impact on the
types of investments made by LSVCCs. First, federal and provincial LSVCC legislation typically penalizes
a fund for failing to invest a stated percentage of its committed capital within a certain period of time
(usually one or two years) following receipt of that capital. This creates an impetus to get the money out
the door quickly, which in turn may lead to poor investment choices. It may also prompt the fund to limit
its purview to larger (and therefore probably older and less risky) investments.
Second, we believe that the rapid influx of capital into LSVCCs has resulted in many of these
funds hiring inexperienced managers.208 If so, LSVCC managers are less likely act effectively at any of the
three stages at which VC expertise is applied: choosing investments, providing value-added services, and
providing sound exit advice. Inexperienced managers are more likely to shy away from younger, riskier
companies in making investment decisions. They are less likely to give effective advice to the entrepreneur
on exit strategy.
The hypothesis of lower skill levels is supported by anecdotal evidence suggesting that U.S. VCs
Francois Vaillancourt, Labour-Sponsored Venture Capital Funds in Canada: Institutional Aspects, Tax
Expenditures and Employment Creation, in PAUL J.N. HALPERN, ED., FINANCING GROWTH IN CANADA (1997).
One notable exception is Quebec’s Solidarite Fund.
Cumming & MacIntosh, supra note 11.
have specialized in particular types of EFs to a much greater degree than their Canadian counterparts. 209
While most Canadian funds have historically been willing to entertain investments in virtually any industry
(especially the large LSVCC funds), many U.S. funds have limited themselves to investments in particular
areas of the high technology spectrum.210 Industry focus is likely to enhance VC profits.211
Third, the LSVCCs are essentially open-ended mutual funds, from which investors may withdraw
at any time. During the period covered by our data, however, investors could typically withdraw after only
5 years without being subject to recapture of the investment tax credit (this has since been changed to 8
years, and investors in Solidarité, the largest Canadian VC fund, must normally wait until retirement to cash
out).212 By contrast, investors in private funds are usually locked in for 10 years.213 Thus, LSVCCs must
maintain a greater percentage of their investment portfolios in comparatively liquid form.
The conjecture that LSVCCs will make larger average investments in older (and probably therefore
less risky) firms is borne out by industry statistics.214 To the extent that the upside potential of LSVCC
investments is therefore lower, we would expect LSVCCs to exit their investments in a manner more suited
to lower growth firms; i.e. with fewer IPOs and acquisitions, and more secondary sales and buybacks.
It may be that the relative lack of expertise of the LSVCC funds will particularly elevate the
number of secondary sales. If LSVCCs are less capable of adding value than private funds, it makes sense
for the LSVCC to sell at least some of its investments to private funds.
The relative lack of expertise of LSVCC fund managers may introduce a more serious problem.
Unskilled managers are likely to make both investment and exit decisions that are not purely the product of
expertise. The resulting randomised component of exit strategy will show up in our data as “noise” that
attenuates the link between our 3 Hypotheses and actual exit behaviour. We thus expect the three
MacIntosh, supra note 14; Macdonald & Associates, 1992, supra note 202, 1994, supra note 201; Sahlman,
supra note 7, at 489.
E.g. biotechnology or computers; see Bygrave & Timmons, supra note 13.
Gompers & Lerner, supra note 4; Robert T. Klienman & Joel M. Shulman, The Risk-Return Attributes of
Publicly Traded Venture Capital: Implications for Investors and Public Policy, 7 J. BUS. VENT. 195 (1992).
hypotheses to bear more fruit in respect of the U.S. data.
Although there are few government funds in Canada, the presence of government funds may
increase the number of buybacks. Governments are less concerned to make profits for the government than
to strengthen the entrepreneurial sector. Anecdotal evidence suggests that such funds will sometimes agree
to a buyback exit even when a more advantageous form of exit is available.215
The Canadian data, described in section VI below, does not distinguish between different types of
venture capital funds (our data is opaque as to fund identity). In view of the fact that the U.S. data are
entirely from private funds but the Canadian data mixes public, private, and hybrid funds, we expect
stronger support for Hypotheses 1, 2 and 3 in the U.S. than in the Canadian data.
B. Tax Factors
Tax factors are clearly important in directing investment dollars to VC funds as opposed to other
investment vehicles. It is clear that changes to the U.S. tax code, for example, were instrumental in the
rapid growth of the U.S. venture capital industry observed in the late 1970s and early 1980s. 216 U.S. tax
law has also impacted upon the VC's choice of the limited partner form of organization that is used by
eighty percent of U.S. venture capital funds.217
For our purposes, the important question is whether different forms of exit are subject to
differential forms of taxation either within the U.S. and Canada, or between the U.S. and Canada. Such
differences may supply a reason for cross-sectional variations in patterns of exit. Taxation factors may also
account for changes in exit strategies over time. While no attempt was made to systematically determine
the tax consequences of all means of exit both in Canada and the U.S., discussions with VCs and tax
attorneys in both countries suggested that tax factors were relatively unimportant in the choice of exit
strategy, and that tax factors do not appear to have coloured the cross-sectional selection of exits as between
the two countries. Whether shares are sold by the VC in an IPO, a secondary market sale, an acquisition, or
a buyback, VCs in both countries will generally pay capital gains tax on an investment’s appreciation in
Innovation Ontario, a now defunct Ontario government fund, was in fact required to give the
entrepreneur an option to repurchase the government’s interest. Because the identities of our survey funds are not
known to us, we cannot tell if there are any Innovation Ontario funds in our data set.
Bygrave &. Timmons, supra note 13.
Gompers, Id.; Sahlman, supra note 7.
value. We thus do not expect taxation factors to have a material impact on observed exit strategies.
C. Securities Regulation
Related research suggests that securities regulatory requirements impact on the VC’s choice of exit
Both Canadian and U.S. securities legislation impose hold periods on any investor purchasing
securities in an exempt market transaction (i.e. one effected without the issuance of a registration statement)
prior to the date of the firm’s IPO. Such requirements, which will virtually always apply to VC holdings,
are designed to prevent a “back-door distribution” in which exempt investors (i.e. those who may purchase
the issuer’s securities without the issuer filing a registration statement) purchase securities not for
investment purposes, but solely for the purpose of funnelling them through to non-exempt investors (i.e.
those who are able to purchase only pursuant to a registration statement).
During the period covered by our study, regulatory hold periods in Ontario (which were
representative of other provincial enactments) ranged from 6 months to 18 months. 219 However, virtually
all of the firms brought to market by VCs would have had hold periods of either 12 or 18 months.220 These
hold periods start to run from the later of the date on which the exempt purchase took place and the date of
the IPO.221 Thus, whenever the VC received its securities in the EF, it typically must hold those securities
for at least 12 months from the date of the IPO before selling, unless a sale is effected to another exempt
purchaser. By contrast, in the U.S., the typical hold period is two years, and this period begins to run from
the date of the exempt purchase and will typically have expired prior to the IPO.222 Thus, hold periods
constitute a constraint on the sale of VC shares in Canada but not in the U.S.
The escrow requirements in force in Canada during the period of our study were also in excess of
MacIntosh, supra note 14.
Ontario Securities Act, R.S.O. 1990, c.S.5, ss. 72(4), (5); Ontario Regulation 1015, R.R.O. 1990, as am.,
The 12 month period will apply if the firm is listed on the Toronto Stock Exchange, while the 18 month
hold period will apply otherwise. Id.
SEC Rules 144 and 145. In April 1997, these hold-period requirements were lowered to one year after
the purchase of restricted stock, with some restrictions between the first and second years; see SEC 17 CFR Part
230 [Release No. 33-7390; File No. S7-17-95].
those in the U.S. During the period covered by our survey data, Canadian escrow requirements arose
pursuant to both securities regulatory rules223 and stock exchange requirements, 224 although for most of the
EFs in our sample, only the stock exchange requirements would apply.225 These rules are designed to
ensure that managers and key investors remain involved with an enterprise for a period of time after the
firm goes public (in order to ensure appropriate governance and continuity of management). Thus, under
the TSE requirements, shareholders holding 10% or more of the voting shares of the EF – including any
VC satisfying the ownership threshold - must place their shares with an escrow agent prior to the elapse
of the escrow period. While in the custody of the escrow agent, these shares cannot be sold without the
permission of the securities regulators. In the period covered by our sample years, the escrow
requirement could extend from 6 months to somewhat in excess of 5 years, although most escrow periods
would have been in the range of 1 to 3 years (Tucker, 1999)). Thus, Canadian VCs exiting via an IPO
experience less post-IPO liquidity than their American counterparts.
The view that these regulatory requirements make it more difficult to effect an IPO exit in Canada
as opposed to the U.S. must be qualified, however, to the extent that Canadian and U.S. markets are
integrated.226 If a Canadian VC can exit into the U.S. market without significant additional cost (as
compared to a Canadian IPO), these differences in regulatory burden would be essential moot. Since exit by
Canadian VCs into the U.S. market is much more likely than exit by U.S. VCs into the Canadian market,
we will deal with the former case only.
Canadian VCs (like other VCs) tend to prefer to invest close to home, and LSVCCs are in fact
constrained to invest only in firms for which the majority of employees, assets and/or payroll are located in
Canada.227 Thus, in most cases, Canadian VCs will be exiting investments in Canadian firms. Is the
Canadian/U.S. border fully transparent to such firms?
During the period of time covered by our study, OSC Policy 5.1, covering junior resource issuers,
specified escrow periods. See (1991) OSCB 899.
See e.g. Toronto Stock Exchange Manual, Company Manual, [loose-leaf] (Toronto: Toronto Stock
Exchange, 1984), Part III, C, s.327, and Appendix C (“Original Listing Requirements”).
Given that few VC-backed firms are resource issuers, OSC Policy would have applied at most to a trivial
number of EFs in our Canadian sample.
See Edward B. Rock, Greenhorns, Yankees and Cosmopolitans: Venture Capital, IPOs, Foreign Firms &
U.S. Markets, 2 Theoretical Inquiries in Law 711 (discussing IPOs by foreign firms in the U.S.).
Cumming & MacIntosh, supra note 203.
We distinguish four cases. First, these markets will be fully integrated if a VC in either country
may choose an exit in either country at the same cost. They will be quasi-fully integrated if a VC in either
country may exit in the other country at the same cost as an identical exit taken by a VC in the other
country. In this case, there may be differences in exit costs in the two countries, but there must be national
treatment of all VCs for regulatory purposes (such that all VCs, wherever situate, may exit by compliance
with a common regulatory regime in any country in which the exit takes place). There will be imperfect
integration if there is non-national treatment in the two markets, such that the regulatory regime for
Canadian VCs when selling into the U.S. is more onerous than that confronted by U.S. VCs. Finally, the
two markets will be fully segregated if cost differences are so great (with or without national treatment) that
the Canadian/U.S. border is opaque to exit transactions.
In the case of VC exits, it is clear that markets are not fully segregated. Anecdotal evidence offers
examples of Canadian VCs exiting their investments through IPOs, acquisition exits, and secondary sales
effected to U.S. buyers. Buybacks are quit different, however. Because Canadian VCs prefer to invest
close to home, and LSVCCs are in fact constrained to invest in Canadian firms, a Canadian VC’s EFs will
usually be located in Canada. Buyback exits will therefore be effected from entrepreneurs located in
In general, empirical evidence suggests that Canadian and U.S. markets are not fully integrated.228
A principal cause of the lack of integration is home bias, although due to our imperfect understanding of
what causes home bias, the phrase is perhaps more a description of the empirical result than an explanation
for it. In all likelihood, home bias results from information asymmetries arising between domestic and
foreign investors, with the result that local investors may be in a position to exploit less knowledgeable
As a first approximation, Canadian issuers selling into the U.S. public market must comply with
the same rules to which U.S. issuers are subject. However, Canadian issuers are in addition subject to a
requirement to reconcile their financial statements to U.S. accounting standards, a non-trivial expense that is
not experienced in a domestic IPO.
Usha Mittoo, Additional Evidence on Integration in the Canadian Stock Market, 47 J. FIN. 2035 (1992);
Philippe Jorion & Eduardo Schwartz, Integration vs. Segmentation in the Canadian Stock Market, 41 J. FIN. 603
Jeffrey G. MacIntosh, International Securities Regulation: Of Competition, Cooperation, Convergence
and Cartelization, University of Toronto, mimeo (1995).
In addition, Canadian hold periods apply to securities purchased by a Canadian VC under
Canadian law even when the VC’s sale is effected in the U.S. 230 Thus, Canadian VCs are subject to more
onerous hold periods than U.S. VCs even when selling into the U.S. public market.231
Finally, a number of Canadian VCs have suggested to us other factors that enter into the decision of
whether to sell into the U.S. or Canadian public markets. In favour of a Canadian IPO, it was suggested to
us that legal costs are substantially higher in the U.S. than in Canada. In addition, because the corporate
landscape is so much vaster in the U.S., it was suggested that it is easier to become an “orphan” firm. An
orphan firm is one that is not followed by analysts and that typically generates little interest from
institutional investors. Once a firm acquires orphan status, it can be extremely difficult to raise further
capital. Because there are Canada substantially fewer issuers in Canada than in the U.S., and because many
Canadian institutions are restricted in the extent to which they can purchase foreign securities,232 it was
suggested to us that it is more difficult to become an orphan firm in Canada.
In favour of a U.S. IPO, however, it was suggested that IPO stock valuations are generally higher in the
U.S. This may devolve from some of the other advantages that are said to inhere in a U.S. offering. In
particular, the pool of investors that an issuer may access in a U.S. offering is vastly greater than that in
Canada. Relatedly, the liquidity of the U.S. public markets is substantially greater than that in Canadian
public markets (see further infra). A few Canadian VCs suggested that they frequently face serious
liquidity constraints following a Canadian IPO, making it difficult to effect an exit from a public company -
without substantially depressing the market price - for a period of many years after the expiry of pertinent
hold and escrow requirements. Also in favour of a U.S. IPO, it was suggested that once the firm has
acquired a public profile in the U.S., future financing efforts are greatly facilitated (again, because of the
deeper pool of potential investors). Each of these factors might yield higher valuations in the U.S. market.
The hold periods are set in motion when the “initial exempt trade” occurs under applicable securities law.
See e.g. OSA, ss.72(4).
These hold periods will not typically affect the VC’s ability to effect a secondary sale or an acquisition
into the U.S., given that in virtually every case a relevant exemption from Canadian secu rities laws will be
available. See e.g. OSA ss.72(1)(d) (exemption purchases in excess of $150,000 from the prospectus
The restriction is question is typically known as the “foreign property rule”. Income Tax Act, S.C.
1970-71-72, c.63, s.206. The foreign property rules, which apply to all tax exempt investors (including holders of
Registered Retirement Savings Plans, or "RRSPs", registered pension plans, and charities, limit the extent to which
shares of non-domestic issuers may be purchased as portfolio investments. Failure to conform to the requirements
of the Act results in tax penalties. The foreign property rules affect mutual funds that wish to sell interests to holders
of RRSPs, since in order to qualify to do so they must become a "registered investment" and comply with the foreign
property rules. See Income Tax Act, id., Part X.2.
Another factor that was said to motivate a U.S. offering was greater visibility and acceptability to
potential customers. When this is particularly important, the Canadian EF will not only make a public
offering in the U.S. (and list on a recognized U.S. exchange, such as NASDAQ) but will also reincorporate
in the U.S. (often in Delaware) and essentially pass itself off as a U.S. corporation.
We draw the following conclusions:
1. U.S. and Canadian markets are neither fully integrated nor fully segregated. In our lexicon, they
are somewhere in the region of quasi or imperfectly integrated.
2. Regulatory differences between Canada and the U.S. colour the cross-section of exits taken by
Canadian and U.S. VCs. In particular, Canadian VCs will effect IPO exits less frequently then
their U.S. counterparts.
3. Only a subset of IPO exits will be effected by Canadian VCs into the U.S. market.
D. Market Liquidity
Liquidity is of value investors and will affect the VC’s exit price. Canada’s economy is
approximately one-tenth the size of the U.S economy, and the depth of Canadian liquidity pools is
commensurately less than in the U.S.
Canadian illiquidity appears to be a function of more than just the number of potential traders on
each side of the market. Many VCs suggested to us that the greater liquidity in the U.S. market is also a
consequence of different appetites for risk in the two countries. U.S. institutions are said to be far more
willing than their Canadian counterparts to trade in comparatively risky technology stocks and more
generally in small firm stocks. While there is, so far as we know, no systematic evidence to back up this
claim, it was almost universally adverted to in our discussions with Canadian VCs.233
Institutional trading creates a public good, in the sense that an institutional decision to buy or sell creates an
opportunity for a trader on the other side of the market. By creating liquidity, institutional activity in secondary
markets also facilitates public offerings by small firms. This emphasizes the importance of regulating institutional
purchases in a manner that does not restrict the purchase of small firms. Legal restraints on institutional investors
have played an uncertain role in institutional purchases of small firm stocks by Canadian institutions. Even
restrictive 'legal for life' statutes have 'basket clauses' allowing for purchases of risky small firm shares, although
recent federal adoption of "prudent person" investing standards (also now adopted in many of the provinces) may
encourage more small firm investment. See generally MacIntosh, supra note 14; BRIAN Z. GELFAND, REGULATION OF
The illiquidity of Canadian markets extends to secondary sales and acquisitions as well as IPOs,
insofar as there are far fewer domestic strategic acquirors than in the U.S. While the pool includes firms
such as Nortel, JDS Uniphase, and Newbridge Networks, it nonetheless lacks significant depth. This
suggests that the cross-section of Canadian exits, when compared to the U.S., will be tilted away from
IPOs, acquisition exits, and secondary sales, and toward buybacks, given that the liquidity of a buyback
will definitionally be the same in Canada and the U.S.
E. Underwriter Support for IPOs
Unfortunately, there is little systematic evidence on the comparative nature of Canadian and U.S.
underwriting industries. However, there is some evidence that there are proportionately more underwriters
willing to bring small and medium-sized firms to the public market in the U.S. than in Canada.234
The U.S. market is also characterized by the existence of niche underwriters that service the high
technology market. There are no such players in Canada, probably because of economies of scale that arise
in the larger U.S. market.235 In the face of imperfect integration, this suggests that the cross-section of U.S.
exits should exhibit more IPOs than in Canada.
We have noted a number of factors that we expect to affect the cross-section of exits taken in
Canada and the U.S. We have suggested that Canadian VCs are less skilled than their U.S. counterparts.
This should lead to a greater proportion of inherently high-value IPO exits in the U.S. We also expect that,
in the face of imperfect integration between Canadian and U.S. capital markets (at least in relation to
smaller firms), the tendency toward fewer IPOs in Canada will be strengthened by more strenuous
regulation of IPOs in Canada, lower market liquidity, and less investment banker support for small firms.
The relative proportion of acquisition exits will also be affected by the comparative skill of U.S.
and Canadian VCs. In particular, we expect to observe more acquisition exits in the U.S. By the same
FINANCIAL INSTITUTIONS (1993).
“Top Brokers in Small-Cap IPO Market: First-Half 1994”, PROFIT 57 (Fall 1994); Economic Council of
Canada, INTERVENTION AND EFFICIENCY (1982), at 29.
MacIntosh, supra note 14.
token, we expect to observe a higher level of secondary sales in Canada, since secondary sales are
relatively low-value exits. The tendency to effect more exits via secondary sales will be moderated to some
extent, however, by the comparative dearth of strategic acquirors in Canada (again, assuming the absence of
The liquidity of buybacks is inherently the same in Canada and the U.S. Moreover, regulatory
factors are not likely to inhibit buybacks in Canada relative to the U.S. Coupled with the fact that buybacks
are typically low value exits, we thus expect to observe a higher proportion of buyback exits in Canada than
in the U.S.
VI. EMPIRICAL EVIDENCE
Our empirical analysis begins with the presentation of a number of summary statistics from the
Canadian and U.S. data in subsection A. A multinomial logit model is then employed in subsection B to
assess the impact of various factors that influence venture capitalists' choice of exit vehicle (Hypotheses 1,
2 and 3). Concluding remarks and policy implications follow.
The survey data comprises exits from 112 portfolio companies from 13 venture capitalists in the
U.S. and 134 portfolio companies from 22 venture capitalists in Canada between 1992 and 1995. The IPO
exits are public data; the non-IPO exits (acquisitions, secondary sales, buybacks and write-offs) are private
data collected by means of a survey of Canadian and U.S. VCs.236
The data are summarized in Tables II and III.237 Table II indicates that the most common exit
Collection of the survey data was done in conjunction with Venture Economics in the U.S. and the
Canadian Venture Capital Association Both companies produce annual yearly statistical summaries of the venture
capital industry in their respective countries. The data comprises approximately 10% of all U.S. exits and 32% of
all Canadian exits from 1992 to 1995. Factors that may induce self-selection reporting bias of private data
(acquisitions, secondary sales, buybacks and write-offs) across Canada and the U.S. are likely to be the same in the
two countries; therefore self-selection bias, if it exists, should not affect the comparative cross-country results. The
Canadian Venture Capital Association (1993-1996), supra note 9, reports the total dollar values of the exits in
Canada for each exit vehicle; Venture Economics (1993-1996), supra note 9, only reports the total dollar values of
IPO and acquisition exits. Additional industry data is not available in the Venture Economics (1993-1996) and
Canadian Venture Capital Association (1993-1996) annual reports; nevertheless, the available industry data do not
suggest significant discrepancies between the Canadian and U.S. samples and industry data.
All dollar amounts were converted into constant 1990 US dollars. US dollar values were converted into
constant 1990 dollars using International Financial Statistics, label 11/64. Canadian dollar values were converted
vehicles in the U.S. were write-offs (29.5% of the total), IPOs (26.8%), and acquisitions (26.8%); the
least common were secondary sales (8.0%), buybacks (5.4%) and other 238 (3.6%). In Canada, the most
common exit methods were company buybacks (30.6%), IPOs (26.9%) and write-offs (20.1%); the least
common were acquisitions (11.9%), secondary sales (9.0%) and other (1.5%) (see Table III).
These cross-sectional results are only partly consistent with our earlier conjectures about the
relative frequency of different types of exits in Canada and the U.S. While we expected fewer IPOs in
Canada, the proportion of IPOs in the U.S. and Canada is virtually the same. The Canadian exits data,
however, shows a much greater proportion of buybacks and a much lower proportion of acquisition exits, as
expected. While we expected a higher proportion of secondary sales in Canada than in the U.S., the
proportion of such exits in the two countries is similar.
We also note, however, that the proportion of write-offs is lower in Canada than in the U.S. On its
face, this is inconsistent with the hypothesis of lower skill levels among Canadian VCs. However, this may
simply reflect the relative opportunity costs facing Canadian and U.S. VCs. If U.S. VCs are more skilled,
the opportunity cost of effecting a buyback (especially when managerial time spent negotiating and
documenting the deal is included) will be higher. Thus, some exits that would in Canada be taken as
buybacks may be taken in the U.S. as write-offs. This explanation is consistent with both the greater
proportion of buybacks and the lower proportion of write-offs in Canada. In support of this theory, we note
that the average annual real return for buybacks in Canada was about 4%, while the average in the U.S. was
about 25%. Given that only 6 exits taken were taken as buybacks in the U.S. this return figure should be
used cautiously. Nonetheless, the comparative rates of return are consistent with the view that the
opportunity cost of effecting buybacks is higher in the U.S. than in Canada.
[TABLES II AND III ABOUT HERE]
We also note, however, that U.S. investments are, on average, about twice the size of those in
Canada. Because repurchase of a larger stake will consume greater entrepreneurial resources (and/or
borrowing) to effect the buyback, also lowering the likelihood of a buyback in the U.S. relative to Canada.
into constant dollars using the CPI from CANSIM, label P700000, and to US dollars using foreign exchange rates
from CANSIM, label B3400.
"Other" exits involve mixed exit strategies (e.g., part buyback, part secondary sale). Other exits were
included in the multinomial logit estimation below; however, their coefficients are not reported because their
expected signs are ambiguous and the coefficients were generally insignificant.
Our data include both full and partial exits.239 A partial exit involves a disposition of only part
of the VC’s shares. In the case of an IPO, by convention, a full exit includes any case in which the VC
disposes of its entire investment within one year from the date of the IPO. In our data, a partial acquisition
is defined as an exit in which the VC received shares, rather than cash, in consideration for parting with its
interest. We also define a partial write-off as a write-down of the value of the investment on the books of
That some exits were partial in nature creates a statistical problem in that, for partial exits, exit
value was reported, but the proportion of the VC’s interest that was liquidated was not. Thus, we were
compelled to estimate what proportion of its interest a VC would typically sell in a partial exit, and
adjust the exit value accordingly to obtain the value of the entire firm at the date of exit. From other
published data,240 a partial exit on average involves a disposition of 69% of the VC’s interest. As this
adjustment to the market values may create bias in the data, we present the summary statistics for the
samples with and without the sample of partial exits. The summary statistics for the full sample and the
sample excluding partial exits are similar. The empirics in the following subsection and the Appendix
focus on the entire sample including the partial exits, given that when we excluded the partial exits our
data yielded qualitatively similar econometric results, and the results in Tables 4 and 5 were robust to
various adjustments to the value of the partial VC dispositions.
On average, there were higher initial investments in the U.S. than in Canada for IPOs, secondary
sales, and write-offs; initial investments were higher in Canada for acquisitions and buybacks (see Tables II
and III). Exit values were highest (lowest) for IPOs (write-offs) in both Canada and the U.S., which is
consistent with the Venture Economics and Canadian Venture Capital Association Annual Reports
(1993-1996). Both average investment and exit values were higher in the U.S. than in Canada.
For all exit vehicles taken together in the full sample, the average annual real return was positive in
the U.S. (5.61%), but negative in Canada (-2.25%). This is consistent with our working hypothesis.
Average annual real returns in the U.S. were highest for acquisitions (57.8%), IPOs (54.9%) and buybacks
(34.0%) (see Table II). Average annual real returns were negative for secondary sales and write-offs in the
For a theoretical discussion with empirical tests of when full and partial exits are likely to occur, see
Cumming & MacIntosh supra note 100.
Gompers & Lerner, supra note 4; Cumming & MacIntosh, supra note 11.
In Canada, average annual real returns were highest for secondary sales (54.9%), followed by
IPOs (27.8%) and acquisitions (13.3%). Average annual real returns were negative only for write-offs (see
Table III). The summary statistics for the data excluding partial exits are broadly similar; see Tables II and
The U.S. summary statistics on profitability are broadly in keeping with our hypothesized rank
ordering of exits by firm quality. While acquisition exits were the most profitable exits in the U.S.,
contrary to expectation, IPOs were a very close second. Given that the IPO market was not particularly hot
in the period covered by our data, this result is not seriously at odds with our hypothesized ranking or with
other published data. Further, our data indicates that those firms with the highest market/book ratio (our
proxy of firm quality) were exited via IPOs, rather than acquisitions.
The other anomaly in the U.S. data is the relatively high return associated with buyback exits
(34%). We note that there were very few buybacks in the U.S. sample (6 of 112) and the surprising
profitability of buybacks is thus not terribly robust. That secondary sales realized a negative annual real
return on average was another surprise: we expected secondary sales to do better than buybacks. Again,
this may be an artifact of the small number of buybacks.
The Canadian summary statistics on profitability are also broadly in keeping with our hypothesized
rank-ordering. The greatest surprise was that secondary sales led all exits in profitability. However, there
were relatively few secondary sales in the Canadian sample (12 of 134) and again this statistic may not be
robust. Absent this anomaly, the rank ordering of exits by profitability is as predicted.
Given the context of the summary statistics, we now turn to a multinomial logit model to formally
test Hypotheses 1, 2 and 3. As discussed above, while there is some integration of U.S. and Canadian
capital markets for smaller firms, this integration is far from perfect. While this suggests that it is better to
segregate the U.S. and Canadian data, we also pool our samples of Canadian and U.S. data and conduct
separate empirical tests on this pooled sample.
B. Multinomial Logit Analysis
In order to investigate the factors that motivate a venture capitalist to choose one particular exit
strategy over another, we employ the multinomial logit techniques first developed by Theil.241 The log
Henri Theil, A Multinomial Logit Extension of the Linear Logit Model, 10 INTL. ECON. REV. 251 (1969).
likelihood function for the multinomial logit model was estimated by Newton's method.
The dependent variable used in our multinomial logit model is the choice of exit vehicle. The
explanatory variables include the market/book ratio, VC investment duration, and a dummy variable
indicating whether the portfolio company operated in a technology industry. The multinomial logit model
assumes the independence of irrelevant alternatives across the explanatory variables. The data did not reject
this assumption according to Hausman and McFadden's asymptotically distributed chi-squared test. 242 Note
that other explanatory variables were explored but not included. 243 For reasons outlined in sections III and
IV, we believe that these explanatory variables had the most direct effect on choice of exit vehicle. In
addition, inclusion of other variables yielded insignificant results and other variables were not supported on
the basis of Akaike and Schwartz information criteria.244
As discussed in sections III and IV, it is important to check for endogeneity of the market/book and
duration explanatory variables. The Durbin-Wu-Hausman test statistics presented in the Appendix do not
indicate significant endogeneity effects. As discussed in subsection A above, our sample contains both full
and partial exits. We present the empirical results using the full sample including partial exits. We also ran
the regressions for the sample excluding partial exits for comparison; some differences were observed, but
not enough to warrant presenting both sets of estimates. The Canadian and U.S. multinomial logit
estimates are presented in Table IV.
[TABLE IV ABOUT HERE]
Hypothesis 1: Quality and Exit Strategy
Our approach is analogous to that used by Peter Schmidt & Robert P. Strauss, The Prediction of Occupation using
Multiple Logit Models, 16 INTL. ECON. REV. 471 (1975). Theil, Schmidt and Strauss have shown that this
specification is not sensitive to ordering, and this specification is superior to a series of individual probits or logits.
Jerry Hausman & Daniel McFadden, A Specification Test for the Multinomial Logit Model, 52
ECONOMETRICA 1219 (1984).
For example, we tested the average annual real return (instead of the market/book value of the VC's
shares upon exit) as a proxy for firm quality (see also Hypotheses 1, 2 and 3 and accompanying text). The results
were not notably different. The market/book value of the VC's shares upon exit was believed to be a more
suitable proxy of firm quality at time of exit. This specification maximized the information criteria. Other
variables in the specification appeared to be inappropriate.
Standard tests did not indicate an omitted variable bias problem; see e.g., Lung-Fei Lee, Specification
Error in Multinomial Logit Models: Analysis of the Omitted Variable Bias, 20 J. ECONOMETRICS 197 (1982).
In Hypothesis 1 we conjectured that higher quality entrepreneurial firms (as proxied by higher
market/book values) would be exited by (in decreasing order of likelihood): IPOs, acquisitions, secondary
sales, buybacks, and write-offs.
In the U.S., we find mixed evidence in support of Hypothesis 1. As expected, the higher the
market to book ratio, the more likely an IPO exit is compared to acquisition, secondary sale, and write-off
exits. Similarly (and hardly surprisingly), increases in the market book ratio raise the likelihood of all exit
vehicles (considered jointly) compared to a write-off. Our data set, however, was unable to distinguish
between the comparative likelihood of acquisitions, secondary sales, and buybacks.
The picture is similar in Canada. As market/book rises, IPO exits are more likely than acquisition
exits, buybacks, and write-offs. Similarly, as market/book rises, all exit types become more likely than a
write-off. Again, however, as between acquisitions, secondary sales, and buybacks, most of the
hypothesized relationships were insignificant, except that secondary sale exits were more likely than
buybacks, as predicted.
The anomalous result that we earlier noted in relation to our raw data on secondary sale profitability
shows up in our multinomial analysis as well; high quality firms are as likely to be exited via a secondary
sale as by an IPO. There is also weak evidence (i.e. significant only at the 10% level) that secondary sale
exits are more likely than acquisition exits, which is contrary to Hypothesis 1. Once again, this may be a
product of the relatively small number of secondary sales in our data set.
The full sample estimates in Table IV indicate further mixed support for Hypothesis 1. As market/
book rises, the likelihood of an IPO increases relative to an acquisition exit, secondary sale, buyback or
write-offs (equations 1, 2, 3 and 4). Similarly, acquisitions, secondary sales and buybacks are all more
likely than write-offs (equations 7, 9 and 10). The full sample of U.S. and Canadian data, however, do not
suggest a rank ordering as between acquisitions, secondary sales and buybacks (equations 5, 6 and 8).
Hypothesis 2: Duration and Exit Strategy
In Hypothesis 2 we conjectured that the longer the VC's duration of investment, the more likely the
following exit vehicles (in decreasing order of likelihood): IPOs, secondary sales, acquisitions, buybacks,
and write-offs. The results in Table IV do not provide very strong support for Hypothesis 2. In the U.S.,
the longer the duration, the more likely the investment would be exited via a secondary sale rather than a
buyback, as predicted (equation 8), and the more likely a secondary sale would occur, rather than a
write-off, also as predicted (equation 9). However, longer investment duration had a negative effect on the
likelihood of IPOs relative to acquisitions and secondary sales (although only the latter was statistically
significant; see equations 1 and 2, respectively).
The Canadian evidence also provided mixed support. In contrast to the U.S. data, IPOs were more
likely than secondary sales the longer the investment duration (equation 2). IPOs were also more likely
than write-offs (equation 4). Acquisition exits and buybacks were also more likely than write-offs
(equations 7 and 10). These relationships were as predicted. However, longer duration enhances the
probability of a buyback compared to a secondary sale (equation 8), contrary to expectation, and an
acquisition exit was more likely than a secondary sale (equation 5), also contrary to expectation.
The combined sample offered only very weak support for Hypothesis 2. The evidence is generally
insignificant, with the exception of equations 7 and 10 in which acquisitions and buybacks are more likely
than write-offs the longer the investment duration, as predicted.
Overall, Hypothesis 2 is not supported. It would appear that there is a more complex relationship
between investment duration and the choice of exit vehicle than merely mitigation of information
asymmetry between firm insiders and outsiders.
Hypothesis 3: Technology and Exit Strategy
We conjectured that high-technology entrepreneurial firms would be exited (in decreasing order of
likelihood) by IPOs and acquisitions, then secondary sales, buybacks, and write-offs. The U.S. evidence
provides weak support for Hypothesis 3. While acquisition exits were more likely than IPO exits (although
only at the 10% level of significance; equation 1), because of conflicting factors at work we had formed no
particular hypothesis about the rank ordering of IPOs and acquisitions. In support of Hypothesis 3,
technology firms were more likely to be exited via either an acquisition or a secondary sale than a buyback
(equations 6 and 8). However, technology firms are less likely to be exited via IPOs than acquisitions
(equation 1) and secondary sales (equation 2) in the U.S., but this evidence is only significant at the 10%
level. None of the other relationships was significant.
In Canada, contrary to the result in the U.S., technology investments were more likely to be exited
via an IPO than via an acquisition. The Canadian results were supportive of Hypothesis 3 insofar as IPOs
were also more likely than buybacks and write-offs. All other coefficients are insignificant.
The full sample estimates provide stronger support for Hypothesis 3. IPOs, acquisitions and
secondary sales are more likely than buybacks and write-offs for technology firms (equations 3, 4, 6, 7, 8
and 9). Contrary to expectation, however, equation 5 suggests that secondary sales are more likely than
acquisitions for high technology firms.
Our empirical results do not support Hypothesis 2. They provide some mixed support for
Hypothesis 3. They provide somewhat stronger support for Hypothesis 1. The data most clearly support
the hypothesis that IPOs are the preferred means of exit for highly valued firms, and (not surprisingly) that
write-offs are the preferred means of exit for the lowest value firms. The data provides mixed support for
the hypothesized rank ordering of acquisitions, secondary sales, and buybacks. In particular, in the U.S.
buybacks were ranked ahead of secondary sales, and showed surprisingly strong average returns. We
attributed this anomalous result to the small number of buybacks in the sample. In Canada, the rank
ordering was as predicted save for secondary sales, which were the most profitable means of exit on the
basis of annualised real return. We also attributed this to the small number of secondary sale exits in the
Canadian sample. The Canadian results, contrary to the U.S., affirmed the hypothesized low profitability of
We also observed significant differences between the U.S. and Canadian results, both in the
frequency with which types of exits are used, and in their profitability. Buybacks were used with much
greater frequency in Canada than in the U.S., although there were fewer Canadian write-offs. Given that
buybacks yield the lowest per annum return of any form of exit, other than write-offs, this is consistent with
our hypothesis that Canadian VCs have a lower average level of skill than their U.S. counterparts. While a
higher proportion of exits are taken as write-offs in the U.S., we suggested that this may be explained by the
U.S. VC’s higher opportunity cost. Exits that might be taken as write-offs in the U.S. are, with the lower
opportunity cost of Canadian VCs, negotiated into buyback exits. It may also be the case that the high
proportion of exits taken as buybacks in Canada reflects the comparative dearth of strategic acquirors in
Canada (when coupled with the lack of full integration between U.S. and Canadian small firm markets).
Supportive of the latter proposition, the data disclose that acquisition exits are used with much
lower frequency in Canada. From a public policy perspective, the comparative dearth of acquisition exits in
Canada is troubling, if acquisitions are (as we have hypothesized) a superior form of exit. It may be,
however, that there is little that government policy can do to correct the situation -- at least in the short
term. The lack of strategic partners in Canada is likely a product of the fact that Canadian markets are
smaller and less developed than those in the U.S. Nonetheless, policy makers should be aware that that
which tends to create a more vibrant, competitive large firm sector will also impact indirectly on the vitality
of the market for small, technology concerns by furnishing a greater variety of potential strategic partners
and hence enhancing exit opportunities. Further integration of U.S. and Canadian markets (e.g. by allowing
Canadian firms to reincorporate in the U.S. without triggering punitive tax consequences) would also lend
new vitality to the market for small EFs.
The evidence presented in this paper adds support to the view that IPOs are central to the venture
capital process. IPOs are the most frequently selected means of exit for high quality firms. This
emphasizes the importance of ensuring that regulatory hurdles to accessing public markets are cost-effective
and not unduly onerous. It also emphasizes the inextricable link between primary and secondary markets.
The price at which securities are sold in primary market transactions reflects the expected liquidity of those
securities in the secondary market.
We also provide the first comprehensive theoretical framework for understanding the comparative
advantages and disadvantages of all forms of VC exit, and not merely IPOs. While it is clear that this
framework needs elaboration (and testing on larger data samples) we hope that our work will lead other
researchers to probe more deeply in the important question if why VCs exit their investments as they do.
As we used the venture capitalists' market/book value to proxy project quality, it is necessary to
check for the endogeneity of the market/book variable (see sections III and IV). We also noted the potential
for endogeneity with duration (section IV). Table V presents Durbin-Wu-Hausman statistics 245 for the
effect of endogeneity in the duration and market/book coefficients in the multinomial logit regression
equations specified in section VI. We selected various states/provinces (including, for example, California
and Massachusetts in the U.S., and B.C., Ontario and Quebec in Canada) in which the entrepreneurial firms
were located as instrumental variables. These were particularly intuitive instrumental variables as an
entrepreneurial firm's quality may depend upon its location (e.g., its location may yield lower monitoring
See, e.g., RUSSELL DAVIDSON & JAMES G. MACKINNON, ESTIMATION AND INFERENCE IN ECONOMETRICS (1993).
costs, less informational asymmetry, and better growth prospects, and resources may be better and more
readily available in certain areas), but a firm's physical location in and of itself is at best a very weak and
indirect determinant of exit strategy. Standard diagnostic statistics confirmed the suitability of the location
instruments. The use of different instruments did not affect the interpretation of the results.
[TABLE V ABOUT HERE]
The Durbin-Wu-Hausman statistics provide strong evidence that endogeneity has not affected the
multinomial logit coefficient estimates presented in Table IV. Consistent with Cumming and MacIntosh, 246
Table V indicates that significant endogeneity effects are only rarely observed for the market/book variable
and duration variable. There is some evidence of significant endogeneity effects (primarily with the write-
off exits) in Canada and the U.S. for the market/book and duration variables; but there is no systematic
evidence across all exit vehicles, and therefore the use of instrumental variables would introduce more bias
than it would mitigate. As such, the standard multinomial logit estimates are presented in Table IV. (Use
of instrumental variables does not affect the qualitative results; e.g., lower market/book values leads to a
greater probability of a write-off.)
As discussed in section VI (see also Tables II and III), some of the VC exits were partial exits. The
DWH tests also consider this factor, and whether the decision to partially exit is a determinant of exit
strategy, or caused by the exit strategy. Consistent with Cumming and MacIntosh,247 the evidence in Table
V indicates that the extent of exit is determined by the choice of exit vehicle and is therefore not an
explanatory variable in Table IV.
Cumming & MacIntosh, supra note 11, supra note 100.
96. Figure I. Efficient Investment Duration and Comparative Statics
Change in capital
available for investment, etc.
Change in market conditions, etc.
VC Exit1 VC Exit0 Time
Table I. Summary of Factors Linking Project Quality to Exit Strategy
Ability of New Owners Ability of New Black and The
to Resolve Owners to Gilson's Transaction Ongoing Costs Liquidity of the
Information Monitor and Implicit Costs of of Operating as a The Liquidity of Exit to Seller: Managerial Must New
Asymmetry and Value Discipline the Contracting Effecting A Public Versus a the Investment Cash or Cash Incentives Transaction Capital Be
Exit Vehicle the Firm Managers Theory Sale Private Firm to the Buyer Equivalent* Post-Exit Synergies Raised?
IPO 4 4-5 1 4 5 1 1 1 2 Yes
5 for High-Tech
Acquisition 1-2 1-2 5 2 1 Indet Indet 4-5 1 No
1 for High-Tech 1 for High-Tech
Secondary Sale 2 4 Indet 2 1 5 Indet 3 2-4 No
Buyback 1 for equity 1 for equity 1 2 1 5 2 1, with 5 No
5 for debt 5 for debt variation
* For IPOs, the ability to convert to cash within one year is considered a cash exit
1 = strongly favours; 2 = favours; 3 = Neutral; 4 = Disfavours; 5 = Strongly Disfavours; Indet = Indeterminate
Table 1 continues on the next page…
Table I (Continued). Summary of Factors Linking Project Quality to Exit Strategy
Cyclicality Fund The Public
High Efficiency of Common Common of Valuations Termination VC's Agency Profile
Growth Risk Form of Exit in IPO Date Reputational Costs of
Exit Vehicle Firms Bearing Exit Strategy Markets Looms Incentives of Debt Firm
1, if IPO hurdle
IPO 1 1 Yes Usually time cleared: 1 1 1
Acquisition 1-2 1 Yes Usually time 2 2 Indet indet
Secondary Sale 3 Indet No ad hoc 3 2 4 3 5
Buyback 5 5 No ad hoc 3 2 5 5 5
* For IPOs, the ability to convert to cash within one year is considered a cash exit.
1 = Strongly Favours; 2 = Favours; 3 = Neutral; 4 = Disfavours; 5 = Strongly Disfavours; Indet - Indeterminate
Table II. United States Venture Capital Full and Partial Exits Data Summarized by Exit Vehicle*
Number of Average Technology Extent Full Sample Including Partial Exits Partial Exits Only Full Exits Only
Portfolio Duration Industry of Exit Average Average Average Gross Average Annual Variance in Average Annual Variance in Average Annual Variance in
Exit Vehicle Companies (Years) No Yes Partial Full Investment** Exit Value** Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%)
IPO 30 4.7000 12 18 8 22 2,035,036 12,565,880 464.6397 54.9152 51.1517 83.5759 154.3296 44.4932 14.9276
Acquisition 30 5.1667 9 21 6 24 1,720,349 3,859,077 143.0386 57.8286 754.7467 20.1013 18.0705 67.2604 943.0674
Secondary Sale 9 6.3333 2 7 3 6 519,931 1,005,871 54.8768 -7.5650 6.6850 -3.1798 15.3582 -9.7570 4.3797
Buyback 6 4.0000 5 1 5 1 784,397 2,687,449 145.0423 24.7910 3.2665 21.6493 3.3428 40.4996 0.0000
Write-off 33 4.3636 15 18 2 31 1,984,068 92,500 -97.8450 -90.0070 4.8772 -100.0000*** 0.0000 -89.3620*** 5.1315
Other 4 2.7500 2 2 1 3 1,112,445 1,539,990 35.2761 34.0191 83.9444 165.6761 0.0000 -9.8670 10.3594
Total 112 4.7500 45 67 25 87 1,714,030 4,706,597 147.3815 5.6146 256.6047 34.1439 83.5232 -2.5835 304.8443
* Source: Venture Economics
** Real U.S. Dollars (base year=1990). CPI data source: International Financial Statistics, Label 11/64; available at www.chass.utoronto.ca.
Partial exit market values are adjusted to reflect full values. Real returns are calculated assuming investment at the beginning of the year, and exit at the end of the year, reflecting the lowest possible estimate.
*** Partial write-offs (write-downs) were recorded without indicating the full cost of the amount not written off. Full write-offs yielded a small return upon liquidation.
Table III. Canadian Venture Capital Full and Partial Exits Data Summarized by Exit Vehicle*
Number of Average Technology Extent Full Sample Including Partial Exits Partial Exits Only Full Exits Only
Portfolio Duration Industry of Exit Average Average Average Gross Average Annual Variance in Average Annual Variance in Average Annual Variance in
Exit Method Companies (Years) No Yes Partial Full Investment** Exit Value** Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%)
IPO 36 5.8611 3 33 20 16 1,464,087 5,170,185 1385.8530 27.8282 9.8247 32.8825 10.6479 21.5102 8.6706
Acquisition 16 6.9375 9 7 1 15 1,945,386 3,271,514 84.5848 13.3089 2.9498 5.9532 0.0000 13.7993 3.1193
Secondary Sale 12 3.0833 0 12 5 7 402,144 968,181 165.6950 54.8972 90.2764 106.4305 179.2162 18.0877 8.0910
Buyback 41 6.3415 30 11 7 34 668,245 808,686 66.9712 3.8207 1.5041 9.9051 1.1401 2.5680 1.5212
Write-off 27 4.0741 18 9 1 26 332,038 3,821 -97.1010 -92.0440 4.3792 -100*** 0.0000 -91.7380*** 4.5280
Other 2 6.0000 2 0 1 1 2,412,731 3,687,627 60.1537 9.5346 0.1692 6.6257 0.0000 12.4435 0.0000
Total 134 5.5299 62 72 35 99 969,012 2,169,579 399.0807 -3.2530 33.8738 33.4777 41.8835 -16.2390 24.9186
* Source: Canadian Venture Capital Association.
** Real Canadian Dollars (base year=1990) converted to U.S. Dollars. CPI data source: CANSIM, Label P700000; available at www.chass.utoronto.ca. Foreign exchange rates from
CANSIM, label B3400. Values expressed in U.S. dollars for comparative purposes only. Returns were computed in Canadian dollars and do not reflect exchange rate changes.
Partial exit market values are adjusted to reflect full values. Real returns are calculated assuming investment at the beginning of the year, and exit at the end of the year, reflecting the lowest possible estimate.
*** Partial write-offs (write-downs) were recorded without indicating the full cost of the amount not written off. Full write-offs yielded a small return upon liquidation.