More than Just Money: The Impact of Traditional and Corporate Venture Capital Firms on Portfolio Company Performance. A Thesis - PDF

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1 More than Just Money: The Impact of Traditional and Corporate Venture Capital Firms on Portfolio Company Performance A Thesis Presented in Partial Fulfillment of the Requirements for the Degree Bachelor
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1 More than Just Money: The Impact of Traditional and Corporate Venture Capital Firms on Portfolio Company Performance A Thesis Presented in Partial Fulfillment of the Requirements for the Degree Bachelor of Science in Business Administration in the Fisher College of Business at The Ohio State University By Xiao Sun * * * * * * * * The Ohio State University 2007 Thesis Examination Committee: Dr. Henrik Cronqvist, Advisor Dr. Bernadette Minton Dr. Rao Unnava 2 Abstract In addition to initial financing, venture capital (VC) firms also provide other value-added contributions. Many VC firms and their portfolio companies consider these value-added contributions the most significant contributions VC firms make. The value-added contributions have been found to be different depending on whether the VC firm is a traditional VC firm or corporate venture capital (CVC) firm. Traditional VC and CVC firms have different investment objectives and possess different areas of expertise, leading to differences in the valueadded contributions provided. The differences in the value-added contributions raise the question of whether the performance of portfolio firms is affected by the type of venture capital backer. This study seeks to 1) quantify the impact of VC-affiliation on portfolio firm performance, and 2) compare the differences in performance of VC and CVC firms portfolio companies. The paper examines the financial performance, IPO valuation, and stock performance of VC-backed, CVC-backed, and independent companies in the 3-year period following an IPO. The years 1998, 1999, and 2002 (representing the height of the tech bubble and bear market of the early 2000s recession) were chosen as the sample period. The results of the analysis indicate that VC-backed companies as a whole outperform independent companies in every aspect, confirming that the value-added contributions of VC firms help the performance of their portfolio companies. The performance of portfolio companies also differed depending on the type of their VC-backer. Traditional VC-backed portfolio companies had higher revenue growth and IPO valuations, while CVC-backed portfolio companies had higher net income growth and slightly better stock performance. Ultimately, the results confirm that VC firms improve portfolio company performance, and the impact of the VC firm s value-added contributions differs depending on the type of VC-backing. 3 Table of Contents: I. Introduction 1 II. Literature Review 2 III. Hypotheses 7 IV. Methodology and Results 9 V. Discussion 13 VI. Implications for Entrepreneurs 17 VII. Implications for Investors 18 VIII. Limitations of Study and Implications for Future Research 18 IX. Conclusion 19 X. Appendix 20 X. References 25 1 Introduction The venture capital industry is a significant driver of growth and innovation in the United States economy. Many of today s largest and most admired companies were once funded by venture capitalists, such as Apple Inc, Cisco Systems, Google, and Yahoo. Many more smaller, lesser known companies were also once part of a venture capital firm s portfolio. Venture capital firms contribute to these companies success not only through providing capital, but also through providing other services to ensure the new venture s survival and success (Hellman & Puri 2002; Barney et al 1996; Sapienza & Manigart 1996). These additional value-added contributions are considered to be most significant contributions by both the VC firms as well as entrepreneurs of new ventures. The venture capital industry can be segmented into two distinct areas: traditional venture capital (VC) and corporate venture capital (CVC) (Gompers & Lerner 1999). Traditional venture capital firms are typically organized as private partnerships, seek to maximize financial returns, and obtain funds from third party investors. Corporate venture capital firms are typically subsidiaries of corporations, seek to meet strategic as well as financial goals, and invest funds from the corporate parent (National Venture Capital Association). Based on the distinction between VC and CVC firms, recent research has focused on developing theoretical bases for determining the sources of value-added contributions to portfolio firms (Maula 2001), as well quantitatively assessing different metrics of VC firms and portfolio companies, such the resource-bases, value-added contributions, objectives, investment areas, and firm performance (Maula et al 2001; Maula et al 2005; Markham 2005; Gompers & Lerner 1999; Bygrave & Timmons 1992). Such prior research has indicated that the two types of firms differ in the types of resources available to portfolio companies, the effectiveness at 2 different value-added contributions, and success in liquidation events. This study will build upon the existing research in the field through two areas. First, the study seeks to quantify the value-added contributions of venture capital firms on the performance of portfolio companies. Second, the study seeks to examine if there is a difference in the impact on the performance of portfolio companies depending on whether the VC firm is a traditional VC firm or CVC firm. The prior literature in this area will be reviewed to develop a theoretical basis, and a quantitative approach will then be developed to assess portfolio company performance, utilizing post-ipo financial performance, IPO valuation, and stock performance as comparison metrics. Finally, the implications of the results will be discussed. Distinguishing Features between Venture Capital and Corporate Venture Capital Venture Capital Corporate Venture Capital Organization Private partnerships; VC as general partner, investors as limited partners Subsidiaries of larger corporations Investment objective Primarily financial return Primarily strategic objectives Source of funds Investors Corporate parent Literature Review Value-Added Contributions of Venture Capitalists Given the impact a venture capitalist can have on the growth and development of new ventures, significant amounts of research on the venture capital industry has focused on identifying and understanding the value-added contributions of venture capitalists beyond pure financial support. The key contribution of venture capitalists is typically thought to be the financial resources invested in the new venture (Gompers & Lerner 1999). Although it is true that venture capitalists play a key role as the agent transferring capital from institutions with capital to entrepreneurs in search of capital, venture capitalists also provide additional value-added 3 contributions in addition to purely financial support (Hsu 2004, Bygraves & Timmons 1992). Venture capitalists are often actively involved in the enterprises in which they invest, offering guidance, know-how, industry contacts, and other such support. Serving as advisors to the new venture enables the venture capitalist to play the role of sounding board, marketing expert, management recruiter, and industry contact, among others. Lee et al (2004) found that linkage to venture capital firms had a significant positive effect on startup performance. Lindsey (2002) found that portfolio companies with a shared venture capital investor were more likely to form strategic partnerships and exchange technical and market information, highlighting the role of the venture capitalist as an information mediator. Bygraves & Timmons (1992) noted that entrepreneurs often saw their venture capital investors as objective outsiders with a depth of knowledge and experience in the industry and market, and utilized this role to test the reality of their business plans and ideas. Sapienza & Manigart (1996) found that VC firms typically believed their strategic involvement and networking center as the most important roles they served. Both Bygraves & Timmons (1992) and Hellman & Puri (2002) noted the role of the venture capitalist in recruiting knowledgeable management. However, the effectiveness of VC firms was found to be different depending on industry, as Lee et al (2001) found a positive effect on technology companies while Brau et al (2004) failed to find significant differences between VC and non-vc backed manufacturing companies. Barney et al (1996) found that the optimal level of VC activity depended upon the extent to which a portfolio company valued the VC s input. Stuart et al (1999) documented the certification effect of venture capitalists, noting that affiliation with a VC firm provided legitimacy to the products of relatively unknown new ventures. Hsu (2004) sought to quantify the value of this type of venture capital support, finding that entrepreneurs were willing to accept 4 lower valuations of their startup in order to become affiliated with more reputable VC firms in order to access their resources and certification from being affiliated with them. Corporate Venture Capital versus Traditional Venture Capital With the growing influence of corporate venture capital, more research in the venture capital field has begun to examine this segment of the industry. Research in the field has covered the structure of the industry, the objectives and effectiveness of CVC activity, and the valueadded contributions of CVC. Hardymon et al (1983) wrote of the early cases of CVC failure. Gompers & Lerner (1999) examined the firm structure of different periods of CVC investment activity, finding that high failure rates among original CVC firms were due to a lack of welldefined missions, inadequate corporate commitment, and poor compensation schemes. Newer CVC firms have tended to be more focused in their investment area, mainly firms in the hightech industries in the development stage. Markham et al (2005) discussed the role that external investments play in bringing new technologies into the parent corporation. Markham et al (2005) argued that such investments were mainly strategic moves to acquire new technologies, support the growth of business, and acquire greater financial and market information. Alvarez & Barney (2001) examined the relationship between entrepreneurs and CVC firms from the perspective of the entrepreneur, arguing that such alliances can create economic value for both parties, but in the long run such value can become appropriated by the larger firm. The most value-creation exists when there are complementary resources between the entrepreneur and corporation. Knyphausen-Aufseb (2002) argued that different types of CVC firms relied on different resource bases, finding that technology-based CVC firms provided the most value due to the significant resources invested in R&D and expertise in their respective technological fields. Maula (2001) examined the value- 5 added contributions of CVC firms to technology start-ups, identifying resource acquisition, knowledge-acquisition, and endorsement benefits as the primary value-adding mechanisms. Maula (2001) also argued that CVCs possessed greater R&D resources, technological knowledge and expertise, and credibility in endorsing the technological and commercial quality of technology ventures than traditional venture capital firms. Differences in Value-Added Contributions Given the previous literature on the venture capital industry and the recent research on corporate venture capital, a natural progression is to draw comparisons between the two segments, their performance, and the performance of their portfolio companies. Maula et al (2005) sought to compare the value-added contributions of VC and CVC investors, theorizing that the financial, social, and knowledge resources of the firms influenced the nature and quality of value-added contributions. Maula et al (2005) found that the resources possessed by the venture capital firms were different but complementary, resulting in better quality of value-added effectiveness when both types were present in a portfolio company. VC firms were found to be superior in many of the traditional services provided by venture capitalists, such as arranging financing, recruiting key employees, advising on competition, and developing the organizational resources of the firm. Such contributions were termed enterprise nurturing, or helping a new venture avoid mistakes to which new businesses are vulnerable. Corporate venture capital firms were found to be better at commerce building activities, focusing on revenue generating activities such as attracting foreign customers, developing distribution channels, stimulation of business from initial orders, as well as technological support through the support of the parent corporation s R&D resources as well as certification from an established market player (Maula et al 2005, Knyphausen-Aufseb 2002). 6 Literature Summary The literature on the venture capital industry shows that there are significant value-added contributions made by venture firms outside of mere financing, and there are also differences between traditional venture capital and corporate venture capital firms. Three key aspects where traditional venture capital and corporate venture capital firms differ are: 1) investment objectives, 2) firm resources, and 3) value-added contributions. The differences in venture capital and corporate venture capital firms in these areas are summarized in following table. Summary of Differences in Resources and Value-Added Contributions Venture Capital Corporate Venture Capital Investment Objective Firm Resources Value-added Contributions Primarily financial return 1. Strong network within financial markets 2. Broad network in multiple industries 3. Contacts with similar or complementary ventures with VC firm s portfolio 4. Extensive experience in developing competitive position in new market 1. Better at strategic planning and advising on competition 2. More effective at management recruiting 3. More effective at obtaining additional financing 4. Developing the organizational resources of the firm Primarily strategic objectives 1. Support of parent corporation s R&D capabilities 2. Specific industry and technological expertise 3. Strong network within industry 4. Recognized reputation within industry 1. Reputation effects resulting from cooperation with an established player 2. Stimulation of business by initial orders 3. Access to distribution channels 4. Development of products/services 5. Arrangement of industry relationships Given the evidence of the value-added contributions of VC firms, and the differences in investment objectives, firm resources, and value-added contributions between traditional VC and CVC firms, how does this affect the performance of portfolio companies? Thus, this study will examine two main issues: 1. Quantifying the impact of a VC firm s value-added contributions on portfolio company performance 2. Quantifying the differences of traditional VC and CVC firm s valued-added contributions on portfolio company performance 7 Three metrics were chosen to measure the impact of venture capital firms. Financial performance post-ipo, i.e. revenues and net income, examine the business performance and success of a portfolio company. IPO valuations examine the market s evaluation of the new venture. Stock returns measure the market performance of portfolio companies. Hypotheses There are two general hypotheses that were formed regarding the performance of VCbacked portfolio companies. First, as the venture capitalist s role is not solely limited to providing financing to a new venture, but also to help the new venture grow and succeed as a company, the value-added contributions of a VC firm should enable a portfolio company to perform better than independent companies without VC-backing. Second, given the differing investment objectives, firm resources, and value-added contributions of VC and CVC firms, such differences should be reflected in the performance of their portfolio companies. Based on these two general hypotheses, two sets of hypotheses have been developed, comparing VC-backed portfolio companies to independent companies, and comparing traditional VC-backed portfolio companies to CVC-backed portfolio companies. The first set of hypotheses examines the performance of VC-backed portfolio companies compared to independent companies. Because of the value-added contributions of the venture capital firms, and the resources that portfolio companies can draw upon, the performance of VCbacked portfolio companies should exceed that of independent companies in all aspects. Thus: H1: VC-backed portfolio companies will have higher revenue growth post-ipo than independent portfolio companies. H2: VC-backed portfolio companies will have higher net income growth post-ipo than independent portfolio companies. 8 H3: VC-backed portfolio companies will have a higher IPO valuation, based on price-tosales valuation ratio. H4: VC-backed portfolio companies will have higher stock returns post-ipo than the overall market. The second set of hypotheses compares the performance of VC-backed portfolio companies and CVC-backed portfolio companies. In examining a CVC firm s investment objectives, the CVC firm is primarily concerned with strategic objectives, and will concentrate resources to activities that help achieve those objectives, such as R&D, developing customer bases, or distribution channels. The resources controlled by CVC firms contribute to activities that enable commerce-building, or the ability to develop revenue streams. The value-added contributions of CVC firms further enable revenue growth, as CVC firms can provide technical advice, access to distribution channels, and certification of portfolio companies from an established industry player. Thus, the focus on commerce-building activities should enable CVCbacked portfolio companies to achieve faster revenue and net income growth than VC-backed portfolio companies. H5: CVC-backed portfolio companies will have higher revenue growth post-ipo than traditional VC-backed portfolio companies. H6: CVC-backed portfolio companies will have higher net income growth post-ipo than traditional VC-backed portfolio companies. VC firms have a different set of investment objectives. VC firms seek to achieve the highest financial return, usually through an IPO or sale of the portfolio company. Thus, a VC firm s resources and contributions are geared towards this particular goal. Such resources include a VC firm s strong connection to the financial markets, and contributions include the nurturing 9 of new ventures to a liquidation event. Thus, this focus on achieving financial returns should enable VC-backed portfolio companies to achieve higher IPO valuations and P/S valuation ratios than CVC-backed portfolio companies. H7: Traditional VC-backed portfolio companies will have better IPO valuations as shown by IPO P/S ratio than CVC-backed portfolio companies. As CVC-backed portfolio companies are expected to have greater sales and net income growth, as well as relationships with established corporations, a portfolio of CVC-backed portfolio companies should have lower volatility in stock price than a portfolio of VC-backed portfolio companies. Consequently, a portfolio of VC-backed portfolio companies should have higher risk (beta) and returns (alpha) than a portfolio of CVC-backed portfolio companies. H8: A portfolio of traditional VC-backed portfolio companies will have higher risk (beta) and higher returns above market (alpha) than a portfolio of CVC-backed portfolio companies. Methodology and Results Methodology In order to test the proposed hypotheses, a quantitative approach was utilized. First, a sample of companies that went public in a specified time period was built, and revenue, net income, IPO valuation, and stock data was collected for each sample. Three different sources were used to obtain the data: 1) Hoover s Online database for IPO and financial data, 2) SEC filings for pre-ipo shareholder information, and 3) Yahoo! Finance for historical stock prices. Th
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