Insider Financing and Venture Capital Returns
54 Pages Posted: 9 Oct 2016 Last revised: 4 Nov 2016
Date Written: October 7, 2016
Staged financing of venture capital-backed firms is valuable to both investors and entrepreneurs, but comes with a potential cost: hold-up. With asymmetric information and strong control rights, financial intermediaries may earn rents on their inside knowledge. We find that environments where insiders have the significant potential to hold-up the entrepreneur -- financings where only previous investors participate -- have predictable outcomes and returns. However, in contrast to predictions from the theory of hold-up, we show that these inside financings lead to a higher likelihood of failure, lower probability of IPOs, and lower cash on cash multiples than rounds with new (outside) investors. Inside financings also appear to be negative NPV, suggesting that investors make inefficient continuation decisions. We propose a novel alternative and show how the findings are consistent with a manifestation of an agency problem driven by changing opportunity costs over the VC fund life-cycle.
Keywords: venture capital, financial intermediation, hold up, entrepreneurship
JEL Classification: G24, G24
Suggested Citation: Suggested Citation