Public or Private Venture Capital?

By Ibrahim, Darian M. | Washington Law Review, September 1, 2019 | Go to article overview

Public or Private Venture Capital?


Ibrahim, Darian M., Washington Law Review


INTRODUCTION

This Article compares two fundamental models for venture capital- the public model, which is found in several countries outside of the United States, and the private model, which is best exhibited in the United States. Venture capital is broadly defined as funds invested in rapid-growth, often high-tech startups.1 These startups are speculative, high-risk, and sacrifice short-term profits for activities meant to pay off in the future.2

In the United States, startups raise funds privately from venture capital funds (VCs), angel investors, and venture lenders.3 Other countries lack the infrastructure of private financing, a skilled high-tech labor force, and past entrepreneurial successes that exists in the United States, particularly in Silicon Valley,4 and they have therefore resorted to public markets to supply startups with venture capital.5 These markets have taken the form of junior stock exchanges, or public venture capital, and thus far have not been successful at replicating the U.S. private venture capital results in propelling early-stage companies to lucrative trade sales6 or public offerings.7 Three of the most notable attempts at public venture capital have been London's Alternative Investment Market (AIM), Germany's Neuer Markt (NM), and Hong Kong's Growth Enterprise Market (GEM).8 While other countries have also attempted to establish public venture capital,9 the AiM, NM, and GEM are the most notable and offer differing approaches to regulation and differing outcomes for fruitful academic study. in addition, their small relative size and express intention to supply growth capital to startups makes these junior stock exchanges more akin to the ecosystem found in Silicon Valley, not the publicly-traded Nasdaq, though they were initially touted as a rival to the latter.10

The holy grail for a startup company is to exit through an initial public offering onto a country's senior stock exchange, which provides the most liquidity to investors.11 This Article explores the AIM, NM, and GEM and examines why none of them have successfully served as a stepping stone to that country's senior stock exchange (like the U.S.'s Nasdaq or NYSE). For startups to attract venture capital, from either public or private investors, they must solve two major problems. First, prior to investment, investors must mitigate information asymmetry, or the consequence of entrepreneurs knowing more about their businesses than investors do.12 Second, after investment, investors must reduce agency costs, or the risk that entrepreneurs can mismanage or use investor funds for personal gain.13

Due to early-stage companies having sparse track records and technological uncertainty, information asymmetry and agency costs exist in extreme form in startup investing.14 This Article offers a contrast in dealing with these problems. The U.S. approach is to tackle them through private ordering and informal mechanisms. Lacking the ability to address them in the same way, the foreign public approach relies on corporate and securities law, similar to our public markets for established companies. Although the public approach works for established companies, it cannot compensate for the exacerbated nature of the risks present in startup investing.15 Finally, the Article argues that the United States took an ill-advised step toward creating its own public venture capital when it legalized crowdfunding in the Jumpstart our Business Startups (JOBS) Act of 2012.16 In a fortuitous turn, however, the Securities and Exchange Commission's (SEC's) final implementing rules in 2015-Regulation Crowdfunding (hereinafter "Regulation CF")-reversed course and situated crowdfunding as an important part of the private venture capital system that preceded it.17

Some caveats are in order. First, this is a law-and-economics article. There are likely cultural differences among countries that also explain differing levels of entrepreneurship, and thus a venture capital system's success or failure. …

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