The Role of Venture Capital Backing in Initial Public Offerings: Certification, Screening, or Market Power?
Thomas J. Chemmanur
Boston College - Carroll School of Management
University of Virginia - Darden School of Business
EFA 2005 Moscow Meetings Paper
We empirically distinguish between three possible roles of venture backing in IPOs: certification, where venture-backed IPOs are priced closer to intrinsic firm value than non-venture backed IPOs due to venture capitalists' concern for their reputation; screening and monitoring, where VCs are able to either select better quality firms to back (screening), or help create such higher quality firms by adding value to them (monitoring) in the pre-IPO stage; and market power, where venture capitalists attract a greater number and higher quality of market participants such as underwriters, institutional investors, and analysts to an IPO, thus obtaining a higher valuation for the IPOs of firms backed by them. We argue that IPO underpricing is not the most appropriate measure to evaluate the role of venture backing in IPOs. Instead, we compare four sets of more direct measures between VC backed and non-VC backed (and between high-reputation VC backed and low-reputation VC backed) IPOs. The evidence strongly rejects the certification hypothesis, while finding considerable support for the market power hypothesis and some support for the screening and monitoring hypothesis. We find that venture capitalists attract higher quality market participants to the IPOs of firms backed by them, thus increasing the heterogeneity in investor beliefs about these firms, resulting in higher valuations for the equity of these firms (both in the IPO and in the secondary market immediately following the IPO).
Number of Pages in PDF File: 58
Keywords: venture capital, certification, screening, monitoring, market power
JEL Classification: G24, G23
Date posted: October 15, 2004