Academic journal article Entrepreneurship: Theory and Practice

Why Do Entrepreneurs Switch Lead Venture Capitalists?

Academic journal article Entrepreneurship: Theory and Practice

Why Do Entrepreneurs Switch Lead Venture Capitalists?

Article excerpt

We examine the dynamics of the positive sorting in the venture capital industry. Our findings indicate that switching lead venture capitalists (VCs) is not uncommon during the course of entrepreneurial firms' development. Companies with upwardly revised perceived quality are more likely to switch to more reputable VCs. Further, companies that switch lead VCs obtain larger capital infusion and higher pre-money valuation. However, companies that switch to more reputable VCs accept smaller investment size and lower pre-money valuation in follow-on rounds. In addition, it takes significantly more time for switchers with downwardly revised perceived quality to obtain subsequent financing.

"A venture capital firm should deliver and focus on its core competency and move on. Just like startups change CEOs as they mature, shouldn't companies change VCs as they mature ? If there is a good startup CEO, shouldn't there also be good startup VCs? Some people can take a company from startup idea to billion-dollar business, but most need to be replaced along the way--this is true for both management teams and board members. (Hoffman, 2009).


There exists substantial uncertainty in venture capital investments, especially in the early stages. It is well established that there exists a positive sorting mechanism in the venture capital market in which more reputable venture capitalists (VCs) invest in better companies (Hsu, 2004; Knill, 2009; Sorensen, 2007). More recently, Bengtsson and Hsu (2010) show that the personal characteristics of VCs and founders also help explain the matching between VCs and entrepreneurial firms. Yavuz, Marquez, and Nanda (2010) show that fund managers may voluntarily limit fund size in order to match with high-quality entrepreneurial firms and consistently deliver superior returns. Given the importance of the matching in private equity investments, how the relationship between VCs and entrepreneurs evolve, however, is more or less neglected. Venture capital-backed companies typically take 2-7 years before they come to fruition in an exit, such as an initial public offering (IPO) or an acquisition. As both VCs and entrepreneurs learn about the potential of a start-up venture over time, it is natural to expect the two-sided matching between VCs, in particular, lead VCs, and entrepreneurs to dynamically adjust.

In this article, we explore the switching dynamic between entrepreneurs and their lead VCs and the underlying motivations. We define switching as when the lead VC firm in previous rounds is not the lead VC in the current or later rounds any more, where lead VC is defined as the one that had invested the largest cumulative amount of capital by the time of a specific round. (1) Switching lead VCs is more common than one might expect. We show that during the period from 1991 to 2002, 23% of the follow-on rounds of financing have lead VCs that are different from those of previous rounds. Further, we examine the consequence of switching lead VCs, for instance, the amount of capital raised and the valuation in the new round. Among the various factors examined, our key interest includes the impact of VC reputation and new information learned about the perceived quality of entrepreneurial firms on switching decisions, and whether companies switch to more reputable VCs regardless of less favorable financial terms, such as valuations, as Hsu (2004) finds these are important determinants of matching when the entrepreneur-VC relationship was initiated.

Theoretically, the switching process can be initiated by VCs or entrepreneurs. We conjecture that entrepreneurs will initiate switching if they view that the benefits of having a more reputable VC rather than the existing VC are greater than the cost of switching. This hypothesis predicts that ventures have a higher probability of success if entrepreneurs are successful in obtaining subsequent funding from more reputable outside VCs. …

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