Download the Word document..doc


Published on

Published in: Economy & Finance, Business
  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Download the Word document..doc

  1. 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 E-mail: Http:// Jeffrey G. MacIntosh Toronto Stock Exchange Professor of Capital Markets Faculty of Law, University of Toronto 78 Queen’s Park Toronto, Ontario, Canada M5S 2C5 Tel: (416) 978-5785 Fax: (416) 978-6020 E-mail: 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).
  2. 2. 2 Venture Capital Exits in Canada and the United States Abstract 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.
  3. 3. 3 CONTENTS INTRODUCTION……………………………………………………………………………………………..3 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 A. Data………………………………………………………………………………………………90 B. Multinomial Logit Analysis……………………………………………………………………...94 CONCLUSION………………………………………………………………………………………………97 APPENDIX…………………………………………………………………………………………………99 INTRODUCTION
  4. 4. 4 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 1 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). 2 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. 3 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. 4 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). 5 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).
  5. 5. 5 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 6 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. 7 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). 8 Sahlman, Id.
  6. 6. 6 (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 (Hypothesis 2). 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, Hypothesis 1. 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
  7. 7. 7 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 9 See, e.g., VENTURE ECONOMICS , EXITING VENTURE CAPITAL INVESTMENTS (1988).
  8. 8. 8 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 target’s technology. 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 enterprise. 10 Gompers and Lerner, supra note 4, 95-123.
  9. 9. 9 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 11 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). 12 See generally Black & Gilson, supra note 1, at 252-255. 13 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). 14 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).
  10. 10. 10 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 information asymmetry). 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
  11. 11. 11 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
  12. 12. 12 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 technology, etc. 3. The VC receives new information about the location of the marginal value or maintenance cost curves 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 15 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.
  13. 13. 13 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 16 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).
  14. 14. 14 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 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 17 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). 18 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. 19 See infra, Part IV, C. 20 Thomas Chemmanur & Paolo Fulghieri, Information Production, Private Equity Financing, and the Going Public Decision, Columbia University, mimeo (1994).
  15. 15. 15 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 problems. 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 appropriately. 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 21 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) 22 Megginson & Weiss, supra note 5. 23 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). 24 Megginson & Weiss, supra note 5.
  16. 16. 16 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 25 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). 26 Megginson & Weiss, Id.; Lin & Smith, Id. 27 Barry et al., supra note 5. 28 Gompers, Grandstanding in the Venture Capital Industry, supra note 7. 29 Lin & Smith, supra note 25. 30 See infra, note 36 and accompany text.
  17. 17. 17 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. Acquisitions 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 31 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. 32 Robert Daines and Michael Klausner, Do IPO Charters Maximize Firm Value? Antitakeover Provisions in IPOs, J, LAW, ECON., & ORG. (forthcoming) (2002). 33 Megginson & Weiss, supra note 5.
  18. 18. 18 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 acquisition exit. Secondary Sales 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 sold. 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. Buybacks 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. 34 Supra, note 9 and accompanying text.
  19. 19. 19 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. 35 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). 36 Id. 37 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.
  20. 20. 20 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. 38 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). 39 Barnea et al., Id. 40 Michael H. Jensen & William H. Meckling, Theory of the Firm, Managerial Behaviour, Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976). 41 Id.
  21. 21. 21 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 problems). 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 IPOs 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 42 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. 43 Lin & Smith, supra note 25.
  22. 22. 22 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 44 Black & Gilson, supra note 1, at 261. 45 Id. 46 Id. 47 Id. at 260. 48 See Part III F. 49 See generally Lucian Bebchuk, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 102 HARV. L. REV. 1435 (1992). 50 Daines & Klausner, supra note 32. 51 Id.
  23. 23. 23 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 imperfectly. 54 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 52 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 53 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). 54 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). 55 Daines & Klausner, supra note 32. 56 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 incorporation. Id. 57 Black, supra note 21. 58 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. 59 Op. Cit.
  24. 24. 24 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 60 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. 61 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). 62 See infra, Part III G. 63 Id. 64 Supra note 38. 65 Id. 66 Id. 67 Randall K. Morck, Andrei Shleifer & Robert W. Vishny, Management Ownership and Market Valuation, 20 J. FIN. ECON. 293 (1998) 68 John J. McConnell & Henri Servaes, Additional Evidence on Equity Ownership and Corporate Value, 27 J. FIN. ECON. 595 (1990).
  25. 25. 25 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. Acquisitions 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. Secondary Sales 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. 69 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). 70 An offset will be an enhanced ability to craft compensation arrangements. See infra, section III.G.1.
  26. 26. 26 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 entrepreneur). 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. Buybacks 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 71 Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 AMER. ECON. REV. 323 (1986).
  27. 27. 27 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 before. 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 72 Supra notes 35-39 and accompanying text. 73 Barry et al., supra note 5. 74 Id.
  28. 28. 28 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. Summary 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 75 Supra, note 1.
  29. 29. 29 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 substantial.77 76 See supra, Part III.A. 77 Gompers & Lerner, supra note 4, at 263-287.
  30. 30. 30 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 ready” condition; 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. 78 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). 79 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). 80 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.
  31. 31. 31 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, 81 Tim Loughran, Jay Ritter and Kristian Rydqvist, Initial Public Offerings: International Insights PACIFIC BASIN FIN. J. 165 (1994).
  32. 32. 32 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 82 See infra parts III.E and F. 83 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). 84 Rule 144, id. 85 Ontario Commission Rule 45-501, Multilateral Instrument 45-102, supra note 82.
  33. 33. 33 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; 86 Ronald J. Gilson & Reinier Kraakman, The Mechanisms of Market Efficiency, 70 VIR. L. REV. 549 (1984).
  34. 34. 34 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. 87 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). 88 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. 89 Macey & O’Hara, supra note 78. 90 Id. 91 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). 92 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).