Venture Capital as an Alternative Means to Allocate Capital: An Agency-Theoretic View

Article excerpt

If an analysis of venture capital is to add value to the study of finance, it must relate to main themes in finance. Venture capital involves aspects of investing and capital structure. But each of these thoughts focuses on just a part, rather than the whole, of the venture capital process. Venture capital involves a five-step process: (1) obtaining funds from limited partners; (2) identifying, analyzing, and selecting appropriate entities in which to invest; (3) structuring the terms of the investment; (4) implementing the deal and monitoring the portfolio firms; and (5) achieving returns and ultimately exiting from the investment. We suggest that this framework is similar to that of the capital budgeting process within a firm, as well as to other processes of capital allocation. Specifically, the five-step venture capital sequence is similar to the process of raising, allocating and harvesting capital in leveraged buyout funds, bank lending, project financing, and intrafirm capital budgeting. We posit that there are unique agency cost concerns which are likely to result in some investments being financed with venture capital rather than one of the other above methods. Whether high- or low-tech, specialized knowledge and monitoring are needed to oversee the investment.

ATTRACTING FUNDS FROM LIMITED PARTNERS

Venture capital funds must be raised competitively, as are the funds raised for LBO and project financing (especially in the case of R&D limited partnerships); all three situations involve investments by limited partners which are risky, illiquid, long-term investments. But LBO situations are heavily debt-financed and involve firms with large cash flows; venture capital involves firms in the early stage of their life cycle in situations where debt is not a suitable financing instrument. Unlike an R&D limited partnership, the purpose of venture capital investment is not so much to develop and patent a new technology as it is to create value and generate wealth for both the entrepreneurial team and venture capital pool investors.

An interesting question is the importance of a venture capitalist's reputation in helping to attract limited partners to join new financing pools. Presumably successes in early pools help the venture capitalist earn a reputation as a general partner who is successful at identifying profitable ventures. Trying to build such a reputation by investing in seed and other early stage deals is risky; such investments themselves are high risk, and even if they are successful the returns ' will not be realized and publicized for 7-10 years after the initial investment. Financing latter-stage deals is less risky, and although the returns won't be as spectacular as finding the next Apple Computer, they may allow a general partner to more quickly show good returns and attract financing for future pools. Thus, new venture capitalists face a tradeoff between a high-risk, high-return, long time horizon investment strategy or a low-risk, low-return, shorter time horizon strategy.

IDENTIFYING AND SELECTING INVESTMENTS

Venture capitalists identify, analyze, and select investments with an eye toward firms that have good quality management teams and that offer a competitively advantaged product with good growth potential. Casual empiricism states that for every 100 potential investments they see, only two or three are funded. (This percentage has some empirical validity, as found by Maier & Walker, 1987.) Unlike LBO situations where the portfolio firm has potential for increasing its operating efficiency, the venture capitalist's investment has potential for growth that will return a multiple of the investment to the venture capitalist.

Corporate capital budgeting is mainly restricted to those projects identified favorably through a Mission-Objectives-Goals-Strategies or Strengths-Weaknesses-Opportunities-Threats analysis that will maintain or build the firm's competitive advantage. …