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Friends or Foes? The Interrelationship between Angel and Venture Capital Markets Thomas Hellmann and Veikko Thiele Forthcoming in the Journal of Financial Economics Abstract This paper develops a theory
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Friends or Foes? The Interrelationship between Angel and Venture Capital Markets Thomas Hellmann and Veikko Thiele Forthcoming in the Journal of Financial Economics Abstract This paper develops a theory of how angel and venture capital markets interact. Entrepreneurs first receive angel then venture capital funding. The two investor types are friends in that they rely upon each other s investments. However, they are also foes, because at the later stage the venture capitalists no longer need the angels. Using a costly search model we derive the equilibrium deal flows across the two markets, endogenously deriving market sizes, competitive structures, valuation levels, and exit rates. We also examine the role of legal protection for angel investments. JEL classification: D53, D83, G24, G32, L26. Keywords: Entrepreneurship, angel investors, venture capital, firm valuation, start-ups, hold-up, search. We would like to thank an anonymous referee, Einar Bakke, Holger Rau, Ralph Winter, conference participants at the Annual International Industrial Organization Conference (IIOC) in Boston, the Canadian Economics Association Annual Meeting in Montreal, the Conference on Entrepreneurship and Finance in Lund, and seminar participants at Queen s University and the University of Rochester (Simon) for valuable comments and suggestions. This project was in part funded by a SSHRC research grant. University of British Columbia, Sauder School of Business, 2053 Main Mall, Vancouver, BC, Canada V6T 1Z2, phone: , fax: , Queen s University, Queen s School of Business, Goodes Hall, 143 Union Street, Kingston, Ontario, Canada K7L 3N6, 1 Introduction Investments by wealthy individuals into start-up companies are typically referred to as angel investments. Over the last decade angels have become a more important source of early stage funding for entrepreneurs. According to Crunchbase (www.crunchbase.com), the US angel market grew at an annual rate of 33% between 2007 and In a 2011 report of the OECD, the size of the angel market was estimated to be roughly comparable to the venture capital (VC henceforth) market (OECD, 2011). For 2009 the report estimates the US (European) venture capital market at $18.3B ($5.3B), and the US (European) angel market at $17.7B ($5.6B). The rise of the angel market coincides with a shift in VC investments towards doing more laterstage deals. As a result the funding path of growth-oriented start-ups typically involves some initial funding from angels, with subsequent funding coming from venture capitalists (VCs henceforth). Facebook and Google, two of the most successful start-ups in recent history, both received angel financing prior to obtaining VC. With this bifurcation in the funding environment of entrepreneurial companies, the question arises how these two types of investors interact, and whether angels and VCs are friends or foes? Angels have limited funds and typically need VCs to provide follow-on funding for their companies. At the same time VCs rely on angels for their own deal flow. As they play complementary roles in the process of financing new ventures it might seem that angels and VCs should be friends. However, in practice angels and VCs often see each other as foes. In particular, there is a concern about so-called burned angels. Angels frequently complain that VCs abuse their market power by offering unfairly low valuations. Expectations of low valuations at the VC stage then affect the willingness of angels to invest in early stage start-ups. Michael Zapata, an angel investor, explains it as follows (Holstein, 2012): In cases where the VCs do see a profit opportunity, they have become increasingly aggressive in low-balling the managements and investors of emerging companies by placing lower valuations on them. [...] Angels call these actions cram downs or push downs. The market has been very rough on the VCs and they are making it tougher on the angels. They are killing their future deal flow by cramming them down, crashing them out. The main objective of this paper is to examine the interdependencies between two types of investors, angels and VCs. Our goal is to provide a tractable model of the equilibrium dynamics between two sequentially related markets, and generate a rich set of empirical predictions. We are particularly interested in identifying the underlying determinants of market size and market competition (which depends on the entry rates of entrepreneurs, angels and VCs), as 1 well as company valuations and success rates. Special attention is given to analyzing the full equilibrium implications of the burned angels problem. From a theory perspective, the challenge is to obtain a model of the two connected markets that generates tractable comparative statics for key variables. To this effect we develop a search model with endogenous entry by entrepreneurs, angels and VCs. Companies require angels for seed investments, and could require VC for funding their growth options. The model generates predictions about the level of competition in both the angel and VC market. It predicts the expected length of fundraising cycles (i.e., the time it takes to raise angel and VC funding), as well as the rate at which companies fail, progress from the angel to the VC market, or achieve an exit. We also derive equilibrium company valuations at both the angel and VC stage. Our model has three key building blocks that build on previously disparate literatures. First we draw on the staged financing literature (Admati and Pfleiderer, 1994; Berk, Green and Naik, 1999), introducing a dynamic investment structure where start-ups first obtain seed funding in the angel market, then follow-up funding in the VC market. This simple dynamic structure allows us to capture the basic interdependencies between angels and VCs: angels invest first but need the VCs to take advantage of a company s growth options. Central to the model are two feedback loops. The first is the forward loop of how the angel market affects the VC market. The key linkage is that outflow of successful deals in the angel market constitute the deal inflow in the VC market. Here we can think of angels and VCs are friends. The second is the backward loop of how the VC market affects the angel market. The key linkage here is that the utilities of the entrepreneurs and angels at the VC stage affect the entry rates of entrepreneurs and angels at the angel stage. A key insight is that at the VC stage, VCs no longer need the angels to make the investment. The angels investment is sunk and they provide no further value to the company. This creates a primal friction between angels and VCs, i.e., this is where angels and VCs become foes. Second, we draw on the search literature. Inderst and Müller (2004) explain how a search model à la Diamond-Mortensen-Pissaridis allows for a realistic modeling of imperfect competition in the VC market. We expand their model to two interconnected markets. We also augment their specification with a death rate for entrepreneurs. Our model highlights the consequences of imperfect competition in the VC market on the angels bargaining position: while a monopolist VC would have a lot of power over angels, such bargaining power get dissipated in a more competitive VC market. Third, to examine further determinants of the relative bargaining strengths of entrepreneurs, angels and VCs, we consider the issue of minority shareholder protection (La Porta, Lopezde-Silanes, Shleifer and Vishny, 2000). In his work on the burned angels problem, Leavitt (2005) provides a detailed legal analysis of the vulnerabilities of angels at the time of raising VC. As new investors, VCs can largely dictate terms. They can also use option grants as a 2 way of compensating the entrepreneur for the low valuation offered to angels. Leavitt argues that legal minority shareholder protection can mitigate the burned angel problem, but cannot fully resolve it. Based on this, we consider a hold-up problem between the angel and the entrepreneur at the time of the follow-up round. The term hold-up only applies for the expost relationship between angel and entrepreneur. The VC cannot hold up the angel or the entrepreneur, as he has no prior contractual relationship with them. In our context hold-up means that entrepreneur colludes with the VC to pursue the venture alone without the angel. While the threat remains unexercised in equilibrium, the hold-up potential redistributes rents from the angel to the entrepreneur and VC. Our analysis traces out the equilibrium effects that such hold-up has on the returns and investment levels of angels and VCs. Our model generates a large number of comparative statics results. Throughout the analysis we consider the joint equilibrium across the two markets. We find that our within-market effects are consistent with results in the prior literature (e.g., Inderst and Müller, 2004), so our main contribution is the analysis of cross-market effects. Here we discover several new insights. For example, a standard within-market result is that while higher search costs for the investor lead to less competition, higher search costs for the entrepreneur lead to more competition (because investors can capture more of the rents). However, this result does not apply in a cross-market setting. We show that there is less angel competition when there are higher search costs at the VC stage for either the VC or entrepreneur. This is because both of these search costs reduce the utilities of the entrepreneur and angel investor. One of the most interesting results concerns the effects of angel protection. One might conjecture that the ability to take advantage of angels increases entrepreneurial entry. However, we show that in equilibrium there is lower entry by entrepreneurs. This is because the direct benefit for entrepreneurs from holding up angels at a later stage is outweighed by the indirect cost of a thinner angel market. Intriguingly, we find opposite effects for entrepreneurial entry and survival. Weaker angel protection actually leads to better entrepreneurial incentives (because it is allows the entrepreneur to capture additional rents) and therefore to higher success rates. We also consider the choice of projects, and the timing of exits. Some angels have been advocating early exits as an attractive investment approach (Peters, 2009). Accordingly, startups focus on projects that can be sold relatively quickly. The advantage of such a strategy is that the entrepreneurs and angels can avoid the various challenges of securing follow-on investments from VCs. The disadvantage is that they could fail to achieve their full potential. In a model extension we allow for a choice between two development strategies: a safe strategy, where the venture is sold in an early exit, versus a risky strategy, which either leads to failure, or generates higher returns, namely if the company succeeds in developing a growth option and obtaining VC financing. The safe strategy of early exits becomes more likely when angel protection is low, such as when the value of the start-up resides mainly in the entrepreneur s human capital. 3 Consistent with this we note that many early exists take the form of so-called acqui-hires where the acquirer is more interested in the human capital of the start-up. Our theory implies a series of testable predictions about the size of angel and VC markets, their competitive structure, as well as the valuations obtained. We discuss these by focusing on alternative explanations for the recent rise of angel markets. We distinguish between explanations based on better angel protection, lower start-up costs, greater market transparency, greater entrepreneurial urgency, and supply shocks in venture capital. For example, better angel protection and lower start-up costs both predict larger and more competitive angel markets. However, better angel protection is associated with lower success rates, whereas lower start-up costs lead to higher success rates. Moreover, valuations at the venture capital stage increase with better angel protection, but are not affected by lower start-up costs. The remainder of the paper is structured as follow. Section 2 discusses the relation of this paper to the literature. Section 3 introduces our main model. We then derive and analyze the angel market equilibrium in Section 4, and the VC market equilibrium in Section 5. Section 6 analyzes how limited legal protection of angels affects the angel and VC market equilibrium. Section 7 examines early exits. Section 8 discusses the empirical predictions from our model. Section 9 summarizes our main results and discusses future research directions. All proofs are in the Online Appendix, which is available on the authors websites. 2 Relationship to literature The introduction briefly discusses how this paper builds on a variety of literatures. In this section we explain in greater detail the connections to the prior literature. The natural starting point is the seminal paper by Inderst and Müller (2004). They were the first to introduce search into a model of entrepreneurial financing, focussing on how competitive dynamics affect VC valuations. Silveira and Wright (2006) and Nanda and Rhodes-Kropf (2012a) also use similar model specifications for other purposes. One theoretical advance of this paper is that it examines the relationship between two interconnected search markets. A limitation of all these search models (including ours) is that they require homogenous types. Hong, Serfes, and Thiele (2013) consider a single-stage VC financing model with matching among heterogeneous types. A growing number of papers examine the implications of staged financing arrangements. Neher (1999) and Bergemann, Hege, and Peng (2009) study the design of optimal investment stages. Admati and Pfleiderer (1994) and Fluck, Garrison, and Myers (2005) consider the differential investment incentives of insiders and outsiders at the refinancing stage. Building on recent work about tolerance for failure (Manso, 2011), as well as the literature on soft budget constraints (Dewatripont and Maskin, 1995), Nanda and Rhodes-Kropf (2012a) consider how 4 investors optimally choose their level of failure tolerance in a staged financing model. These models all assume that the original investors can finance the additional round. Our model departs from this assumption by focusing on smaller angels who do not have the financial capacity to provide follow-on financing. The theory closest to ours is the recent work by Nanda and Rhodes-Kropf (2012b) on financing risk. They too assume that the initial investors cannot provide all the follow-on financing. Their analysis focuses on the possibility of multiple equilibria in the late stage market, and shows how different expectations about the risk of refinancing affects initial project choices. Our model does not focus on financing risk, but instead focuses on the hold-up problem at the refinancing stage. Our model distinguishes between angels and VCs on the basis of the investment stage and the amount of available funding: angels only invest in early stages and have limited funds; VCs only invest in later stages and have sufficient funds to do so. The empirical evidence of Goldfarb, Hoberg, Kirsch and Triantis (2012) and Hellmann, Schure and Vo (2013) is broadly supportive of these assumptions. The latter paper also provides empirical evidence on the financing dynamics, showing how some companies obtain only angel financing (possibly exiting early), whereas others transition from the angel to the VC market. Our model cannot capture all the nuances of reality. First, it is sometimes difficult to draw a precise boundary between what constitutes an angel investor versus a VC. Shane (2008) and the OECD report (OECD, 2011) provide detailed descriptions of angel investing, and the diversity within the angel community. Second, we do not model value-adding activities of angels versus VCs. Chemmanur and Chen (2006) assume that only VCs but not angels can provide value-added services. By contrast, Schwienbacher (2009) argues that both angels and VCs could provide such services, but that angels provide more effort because they still need to attract outside investors at a refinancing stage. See also the related empirical work of Hellmann and Puri (2002) and Kerr, Lerner and Schoar (2013). Third, in our model both angels and VCs are pure profit maximizers. The work of Axelson, Strömberg, and Weisbach (2009) suggests that the behavior of VCs could be influenced by agency considerations. Moreover, angels can be motivated by non-financial considerations, such as personal relationships or social causes, as discussed in the work of Shane (2008) and Van Osnabrugge and Robinson (2000). Finally, while we motivate our paper with angels and VCs, our theory applies more broadly to the relationship between early and late investors. Further examples of early investors include friends and family, accelerators, and university-based seed funds. Further examples of late investors include corporate investors, bank funds, and growth capital funds. Our paper is also related to the literature on the staged commercialization of new venture ideas. Teece (1986), Anand and Galetovics (2000), Gans and Stern (2000) and Hellmann and Perotti (2011) all consider models where complementary asset holders have a hold-up opportu- 5 EARLY STAGE LATE STAGE Angels (A) VCs (V) Entrepreneurs (E) Angel Market (, ) Success of Early Stage Investments Start ups attractive for VCs * VC Market (, ) Success (payoff ) 1 1 Obsolete Ideas Failure (zero payoff) Liquidation (payoff ) Obsolete Ideas * Section 7 (Early Exits) allows for additional uncertainty about the presence of growth options (prob. ). Figure 1: Financing Stages Angel and VC Markets nity at a later stage. They mainly ask how this hold-up problem impacts the optimal organization of the early stage development efforts. This paper focuses on the challenges of financing ventures across the different commercialization stages. 3 The base model Our objective is to build a tractable equilibrium model that endogenously derives the size and competitive structure of the early stage (angel) and late stage (VC) market. Conceptually we want a model with endogenous entry to determine market size, and with a continuum between monopoly and perfect competition to determine the level of competition. This naturally leads us to a search model in the style of Diamond, Mortensen and Pissaridis (see Pissarides, 1979, 2000; Mortensen and Pissarides, 1994; Diamond, 1982, 1984). This model has free entry, and it endogenously generates a market density that is a continuous measure of competition. Moreover, the real-life search process of entrepreneurs looking for investors closely resembles the assumptions of pairwise matching used in such search models (Inderst and Müller, 2004). We consider a continuous time model with three different types of risk-neutral agents: entrepreneurs, angels, and VCs. The length of one period is 0, and the common discount rate is r 0. In each period a number of potential entrepreneurs discover business opportunities. The cost for an entrepreneur to start his business is l [0, ), which is drawn from the distribution F (l). We interpret l as the personal labor cost associated with establishing the new venture (e.g., the cost of developing a business plan). The endogenous number of start-ups founded in each period is m E 1 ; see Figure 1 for a graphical overview. 6 Entrepreneurs are wealth-constrained, so they require external financing for their start-up companies. Specifically, each entrepreneur needs an early stage investment k 1, and a late stage investment k 2. What we have in mind is that entrepreneurs first need funding to develop prototypes of their products (early stage financing) to prove the viability of their business models
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