Academic journal article Journal of Financial Management & Analysis

Stochastic Properties of the Venture Capital Funding Process

Academic journal article Journal of Financial Management & Analysis

Stochastic Properties of the Venture Capital Funding Process

Article excerpt


The germination of corporate vitality via venture capital is growing rapidly. By the end of year 2001, companies financed with venture capital since the 1970s accounted for 5.9 per cent of the jobs in the U.S.A. and 13.1 per cent of U.S. gross domestic product in year 2000(1). From 1980 to 2001 the aggregate venture capital commitments have grown exponentially at a compound annual rate of 15.1 per cent. Figure 1 displays a histogram that vividly illustrates the annual increases in commitments during the 21-year period. These statistics, as well as others that can be adduced, evidence the tremendous impact that venture capital has had on employment and revenue generation in the U.S.A. during the past thirty years, and Given that venture capital was less than one per cent of U.S. investment activity during most of the period studied, its impact is remarkable1

In view of the growing significance of the venture capital industry in the U.S., it is odd that so little attention has been given to the development of a formal theory of entrepreneurial behavior in the venture capital solicitation process. There is a large body of literature describing the attitudes and the investment behavior of the venture capitalists.*2 There are empirical studies documenting the realized rates-of-return to the venture capitalists employing different exit strategies.3 There is an abundant supply of how-to-do-it books and articles dispensing practical guidance to entrepreneurs seeking financing.4 There are books and articles describing the financial contracting process.5 The author has not found any general theory purporting to analyze the properties of the funding solicitation events. The lacuna is confirmed by a very recently published paper wherein its author Saetre commented:

...though entrepreneurial firms are a pivotal source of new employment in Europe, the entrepreneur's perspective on capital acquisition is rarely discussed in the literature.6

Saetre conducted a case study consisting mainly of interviews with successful entrepreneurs. However, without a rigorous theory of the solicitation process, the statistics yielded by the data collected might yield only a few banalities.7

This paper establishes a template for a theory of the venture capital funding by focusing attention on the activities of the entrepreneur at the incipiency of the investment process: namely the solicitation event : A "solicitation event" is a series of activities wherein the entrepreneur (or the entrepreneurial group) searches for a venture capitalist to solicit, proposes an investment to a venture capitalist and elicits a financial commitment or, more frequently, a rejection. A series of such events constitutes the solicitation process. This way of describing a solicitation event makes it possible to characterize it as a binary-valued variable; i.e. either the entrepreneur secures a financial commitment, or he does not. This paper describes the series of solicitation events as the realization of random variables. The successes and the failures of the entrepreneurial group are shown to have characteristics conforming to those of a stochastic process with ergodic properties.* We exploit some of the properties of such processes to derive behavioral implications as well as inferences pertaining to the probability distributions governing the success of the funding solicitations.

Synoptic Description :Prelude

From the perspective of the microeconomic theory of financial institutions, the venture capitalist is a kind of financial intermediary.9 The venture capitalist manages funds for downstream investors (i.e. the buyers of the stock when, and if, the business goes public) who are not interested in direct investment in high risk / high return investments. Without such financial intermediaries, the market for venture capital would tend to dry up. This is because relatively poorly informed investors who were drawn into failing investments would decline to provide venture capital finance. …

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