DYNAMIC FINANCING STRATEGIES: THE ROLE OF VENTURE CAPITAL
Katleen Baeyens, Ghent University, Belgium
Sophie Manigart, Ghent University and Vlerick Leuven Gent Management
School, Belgium
ABSTRACT
THE ROLE OF VENTURE
CAPITAL IN FINANCING STRATEGIES
DATA AND METHODS
ANALYSES AND RESULTS
DISCUSSION AND CONCLUSIONS
NOTES
CONTACT
REFERENCES
TABLE 1
TABLE 2
TABLE 3
Entrepreneurial firms often lack the necessary financial resources to grow and even to survive. Venture capital (VC) is considered to be an important alternative financing source for young and fast-growing companies that reduces problems of information asymmetry, adverse selection and moral hazard. Besides financial resources, VC provides credibility and legitimacy to its portfolio companies. Therefore, VC backed firms should be able to attract more outside financing. We empirically show that VC backed companies are, indeed, able to attract more long term and short term financing. However, more collateral is required for the additional debt financing.
THE ROLE OF VENTURE CAPITAL IN FINANCING STRATEGIES
In perfect financial markets, funds are always available for value creating investment projects and financing decisions can be separated from investment decisions (Modigliani and Miller, 1958). Financial markets, however, are not perfect. Generally, they are characterised by important information asymmetries between entrepreneurs and investors and by resulting agency problems such as goal incongruence, adverse selection and moral hazard (Eisenhardt, 1989). In the presence of market imperfections, investors may ration capital and positive net present value projects may be denied financing, or only be able to obtain certain types of funding (Fluck et al., 1998).
Entrepreneurs of high growth companies often develop products and ideas that require substantial capital, exceeding the internally generated cash flows or entrepreneur’s own funds, especially in the formative stage of their company’s lifecycle (Gompers, 1995). These companies are typically characterised by large information asymmetries and potential agency problems (e.g. Admati and Pfleiderer 1994) and hence may also have limited access to more traditional external financing sources. Informed investors, such as venture capitalists (Rajan, 1992), may offer a solution for this type of financing problem. Through their information gathering and processing activities, VCs are able to reduce information asymmetries and potential agency problems which allows them to invest profitably in projects that uninformed outsiders reject.
Venture capitalists play a critical role in reducing information asymmetries through the collection of critical, private information (Berger and Udell, 1995; Manigart et al., 2000). Amit et al. (1998) argue that one of the primary reasons for the existence of VC companies is their information processing capacities which may reduce information asymmetries, and hence potential agency problems. Adverse selection problems are addressed through intensive screening before the funds are provided (Manigart and Sapienza, 1999; Lerner, 1995). VCs screen potential investments by conducting due diligence, including the collection of information about the business, the market in which it operates, and the entrepreneur or start-up team (Berger and Udell, 1998). A good financing contract can reduce goal incongruence between entrepreneurs and investors (Sahlman, 1990) for example by using convertible instruments (Gompers, 1998). Moral hazard problems are dealt with by monitoring the firm as soon as funds are provided (Cable and Shane, 1997; Lerner, 1995; Gompers, 1995). Finally, the investment is typically staged to hedge against moral hazard problems (Sahlman, 1990; Gompers, 1995). Venture capitalists further provide value-creating services to their portfolio companies (Amit et al., 1998).
Attracting VC financing may not only offer a financing solution for those companies that are unable to attract sufficient funds. We argue that the presence of VC in a company may influence the further financing of the company. Besides financial resources, VC provides credibility and legitimacy to its portfolio companies (Manigart and Sapienza, 1999). Moreover, because they reduce information asymmetries through screening and monitoring, their portfolio companies will be more attractive to other investors. Other parties may therefore free-ride on the efforts that the VC has exerted. The central research question in this study is whether companies are able to attract more outside financing, once they have received VC funding.
As screening is an important role of VC companies (Lerner, 1995; Manigart and Sapienza, 1999) and as VCs are extremely selective, the mere fact that a VC company has invested in an unquoted company conveys positive information about that company. Hence, convincing a VC to invest should increase the potential of portfolio companies to attract subsequent financing from other parties. Moreover, through their roles of screening, contracting and monitoring, venture capitalists minimize the costs of delegating decisions to entrepreneurs or induce them to reveal critical information on their activities (Berger and Udell, 1998; Manigart and Sapienza, 1999). If they perform their roles well, informed investors, such as venture capitalists, may develop an information monopoly on the firm (Rajan, 1992), which enables them to generate substantial profits by providing funds at a higher price. The information monopoly, however, is limited in time: as time goes by other financing parties will observe the performances and creditworthiness of the firm. A strong, positive signal about the financial health and the future prospects of the firm is then sent to other potential investors, which increases the legitimacy of the firm (Megginson and Weiss, 1991). This should allow companies with a good reputation to attract financing at better conditions (Diamond, 1991). Moreover, by providing equity, venture capitalists reduce the financial risk of other potential investors and hence should improve the access to subsequent financing. Finally, funding provided by venture capitalists can be used to buy tangible assets, such as buildings, which can in turn be used as collateral to acquire additional debt. These arguments lead to the following hypotheses:
Hypothesis 1: VC backed companies are able to attract more financing, compared to companies that did not receive VC financing
Hypothesis 2: VC backed companies are able to attract financing at better terms compared to companies that did not receive VC financing
Sample and Design
The foregoing hypotheses are tested on a sample of unquoted, young Belgian VC backed companies and a sample of comparable (matched) non VC backed companies, using yearly accounting data collected by the National Bank of Belgium. In contrast with the U.S., Belgium has a Continental European financial system. Only a minority of Belgian firms are quoted on a stock exchange, while the most important source of external financing is debt, and more precisely bank loans, even for small and/or young companies. The venture capital industry, however, is quite well developed in Belgium compared to other European companies. In 1999, Belgian venture capital companies invested the equivalent of 0,27% of GDP in “classic” venture capital (excluding management buy-outs). This figure was approximately half of the amount invested in the U.S., where 0,53% of GDP is invested in venture capital, but it was comparable to the U.K. (0,21% of GDP) and higher than in any other European country (Reynolds et al., 2000).
553 Belgian companies in which VC companies invested between 1987 and 1997 are identified through secondary sources (see also Manigart et al., 2002 and Manigart et al., 2003), such as annual reports of VC companies, other financial accounts, reports and press releases of VC companies, representing 56% of the total number of investments in Belgium from 1987 to 1997 (European Venture Capital Association statistics).
Following Megginson and Weiss (1991) and Lerner (1999), each VC backed company is matched with a non VC backed company on following criteria, measured in the year before the VC funding (or the year of VC funding, for the companies that received VC from their inception) : activity (NACE-code), size (with total assets as proxy), and stage. The pre-investment situation of the VC backed companies is used, so as not to introduce a size bias caused by the funding itself. For matching purposes, a start-up company is defined as a company at most 2 years old at the time of funding, an early stage company is between 3 and 5 years old at the time of funding and a mature company is older than 5 years at the time of funding.
The main data for the study are the yearly accounts of the companies, from the year of the investment up to at most 5 years after the initial investment or 1999, whatever comes first. This yields an unbalanced panel with 4961 company-year data. The yearly financial accounts of the companies—collected by the National Bank of Belgium—are the major source of data. For each company-year, more than 50 variables from the financial accounts (balance sheet, profit and loss statement, and additional information) are recorded. Moreover, for each company, we know whether it still exists as an independent entity, whether and when it has gone bankrupt, been involved in a merger or acquisition, been closed or split. This set-up allows us to include surviving (successful) and failing (unsuccessful) companies, in contrast to most studies of this type. Including both surviving and non-surviving companies eliminates a positive survivor bias and increases the validity of the results.
Variables and Method of Analysis
Financial accounts of Belgian companies provide a detailed description of their liabilities. Information is available on equity (amounts of capital, share premium account, revaluation surplus, retained earnings, profit/loss carried forward and capital subsidies) and debt financing (short term versus long term, financial versus operational debt, bank debt, leasing and subordinated loans, mortgages and other collateral). All Belgian companies are required to make their financial statements public. Small companies, however, have to provide less information than large companies. Therefore, not all variables used here are available for small companies.
We analyse changes in sources of financing and conditions at which additional financing is attracted by looking at the use of guarantees, mortgages and pledges. Four measures of financing dynamics are analysed: evolution of financing in absolute terms (increase and decrease), evolution of financing relative to total assets and the number and amount of increases in financing.
Data are analysed using univariate and bivariate analyses. For the bivariate analyses, we mainly use Wilcoxon tests and Chi Square tests.
Importance of Different Sources of Funding after VC Participation
Equity
Table 1 shows that VC backed companies have significantly more capital, compared with non VC backed companies. The ratio of capital to total assets is 27% for VC backed companies, while it is only 14% for comparable non VC backed companies. However, there is no significant difference in the ratio of equity to total assets (28%): the amount of losses carried forward by VC backed companies is significantly larger, compared to non VC backed companies.
VC backed companies issue more new shares. After having received VC, half of the VC backed companies issue new shares and increase their share capital, compared to only one out of three non VC backed companies (Table 2, panel A). A chi-square test (not reported) shows that the difference is significant at the <0.0001 level. Table 2, panel A further shows that staged VC financing is not really important in Belgian VC backed companies. Only one third of the VC backed companies receive one additional round of financing within the first 5 years after VC participation and only 12% receive 2 additional rounds of financing. Table 3 shows that VC backed companies that issue new shares obtain significantly larger amounts (median value: 347,052 Euro) than comparable non VC backed companies (median value: 74,381 Euro).
Long Term Financial Debt
Long term financial debt is an important financing source for the VC backed companies in our sample, both in absolute and in relative terms. Analyses (not reported) indicate that whereas only 35 VC backed companies (6% of the VC backed sample) do not use long term financial debt, as much as 104 non VC backed companies (20% of the non VC backed sample) do not use any long term financial debt. Moreover, when comparing those companies that use long term financial debt, it is clear that VC backed companies use significantly larger amounts of long term financial debt (median value: 504,934 Euro) than comparable non VC backed companies (median value: 165,525 Euro). Wilcoxon tests (see Table 1) indicate that long term financial debt is significantly more important in relative terms for VC backed companies (20% of total assets) compared to their non VC backed counterparts (9% of total assets). This result does not change when excluding companies that make no use of long term financial debt.
After having received VC, VC backed companies raise more additional long term financial debt. Table 2, panel B indicates that one third of the non VC backed companies (or 185 companies) does not attract additional long term financial debt, compared to only one fifth (or 112 companies) of the VC backed companies. This difference is significant at the <0.0001 level. Table 2, panel B further shows that slightly more non VC backed companies than VC backed companies get additional long term debt once. However, more VC backed companies get additional long term financial debt twice or even more times. VC backed companies get more often additional long term financial debt (918 increases on a total of 2424 observations), compared to their non VC backed counterparts (666 increases on a total 2537 observations, significant difference at the < 0.0001 level). Even for VC companies, however, receiving additional long term financing is not simply a recurring event: about three quarter of the VC backed companies receives additional long term financial debt on two or fewer occasions within the first 5 years after VC participation (Table 2, panel B). When receiving additional long term financial debt, VC backed companies attract significantly larger amounts (median value: 220,005 Euro) of long term financial debt, compared to non VC backed companies (median value: 82,535 Euro).
Subordinated Loans
More detailed information about the long term financial debt (subordinated debt, bank debt, leasing) is available for 306 VC backed and for 234 non VC backed companies. 34% of the VC backed companies are financed with subordinated loans, compared to only 11% of the non VC backed companies. The amount of the subordinated loans is, however, not significantly different between VC backed (median value: 242,861 Euro) and non VC backed companies (median value: 190,075 Euro). The relative amount of subordinated debt (Table 1) is significantly larger for the VC backed companies. Unreported analyses further show that after receiving VC, companies issue subordinated debt more often than non VC backed companies (significant at 0.0001 level).
Bank Debt
VC backed companies not only issue more subordinated debt, which may be provided by the venture capitalist, they also use more long term bank debt and more leasing. 56% of the non VC backed companies use bank debt, compared to 73% of the VC backed companies. The amount of debt outstanding is larger for VC backed companies that use this type of financing (median value: 485,921 Euro, compared to 309,334 Euro for the non VC backed companies). As shown in Table 2, panel E, half of the VC backed companies does not use additional bank debt, compared to 59% of their non VC backed counterparts (chi-square test: significant at the 0.01 level). More VC backed companies than non VC backed companies raise additional bank debt more than once. Moreover, VC backed companies raise significantly larger amounts of bank debt (median value: 441,771 Euro) than non VC backed companies (median value: 200,372 Euro).
Leasing and Other Methods of Financial Bootstrapping
56% of the VC backed companies use leasing, compared to only 41% of the non VC backed companies. The leasing amount differs significantly between VC backed (median value: 27,987 Euro) and non VC backed companies (median value: 20,674 Euro). The relative amount of leasing (Table 1) is also significantly larger for the VC backed companies. Unreported analyses show that after receiving VC backing, companies use more often additional leasing than non VC backed companies (significant at the 0.01 level).
Besides leasing, companies can meet their need for financial resources without relying on long term external financing by bootstrap finance, for example, by offering discounts to customers that pay cash, using routines to speed up invoicing, deliberately choosing customers who pay quickly or by deliberately delaying payment to suppliers (Winborg and Lanström, 2000). Unreported analyses show that VC backed companies use more days of credit from their suppliers (mean value: 85 days, compared to 73 days for non VC backed companies; significant at the 0.0001 level). On the other hand, they provide more days of credit to their customers (median value: 75, compared to 65 for non VC backed companies; significant at the 0.0001 level).
Short Term Financial Debt
The results for short term financial debt are similar to those for long term financial debt: VC backed companies use more short financial debt in absolute and in relative terms and VC backed companies obtain additional short term financial debt more often and in larger amounts. 87% of the companies in the VC backed sample uses short term financial debt, compared to only 78% of the non VC backed companies. VC backed companies that are financed with short term financial debt use approximately 4 times more short term financial debt (median value: 76,512 Euro), compared to non VC backed companies (median value: 19,757 Euro). Short term financial debt is not only more important for VC backed companies in absolute terms, but also in relative terms (see Table 1). The results in Table 2, panel C further indicate that almost one third of the companies (or 160 companies) in the non VC backed sample does not use additional short term financial debt, compared to only 109 VC backed companies (or 20% of the companies; difference significant at the <0.0001 level). VC backed companies do use additional short term financial debt more often (945 increases on a total of 2424 observations), compared to their non VC backed counterparts (792 increases on a total 2537 observations, significant at the < 0.0001 level).
Not only do VC backed companies receive more regularly additional short term financing, but when they do, the amount is twice as large (median value: 123,947), compared to non VC backed companies (median value: 61,255).
Short Term Operational Debt
Short term operational debt1 is used by all companies, both in the VC backed and in the non VC backed companies. Whereas short term financial debt is larger in absolute terms for VC backed companies (median value: 684,744 Euro for VC backed companies, compared to 435,835 Euro for non VC backed companies), it is not in relative terms. Table 1 shows that the relative amount of short term operational debt of VC backed companies (28% of total assets) is significantly lower compared to their non VC backed counterparts (37% of total assets). In relative terms, short term operational debt is a more important financing source for non VC backed companies. Increases in operational debt are, however, significantly larger for VC backed companies. Whereas the median value of increase in short term operational debt of VC backed companies equals 200,458 Euro, non VC backed companies have a median increase of 121,827 Euro.
While short term operational debt is an important financing source for both VC backed and non VC backed companies, increases in short term operational debt occur more frequently and increases will typically be larger for the VC backed companies. In relative terms, however, non VC backed companies use more operational debt.
The findings of the bivariate analyses clearly support hypothesis 1. VC backed companies use more additional debt and equity financing, both in terms of amount and number of additional funding rounds. The results indicate that VC financing helps companies in getting more short and long term debt financing, by reducing information asymmetries and increasing the legitimacy of their portfolio companies.2 Moreover, VC backed companies show more creativity in their financing strategy.
In the following section, the terms at which additional debt financing can be issued are analysed. In particular, the use of collateral (guarantees, mortgages and pledges) is analysed.
Terms of Debt Financing
Financial Debt Guaranteed by Real Securities
We study whether the financial debt is guaranteed by real securities. This will give a first indication of the terms at which debt can be issued. The median amount of financial debt guaranteed by real securities is zero, both for VC backed and non VC backed companies. 229 VC backed companies (41% of the VC backed sample) have no financial debt guaranteed by real securities compared to 308 (56%) non VC backed companies. We further analyse the amounts of financial debt guaranteed by real securities, excluding companies that do not use this type of collateral. The median amount of debt, guaranteed by real securities, is significantly larger in VC backed companies (421,419 Euro) than in non VC backed companies (150,397 Euro). Wilcoxon tests (Table 1) indicate that VC backed companies use significantly more guaranteed financial debt relative to total assets, compared to their non VC backed counterparts.
Mortgages
A Wilcoxon test of the absolute amounts of mortgages (not reported) shows that VC backed companies have significantly more mortgages than comparable non VC backed companies. Analyses indicate that 360 VC backed companies (65%) have no mortgages and 399 non VC backed companies (72%) do not use mortgages. The median amount of mortgages of VC backed companies that have mortgages (495,787 Euro) is twice as high as that of non VC backed companies (254,091 Euro). Table 1 shows that VC backed companies use significantly more mortgages relative to total assets and their mortgages increase more often.
Pledging of Commercial Funds
263 VC backed companies (47%) do not pledge commercial funds, compared to 379 non VC backed companies (68%). The median amount of pledging of commercial funds of VC backed companies (434,558 Euro) is twice as high as that of non VC backed companies (212,569 Euro). Table 1 indicates that the ratio of pledging of commercial funds to total assets is significantly larger for VC backed companies. A chi-square test (not reported) also show that more VC backed companies exhibit increases in pledges of commercial funds compared to non VC backed companies. The amounts of increases in pledges of commercial funds are significantly larger for VC backed companies compared to non VC backed companies.
Clearly, VC backed companies have to give more collateral when receiving debt financing. A significantly larger proportion of the financial debt is guaranteed by real securities in VC backed companies than in non VC backed companies. The use of mortgages and pledging of commercial funds is more important for VC backed companies. These results, however, may be driven by the fact that VC backed companies have more assets that can be used as collateral.
This longitudinal study shows that there are significant differences between the financing sources of VC backed and non VC backed companies. After receiving VC, long term and short term debt financing is a more important financing source for VC backed companies, in comparison with their non VC backed counterparts. In relative terms, operational debt is more important for non VC backed companies. VC backed companies are able to attract more additional debt financing once a VC has invested. This effect is not limited to one source of financing: VC backed companies get more financial debt and more operational debt. We interpret these results as an indication that VCs send a positive signal to debt providers and thus ease further debt financing. This may be an indication that VCs have a positive impact that goes beyond mere financing. Their information processing capacities are valued by other investors.
In this study, we also examine the use of collateral when receiving additional debt financing. VC backed companies are clearly required to give more collateral when issuing additional debt. This may be interpreted as an indication that VC backed companies receive additional funding at less attractive terms, compared to non VC backed companies, probably due to the risky nature of their business. However, it may also be due to the fact that VC backed companies simply have more assets that can be used as collateral.
This study has shown that getting VC may enable companies to get more subsequent financing, but they are also required to provide more collateral. However, it may well be that not all companies in our sample are looking for additional financing. A limitation of this study is that it is impossible to differentiate between companies that do not need additional financing and those that are looking for additional financing, but are unable to get it. Further research in this area is needed.
A good understanding of the impact of informed investors, such as venture capitalists, on the further financing of entrepreneurial companies is important for entrepreneurs. From the point of view of entrepreneurs, having different types of investors involved may have far-reaching implications. Getting VC, for example, has two major implications. First, VC is associated with considerable loss of control. Moreover, it is an expensive financing source: required rates of return in Europe vary between 15% and 45% depending on the stage of development of the investee company (Manigart et al., 1997). It is, therefore, important for entrepreneurs to know whether venture capitalists may also influence the amount and the conditions of further financing and hence, “whether VC is worth its cost.”
A better insight in this issue is also important for policy makers. All over the world, governments have set up programs to enhance financing of entrepreneurial firms. For example, governments stimulate the VC industry both directly, by setting up government-backed VC firms, and indirectly by providing a healthier institutional, fiscal, and legal environment. One of the main rationales of government intervention in the VC market is: diminishing perceived funding gaps (OECD, 1997; Lerner, 1999). However, little is known so far about the effectiveness of the VC industry in achieving this goal.
This article originally appeared in the Winter 2003 issue of The Journal of Private Equity and is reprinted with permission from Institutional Investor, Inc. For more information please visit www.iijournals.com.
1. Only a minor
part of operational debt is long term financing, therefore only short
term operational debt is analysed.
2. These results remain, even if the sample of VC backed companies that
experience a failure is compared to the matched sample of non VC backed
companies (of which only a small part experiences a negative
event).
CONTACT: Katleen Baeyens, Vakgroep Bedrijfsfinanciering, Ghent University, Kuiperskaai 55E, 9000 Gent, Belgium; (T) +32 (0)9/264.35.07; (F) +32 (0)9/264.35.77; Katleen.Baeyens@Ugent.be
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