venture capitalists as benevolent vultures: the role of network externalities in financing choice

Venture Capitalists As Benevolent Vultures:The Role of Network Externalities in

Financing Choice

http://campus.hec.fr/profs/leshchinskii/externalities.pdf

Dima Leshchinskii, HEC

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”


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?


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


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)


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)


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)


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


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

FMC, May 2nd, 2002 10

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

FMC, May 2nd, 2002 11

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

FMC, May 2nd, 2002 12

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

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

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

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

FMC, May 2nd, 2002 16

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

FMC, May 2nd, 2002 17

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)

FMC, May 2nd, 2002 18

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

FMC, May 2nd, 2002 19

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

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

FMC, May 2nd, 2002 21

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

FMC, May 2nd, 2002 22

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

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)

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

FMC, May 2nd, 2002 25

Question:

Can entrepreneurs achieve VC-like results with angel investment...

by cross-holding stakes in each other projects?

venture capitalists as benevolent vultures: the role of network externalities in financing choice

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