Liquidity Risk and Venture Capital Finance

By Cumming, Douglas; Fleming, Grant et al. | Financial Management, Winter 2005 | Go to article overview

Liquidity Risk and Venture Capital Finance


Cumming, Douglas, Fleming, Grant, Schwienbacher, Armin, Financial Management


This article provides theory and evidence in support of the proposition that venture capitalists adjust their investment decisions according to liquidity conditions on IPO exit markets. We refer to technological risk as a choice variable in terms of the characteristics of the entrepreneurial firm in which the venture capitalist invests, and liquidity risk as the current and expected future external exit market conditions. We show that in times of expected illiquidity of exit markets (high liquidity risk), venture capitalists invest proportionately more in new high-tech and early-stage projects (high technology risk) in order to postpone exit requirements. When exit markets are liquid, venture capitalists rush to exit by investing more in later-stage projects. We further provide complementary evidence that shows that conditions of low liquidity risk give rise to less syndication. Our theory and supporting empirical results facilitate a unifying theme that links related research on illiquidity in private equity.

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Policymakers around the world often express concern about why there is not more investment in privately held early-stage companies. (1) Further, the extreme cyclicality of early-stage investment, and what the drivers are, remains a relatively unexplored issue in private equity and venture capital research. (2) This article introduces a new and somewhat counterintuitive theory to facilitate an understanding of these issues. The US data examined herein support the theory.

Venture capitalists ("VCs") invest in small private growth companies that typically do not have cash flows to pay interest on debt or dividends on equity. VCs invest in private companies over a period that generally ranges from two to seven years prior to exit. As such, VCs derive their returns through capital gains in exit transactions. IPO exits typically provide VCs with the greatest returns and reputational benefits (Gompers, 1996 and Gompers and Lerner, 1999, 2001). (3) Liquidity risk in the context of VC finance therefore refers to exit risk, particularly IPO exit risk. That is, liquidity risk refers to the risk of not being able to effectively exit and thus being forced either to remain much longer in the venture or to sell the shares at a high discount. (4) The risk of not being able to effectively exit an investment is an important reason why VCs require high returns on their investments (Lerner, 2000, 2002; Lerner and Schoar, 2004, 2005). It is therefore natural to expect that exit market liquidity affects VCs' incentives to invest in different types of entrepreneurial firms.

Liquidity risk is, of course, not the only type of risk that VCs face when deciding to invest in a particular project. The other types of risk may be grouped into a broad category of what we refer to in this article as technological risk, or the risk of investing in a project of uncertain quality (particular types of technological risk could include the quality of the product technology as well as the quality of entrepreneurs' technical and managerial abilities). This article considers whether changes in external conditions of liquidity risk give rise to adjustments in VCs' undertaking of projects with different degrees of technological risk. In particular, we investigate whether exit market liquidity affects the frequency of VC investment in nascent early-stage firms and high-tech firms with intangible assets. (5) We provide a theory and supporting empirical evidence that show the willingness of VCs to undertake projects of high technological risk is directly related to conditions of liquidity risk. We further provide complementary evidence that shows that external conditions of high liquidity risk give rise to more prevalent syndication, which in turn shows that while VCs assume more technological risk in periods of low liquidity, they take steps to mitigate this risk through syndication. We show that the theory and evidence in regards to liquidity risk introduced herein provides a unifying theme that links the results in a number of related papers on venture capital finance. …

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