Adverse Selection and Capital Structure: Evidence from Venture Capital

Entrepreneurship Theory and Practice, Vol. 30, pp. 155-184, 2006

Posted: 9 Jun 2005 Last revised: 10 Sep 2008

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Abstract

Venture capitalists in all non-U.S. countries around the world have consistently reported the use of a variety of securities, including common equity, preferred equity, convertible preferred equity, debt, convertible debt, and combinations (in the U.S., venture capitalists typically use convertible preferred equity, and there is a tax bias in favour of that instrument in the U.S.). The types of entrepreneurial firms that receive venture finance may be defined by a variety of characteristics, such as stage of development, type of industry, and capital requirements. Given this broad context observed in practice, previous research has not considered the extent to which different securities, among the complete class of forms of finance, attract different types of entrepreneurial firms. In this paper we investigate the empirical tractability of the adverse selection risks associated with capital structure from 4114 first-round Canadian venture capital investments. We first characterize of the nature of uncertainty (in terms of the risk of financing a "lemon" or a "nut") facing investors for different types of entrepreneurial firms. We then show that venture capitalist syndication significantly mitigates problems of adverse selection.

Keywords: Capital structure, adverse selection, venture capital, syndication

JEL Classification: G24, G28, G32, G38

Suggested Citation

Cumming, Douglas J., Adverse Selection and Capital Structure: Evidence from Venture Capital. Entrepreneurship Theory and Practice, Vol. 30, pp. 155-184, 2006. Available at SSRN: https://ssrn.com/abstract=739044

Douglas J. Cumming (Contact Author)

Florida Atlantic University ( email )

777 Glades Rd
Boca Raton, FL 33431
United States

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