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Abstract
All venture capital investments exhibit some form of asymmetric information. The seminal paper on the structure of venture investments, Kaplan and Stromberg (2004), investigates how venture capitalists use deal construction to control agency conflicts within funded deals and their associated internal, external and execution risks. Another key strand of the academic literature has reviewed the contractual arrangements venture capital firms reach, the process of venture capital selection and determinants of their success from a post-investment perspective (Fried and Hisrich (1994), Manigart, Vermeir and Sapienza (1996), Gompers and Lerner (2004), Wright and Robbie (1998)). This thesis also explores venture capital investment, albeit from a pre-investment standpoint. In contrast to Kaplan and Stromberg’s (2004) demonstration of the use of venture capital mechanisms to control agency issues, this research addresses how agency issues influence the final selection of potential investments by venture capitalists.
Kaplan and Stromberg (2004) use post-funding metrics to capture risks, which influence post-contract design. From a pre-funding perspective, internal, external and execution risks are subjective, rare and difficult to measure. Nevertheless, this thesis uses pre-funding proxies to replicate these risks, some of which have direct empirical academic support. Information for sixty-two deals, thirty-four funded and twenty-eight unfunded, was hand collected through a combination of surveys, interviews and consultation with five of Australia’s leading venture capital firms, and individuals from the Australian Private Equity and Venture Capital Association (AVCAL) board and executive.
The key results indicate that once past initial screening stages, investment proposals that have a higher likelihood of receiving venture investment are those that had prior government investment, and/or, where the entrepreneur has proposed the investment be through milestone tranches and where revenue is already being generated (for early stage ventures). The results suggest that venture capitalists tend to allocate capital to investments perceived as ‘safer’ with respect to agency conflicts. More specifically, venture capitalists are more reliant on signals of quality and lower risk, such as government grants, restriction of capital outlay and prior revenue generation – all of which reduce associated levels of internal and execution risk in new ventures.