venture capitalists as benevolent vultures: the role of network externalities in financing choice
TRANSCRIPT
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Venture Capitalists As Benevolent Vultures:The Role of Network Externalities in
Financing Choice
http://campus.hec.fr/profs/leshchinskii/externalities.pdf
Dima Leshchinskii, HEC
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FMC, May 2nd, 2002 2
Objective
To study how entrepreneurs’ choice of active investors to finance entrepreneurial projects is affected by: interaction between projects control rights of potential investors
• where potential active investors are VCs and angels
In other words, to show “how and when VCs create more value than other investors”
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FMC, May 2nd, 2002 3
Example
You are an entrepreneur with a new project: R&D required investment of 2 M $; Probability of success b = 0.3; Project’s gross payoff is 4 M $;
Another entrepreneur with a similar project. In case of her success, you can borrow her technology investing much less;
Whom should you ask for funding? Who would agree to invest?
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Professional angels• Back a single firm in the industry
(no deep pockets or no time to support more firms)
VCs• Invest into portfolio of
companies• same industry or stage
Some Facts About Investors
Both VCs and angels:• Have control rights not linked to cash flow rights• Advise the entrepreneurs
– Invest more than just money (time, effort, knowledge)
• Practice stage financing
But
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Main Results
VCs can create more value for their portfolio companies … Through investment coordination and portfolio
approach (internalizing positive externality)• investment decision based on NPVi>0, not on NPVi>0)
Through early project termination (as vultures eliminating negative externality)
...Only if ex-ante entrepreneurs are better off with VCs than with angel investors (benevolent vultures)
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Related Literature
Sahlman (JFE 1990), Gompers & Lerner, Hellmann & Puri (RFS 2000), Kaplan & Stromberg (1999), Stuart & Robinson (1999)
Bhattacharya & Chiesa (JFI 1995), Cabral (1998), Economides (EJPE 1996); Cestone & Fumagalli (2000)
Hellmann (2000), Ueda (2000)
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FMC, May 2nd, 2002 7
Model
Two entrepreneurs with own projects Two-stage projects:
R&D stage: investment Ii, Ii = {0, , I} If Ii = I, then R&D success of the project with
probability Outcomes of R&D stage are independent Market stage:
• If Ii = , then free technology transfer from a rival project
• net payoff iV (if both projects continue)• or V (if only one continues)• (1+2 1, 1<2)
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FMC, May 2nd, 2002 8
Model
Entrepreneurs with projects Externalities:
• R&D (technology transfer)• Payoff externality
Competitive Investors: angels (can invest only into one project) VC (can invest into two projects) In return for investment ask for share i in a project i.
• Non-zero investment is not verifiable (time, effort etc.)• Investors have control rights even for i < 0.5
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1-
iVAngelfunds
project i
I
eI j
= I
Ij < I 0
VC(funds 2)
2I
0I+e
(1-)2
1-(1-) 2
(1-)
0
0
Max{(1+2)V;V}
Externality and Investment
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Timeline
t = -1 Investors ask for share i in return for investment. Entrepreneurs choose investors, who get zero expected return
t = 0 Ii, Ii = {0, , I} are invested
t = 1 R&D results are observed. (Technology transfer, if possible). Projects are continued/terminated
t = 2 Final payoffs are realized
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Project 2
Project 10 I
0 (0; 0) (0; -) (0; V-I)
(-; 0) (-; -) (1V-; 2V-I)
I (V-I; 0) (1V-I; 2V-) ((2-)1V-I; (2-)2V-I)
Projects’ Payoffs With Angel Investment
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Project 2
Project 10 I
0 (0; 0) (0; -) (0; V-I)
(-; 0) (-; -) (1V-; 2V-I)
I (V-I; 0) (1V-I; 2V-) ((2-)1V-I; (2-)2V-I)
Projects’ Payoffs With Angel Investment
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FMC, May 2nd, 2002 13
Condition Decision rule NPV
(1-)(1+2)V I- Invest I in each project (2-)(1+2)V-2I
(1-)(1+2)V < I-(1+2)V I + Invest I and (1+2)V-I-
(1+2)V < I + Do not invest 0
Positive Externalities (1+2>1):First Best Result
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FMC, May 2nd, 2002 14
Angel financing
Entrepreneurs choose angels if:
E[NPVEntr.|Angel] E[NPVEntr.|VC] Participation constraint for angels:
E[NPVAngel] 0
One possible pair of contracts
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FMC, May 2nd, 2002 15
VC financing
Entrepreneurs choose VCs if
E[NPVEntr.|VC] E[NPVEntr.|Angel] Participation constraint for VC:
E[NPVVC] 0 Incentive compatibility for VC (Deviation-
proof)
Continuum of contractsEverybody wants higher stakes
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Example: Positive externalities, investment in both project is the first-best
(1-)(1+2)V>I-e Angel investment is optimal if
(1-)1V>I-e VC cannot improve
Angel investment is suboptimal if 1V<I or (1-)2V<I VC can improve (except when 1V<I and (1-)2(1+2)V<I) by
investing into both projects Angel financing is impossible if 2V<I
VC always reaches the first best
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1
Lambda, l (market externality)
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
0.5 1.5 2.5 3.5 4.5
Bet
a, b
(R
&D
ext
ern
alit
y) (1- ) =b b l k
(1- )*2 =b b l k
=bl k
*2 =b l k
Improvement
No advantage for VC(I;I)
resuscitation by VC
Positive Externality, I/V = 0.5, 1=2>0.5. First Best is (I, I)
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1
Lambda, l (market externality)
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
0.5 1.5 2.5 3.5 4.5
Bet
a, b
(R
&D
ext
ern
alit
y) (1- ) =b b l k
(1- )*2 =b b l k
=bl k
*2 =b l k
No investment zone
resuscitation by VC
Improvement
No advantage for VC(I;I)
Positive Externality, I/V = 0.5. 1=2>0.5
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Negative Externalities (1+2<1):First Best Result
Condition Decision rule NPV
(1-)V I - Invest I in each of projects (2-)V-2I
(1-)V< I - V I + Invest I and V-I-
V < I + Do not invest 0
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FMC, May 2nd, 2002 20
VC contracts
Participation constraint for entrepreneurs• VC’s share in firm 1 = VC’s share in firm 2
• “Face” NPVi 2 E[NPVi|Angel]
Incentive compatibility for VC (Deviation-proof): Prefers to continue only one project
One single contract.At t = 1 each entrepreneur wants to get formally less!
0
V1/2
1/2
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Example: Negative externalities, investment in both projects is the first best
(1-)V>I-e
Angel investment is never optimal
Angel investment is suboptimal if
(1-)1V>I-e or 1V<I or (1-)2V<I
VC can improve (except when 2>0.5 and (1-)1>I) by investing into both projects
Angel financing is impossible if 2V<I VC always reaches the first best
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Negative Externality I /V=0.05
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0 0.1 0.2 0.3 0.4 0.5
Lambda, l
Bet
a, b
(1- ) =b b l k
(1- )*2 =b b l k
=bl k
*2 =b l k
No investment zone
Improvement
Resuscitationby VC
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FMC, May 2nd, 2002 23
Empirical implications
We should observe more VC investment in the industries with high externalities, especially negative ones
VCs invest more than angels into risky projects (low ) … with high profitability (V/I)
Portfolio companies of the same VC should have similar characteristics (size and i)
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FMC, May 2nd, 2002 24
Conclusion
High externalities give VCs potential to create more value for their portfolio companies than angel investors• By better coordinating investment• By influencing project continuation
Their actions increase the value of the portfolio, sometimes at the expense of individual companies
Interests of individual entrepreneurs and possible opportunistic behavior of VCs may prevent from getting the optimal outcome
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FMC, May 2nd, 2002 25
Question:
Can entrepreneurs achieve VC-like results with angel investment...
by cross-holding stakes in each other projects?