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The dynamics of switching between governmental and independent venture capitalists: theory and evidence

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Abstract

In this paper, we study the switching dynamics between independent VCs (IVCs) and governmental VCs (GVCs) by means of a theoretical model and an empirical analysis. By assuming that (i) VCs of higher reputation are more selective in terms of venture quality and (ii) IVCs are mainly motivated by the desire to maximize the economic return of a venture, while GVCs also care about the social repercussions, we have obtained two results. First, low economic return ventures are more likely to be adopted by a new lead GVC that is more reputable than the IVC that drops them. Second, when switches from a GVC to an IVC are considered, a low economic return increases the likelihood that the venture dropped by the incumbent GVC will be re-matched with a less-reputable IVC. Our theoretical predictions match evidence that has emerged from a sample of 9610 rounds of VC financing in the USA between 1998 and 2010. Overall, our analysis sheds light on the puzzling evidence that GVCs seem to be more inclined to drop low return ventures than IVCs, but, at the same time, they are also more willing to adopt them.

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Notes

  1. As reported in Cumming and MacIntosh (2001), only 10% of portfolio investments are “home runs” that provide the bulk of VC profits, a further 20% are less profitable and approximately 10–30% of investments are write-offs, while the remainder are investments that do not generate more than nominal returns for VC investors.

  2. Prior research has shown that VCs often prefer to escalate their commitment to a prior course of action rather than terminate their investment, even when they receive negative information about future prospects of an investment (see Guler (2007) for a review of such studies). Guler (2007) examined multilevel influences on sequential investment decisions in the US venture capital industry and found that VC firms do not adjust their investment practices to reflect the change in expected returns, due to political and institutional constraints.

  3. Cumming and Dai (2013) reported that, from 1991 to 2002 in the USA, in 23% of the cases, the lead VCs of follow-on rounds of financing were different from those of previous rounds. An even higher percentage (47.99%) was reported by Croce and Ughetto (2016) for the years 1998–2010 in the USA.

  4. Two other related studies examined what drives GVC-backed ventures to receive additional financing by other VCs, especially when investments are syndicated between GVCs and IVCs (Brander et al. 2015; Guerini and Quas 2016).

  5. VC investors are usually classified on the basis of different configurations of ownership and governance. VCs can be independent firms that manage pools of funds raised from limited partners, often institutional investors (Sahlman 1990), or captive firms, which are structured as investment vehicles, where the capital is provided by a parent company, which may be a financial institution (e.g., a bank), a corporation or a government agency.

  6. Both Cumming and Dai (2013) and Croce and Ughetto (2016) also explored the perspective of entrepreneurs. They argued that switching may occur if entrepreneurs perceive that a change in the lead VC would allow their venture to access additional deal opportunities, financial resources, more valuable advice or coaching services from the new VC. However, informal talks with venture capital partners have suggested that, most of the time, the switching decision is not undertaken by the venture itself, but by the incumbent VC. Accordingly, we decided to leave aside the arguments concerning the decision of entrepreneurs to change lead VC investor and to only concentrate on the perspectives of both the incumbent and the new VCs.

  7. A large body of research has identified the benefits and potential distortions of public intervention on the VC market, and has described successful and unsuccessful experiences developed in different countries (Avnimelech and Teubal 2006; Cumming and Li 2013; Cumming 2007; Cumming and MacIntosh 2006, 2007; Da Rin et al. 2006; Johan et al. 2014; Leleux and Surlemont 2003; Lerner 1999, 2010, among others). Governmental VC funds have been created in numerous countries to develop an active VC market (Brander et al. 2015). Examples of relevant worldwide initiatives are the Yozma program in Israel, the Small Business Investment Companies program (SBIC) in the USA, the Canadian labor-sponsored venture capital corporation, and the Australian Innovation Investment Fund. In Europe, the examples include the Fund for the Promotion of Venture Capital in France, the High Tech Fund of Funds in the UK, the German ERP-EIF Dachfonds fund, the Dutch TechnoPartner Seed facility fund, and the Danish Vækstfonden fund.

  8. A VC’s reputation is generally associated with its skills to select the best ventures or to enhance their performance (Bertoni et al. 2016; Bertoni et al. 2015; Gompers 1996; Nahata 2008). However, a VC’s reputation may by itself attract high quality ventures, either as a means for the latter to signal their potential, or because of the easier access to resources that the association with a highly reputable VC would engender (Dimov et al. 2007; Lee et al. 2011). We simply focus here on the probability that a reputable VC matches with high-quality ventures, regardless of its source.

  9. The extraction refers to April 2012.

  10. As a robustness check, we followed the method of Cumming and Dai (2013) and employed a different definition of lead VC, that is, the one that invested the largest cumulative amount of capital. The obtained results were robust to the adoption of this different definition.

  11. Thomson One defines an IVC as “an Independent Private Partnership,” namely “an independent private firm that makes private equity investments and which raises a portion or all of its capital from outside investors.” We included the following typologies of funds in the GVC category: “Government”, defined as “A program funded by a government agency used to make private equity investments,” SBIC funds and “Business/Community Development Program,” defined as “a private equity fund formed by a local community to help fund community interests, such as housing developments, workforce programs, childcare centers, schools, businesses, and community centers.” Out of 1551 total rounds (i.e., first rounds and follow-on rounds, for both switchers and non-switchers) led by GVCs, 64.21% refers to the Small Business Investment Company (SBIC) Program, 30.11% refers to Government VC funds and 5.61% refers to the Business/Community Development Program.

  12. It should be noted that a venture may switch more than once in the observed period.

  13. The remaining 40 switching rounds refer to a switching from a GVC to another GVC. We did not include these rounds in our analysis, because the limited number of observations did not allow us to perform a significant analysis of the phenomenon.

  14. We also compared switcher and non-switcher ventures according to the “size of government” component of the EFW index (Economic Freedom of the World, Frazer Institute). The results indicate that ventures switching to or from a GVC show a significantly higher value than non-switchers, with respect to several variables that measure the role and the incidence of Government (e.g., General Government Consumption Spending and Transfers and Subsidies as a percentage of GDP, both measured considering the average value from 1998 to 2010). The results of these tests are not reported in the manuscript, for the sake of brevity, but are available from the authors upon request.

  15. This number was estimated by year, considering those IPOs for which the focal VC was the lead investor at the time of the last funding round.

  16. Lee et al.’s (2011) VC reputation index is available for public use at www.timothypollock.com. The VC investors in our sample were not all included in Lee et al.’s (2011) index. The presence of these missing values explains why we replicated Lee et al.’s (2011) procedure instead of directly using their index.

  17. We adopted the industry classification provided in the Thomson One database.

  18. We have provided a number of robustness checks in the Appendix: a multinomial logit that discards first rounds (Table 9 in Appendix 1) and two probit models that run separately on IVC investments (which are the only ones that can switch to a GVC) in the first column in Table 10 in Appendix 2 and on GVC investments (which are the only ones that can switch to an IVC) in the second column in Table 10 in Appendix 2, respectively.

  19. The results of this regression have been omitted for the sake of brevity, but are available to the readers upon request to the authors.

  20. We estimated the probability of a successful exit for each venture at the start of each round; therefore, we employed a non-static measure of perceived quality.

  21. As a robustness check, we also applied another similar estimation procedure with sample selection. We ran the first stage probit model of the Heckman procedure and we obtained the inverse Mills’ ratio (IMR), which is the estimated value of the generalized residual. To correct for any selection bias, the inverse Mills’ ratio control factor was then included in a second probit model, according to the specifications of the second stage of the Heckman procedure. The results of these estimates are not reported in the text, for the sake of brevity, but are available upon request to the authors.

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Correspondence to Elisa Ughetto.

Additional information

The paper circulated in its working paper version with the title: Dumping or taking on entrepreneurial ventures: the dynamics of switching between governmental and independent venture capitalists

Appendices

Appendix 1

Table 9 Probability of switching

Appendix 2

Table 10 Probability of switching

Appendix 3

1.1 Proofs

Proof of Proposition 1

Note that, since the expected value of the investments of the least reputable GVC (rG = 0) is 1/2, no switch occurs for vG < ½, as there does not exist a type of GVC willing to adopt the venture. Then, given vG  ½, we distinguish between three cases.

Case 1: ρ < σ (i.e., ρ < vG) and ρ < 1/2. In this case, the incumbent IVC drops the venture with ex ante probability 1 − rI, for all rI ∈ [0, 1]. The entrant GVC adopts the venture whenever rG ≤ 2vG − 1, i.e., with probability 2vG − 1. Then,

$$ \Pr \left(s\in {S}_{IG}\right)=\underset{0}{\overset{1}{\int }}\left(2{v}_G-1\right)\left(1-{r}_I\right)\mathrm{d}{r}_I=\frac{2{v}_G-1}{2}. $$

A switch involves a more reputable GVC only if 0 ≤ rI ≤ 2vG − 1:

$$ \Pr \left(s\in {A}_{IG}\right)=\underset{0}{\overset{2{v}_G-1}{\int }}\left(2{v}_G-1-{r}_I\right)\left(1-{r}_I\right)\mathrm{d}{r}_I=\frac{{\left(2{v}_G-1\right)}^2}{2}-\frac{{\left(2{v}_G-1\right)}^3}{6}. $$

Hence,

$$ \frac{d\Pr \left(s\in {A}_{IG}|s\in {S}_{IG}\right)}{d\rho}=0 $$

for all ρ < ½.

Case 2: ρ < σ and ρ ≥ 1/2. Let us explicitly express

$$ \Pr \left(s\in {S}_{IG}\right)=\left(2{v}_G-1\right)\underset{2\rho -1}{\overset{1}{\int }}\left(1-{r}_I\right)\frac{1+{r}_I}{2}\mathrm{d}{r}_I=\kern0.75em \left(2{v}_G-1\right)\left(\frac{2}{3}+\frac{4}{3}{\rho}^3-2{\rho}^2\right) $$

and

$$ {\displaystyle \begin{array}{c}\Pr \left(s\in {A}_{IG}\right)=\underset{2\rho -1}{\overset{2{v}_G-1}{\int }}\left(2{v}_G-1-{r}_I\right)\left(1-{r}_I\right)\frac{1+{r}_I}{2}\mathrm{d}{r}_I=\\ {}=\frac{{\left(2{v}_G-1\right)}^2}{4}\left(1-\frac{{\left(2{v}_G-1\right)}^2}{6}\right)-\frac{\left(2\rho -1\right)\left(2{v}_G-1\right)}{2}\left(1-\frac{{\left(2\rho -1\right)}^2}{3}\right)+\frac{{\left(2\rho -1\right)}^2}{4}\left(1-\frac{{\left(2\rho -1\right)}^2}{2}\right).\end{array}} $$

The derivative of (1) with respect to ρ is equal to

$$ \frac{d\Pr \left(s\in {A}_{IG}|s\in {S}_{IG}\right)}{d\rho}=\frac{\frac{d\Pr \left(s\in {A}_{IG}\right)}{d\rho}\Pr \left(s\in {S}_{IG}\right)-\Pr \left(s\in {A}_{IG}\right)\frac{d\Pr \left(s\in {S}_{IG}\right)}{d\rho}}{{\left(\Pr \left(s\in {S}_{IG}\right)\right)}^2} $$
(3)

We are interested in the sign of (3). Then, we can focus on its numerator. In particular,

$$ \frac{d\Pr \left(s\in {A}_{IG}\right)}{d\rho}=\frac{\partial \Pr \left(s\in {A}_{IG}\right)}{\partial \rho }+\frac{\partial \Pr \left(s\in {A}_{IG}\right)}{\partial {v}_G}\frac{\partial {v}_G}{\partial \rho } $$

Since \( \frac{\partial {v}_G}{\partial \rho }=1-\alpha \), in the limit for α = 1 we have

$$ \frac{d\Pr \left(s\in {A}_{IG}\right)}{d\rho}=\frac{\partial \Pr \left(s\in {A}_{IG}\right)}{\partial \rho }=-8\left({v}_G-\rho \right)\rho \left(1-\rho \right). $$

Moreover,

$$ \frac{d\Pr \left(s\in {S}_{IG}\right)}{d\rho}=\frac{\partial \Pr \left(s\in {S}_{IG}\right)}{\partial \rho }+\frac{\partial \Pr \left(s\in {S}_{IG}\right)}{\partial {v}_G}\frac{\partial {v}_G}{\partial \rho } $$

Since \( \frac{\partial {v}_G}{\partial \rho }=1-\alpha \), in the limit for α = 1 we have

$$ \frac{d\Pr \left(s\in {S}_{IG}\right)}{d\rho}=\frac{\partial \Pr \left(s\in {S}_{IG}\right)}{\partial \rho }=-4\left(2{v}_G-1\right)\rho \left(1-\rho \right). $$

The numerator of (3), in the limit for α = 1, can thus be rewritten as

$$ -\frac{8}{3}\left({v}_G-\rho \right)\rho \left(1-\rho \right)\left(2{v}_G-1\right)\left[\frac{5}{2}+\left({v}_G+\rho -2\right)\left({v}_G^2+{\rho}^2\right)+{v}_G\left(2\rho -1\right)\right] $$

Since by hypothesis vG > ρ and vG > 1/2, the above expression is negative provided that the term in the square parenthesis is positive. Note, however, that the square parenthesis is increasing in ρ. Then, the square is minimized for ρ = 1/2, and in this case, it is equal to \( \frac{5}{2}+\left({v}_G-3/2\right)\left({v}_G^2+1/4\right) \), which is always positive. By continuity, the derivative in (3) is negative for α sufficiently high when ρ < σ and ρ ≥ 1/2. Moreover, the probability that s ∈ AIG, conditional on s ∈ SIG when ρ ≥ ½ is lower than in case 1, when ρ < 1/2.

Case 3: ρ ≥ σ. Then, Pr(s ∈ AIG| s ∈ SIG) = 0, which implies that its derivative with respect to ρ is zero. Hence, if α is sufficiently high,

$$ \frac{d\Pr \left(s\in {A}_{IG}|s\in {S}_{IG}\right)}{d\rho}\le 0 $$

for all ρ ∈ [0, 1]. Q.E.D.

Proof of Proposition 2

First observe that, since the expected value of the investments of the least reputable IVC (rI = 0) is 1/2, no switch occurs for ρ < ½, as there does not exist a type of IVC willing to adopt the venture. Then, given ρ ≥ ½, we distinguish between three cases.

Case 1: ρ > σ and vG < 1/2. In this case, the incumbent GVC drops the venture with ex ante probability 1 − rG for all rG ∈ [0, 1]. The entrant IVC adopts the venture whenever rI ≤ 2ρ − 1, i.e., with probability  − 1. Then,

$$ \Pr \left(s\in {S}_{GI}\right)=\underset{0}{\overset{1}{\int }}\left(2\rho -1\right)\left(1-{r}_G\right)\mathrm{d}{r}_G=\frac{2\rho -1}{2}. $$

A switch involves a more reputable IVC only if 0 ≤ rG ≤ 2ρ − 1:

$$ \Pr \left(s\in {B}_{GI}\right)=\underset{0}{\overset{2\rho -1}{\int }}\left(2\rho -1-{r}_G\right)\left(1-{r}_G\right)\mathrm{d}{r}_G=\frac{{\left(2\rho -1\right)}^2}{2}-\frac{{\left(2\rho -1\right)}^3}{6}. $$

From (2), we obtain.

\( \Pr \left(s\in {A}_{GI}|s\in {S}_{GI}\right)=1-\frac{\frac{{\left(2\rho -1\right)}^2}{2}-\frac{{\left(2\rho -1\right)}^3}{6}}{\frac{2\rho -1}{2}}. \)Hence,

$$ \frac{d\Pr \left(s\in {A}_{GI}|s\in {S}_{GI}\right)}{d\rho}=-\left(\frac{{\left(2\rho -1\right)}^2}{2}-\frac{{\left(2\rho -1\right)}^3}{3}\right) $$

which is negative for all ρ ≥ ½, i.e., for all ρ such that a switch occurs.

Case 2: ρ > σ and vG ≥ 1/2. Let us explicitly express

$$ \Pr \left(s\in {S}_{GI}\right)=\underset{2{v}_G-1}{\overset{1}{\int }}\left(2\rho -1\right)\left(1-{r}_G\right)\frac{1+{r}_G}{2}\mathrm{d}{r}_G=\left(2\rho -1\right)\left(\frac{2}{3}+\frac{4}{3}{v}_G^3-2{v}_G^2\right) $$

and

$$ {\displaystyle \begin{array}{c}\Pr \left(s\in {B}_{GI}\right)=\underset{2{v}_G-1}{\overset{2\rho -1}{\int }}\left(2\rho -1-{r}_G\right)\left(1-{r}_G\right)\frac{1+{r}_G}{2}\mathrm{d}{r}_G=\\ {}=\frac{2\rho -1}{2}\left[\left(2\rho -1\right)\left(1-\frac{{\left(2\rho -1\right)}^2}{3}\right)-\frac{2\rho -1}{2}+\frac{{\left(2\rho -1\right)}^3}{4}\right]+\\ {}-\frac{2{v}_G-1}{2}\left[\left(2\rho -1\right)\left(1-\frac{{\left(2{v}_G-1\right)}^2}{3}\right)-\frac{2{v}_G-1}{2}+\frac{{\left(2{v}_G-1\right)}^3}{4}\right]\end{array}} $$

From (2), we have

$$ \frac{d\Pr \left(s\in {A}_{GI}|s\in {S}_{GI}\right)}{d\rho}=\frac{-\left(\frac{d\Pr \left(s\in {B}_{GI}\right)}{d\rho}\Pr \left(s\in {S}_{GI}\right)-\Pr \left(s\in {B}_{GI}\right)\frac{d\Pr \left(s\in {S}_{GI}\right)}{d\rho}\right)}{{\left(\Pr \left(s\in {S}_{GI}\right)\right)}^2} $$
(4)

We are interested in the sign of (4). Then, we can focus on its numerator. In particular,

$$ \frac{d\Pr \left(s\in {B}_{GI}\right)}{d\rho}=\frac{\partial \Pr \left(s\in {B}_{GI}\right)}{\partial \rho }+\frac{\partial \Pr \left(s\in {B}_{GI}\right)}{\partial {v}_G}\frac{\partial {v}_G}{\partial \rho } $$

Since \( \frac{\partial {v}_G}{\partial \rho }=1-\alpha \), in the limit for α = 1, we have

$$ \frac{d\Pr \left(s\in {B}_{GI}\right)}{d\rho}=\frac{\partial \Pr \left(s\in {B}_{GI}\right)}{\partial \rho }=\left(2\rho -1\right)\left(1-\frac{{\left(2\rho -1\right)}^2}{3}\right)-\left(2{v}_G-1\right)\left(1-\frac{{\left(2{v}_G-1\right)}^2}{3}\right). $$

Moreover,

$$ \frac{d\Pr \left(s\in {S}_{GI}\right)}{d\rho}=\frac{\partial \Pr \left(s\in {S}_{GI}\right)}{\partial \rho }+\frac{\partial \Pr \left(s\in {S}_{GI}\right)}{\partial {v}_G}\frac{\partial {v}_G}{\partial \rho } $$

Since \( \frac{\partial {v}_G}{\partial \rho }=1-\alpha \), in the limit for α = 1, we have

$$ \frac{d\Pr \left(s\in {S}_{GI}\right)}{d\rho}=\frac{\partial \Pr \left(s\in {S}_{GI}\right)}{\partial \rho }=2\left(\frac{2}{3}+\frac{4}{3}{v}_G^3-2{v}_G^2\right). $$

The numerator of (4), in the limit for α = 1, can thus be rewritten as

$$ -\left(\frac{2}{3}+\frac{4}{3}{v}_G^3-2{v}_G^2\right)\left[\frac{{\left(2\rho -1\right)}^2}{2}\left(1-\frac{{\left(2\rho -1\right)}^2}{2}\right)-\frac{{\left(2{v}_G-1\right)}^2}{2}\left(1-\frac{{\left(2{v}_G-1\right)}^2}{2}\right)\right]. $$

The first factor is positive for all vG ∈ [0, 1]. The factor in the square parenthesis is strictly positive as well. In fact, the function \( f(x)=\frac{{\left(2x-1\right)}^2}{2}\left(1-\frac{{\left(2x-1\right)}^2}{2}\right) \) is increasing for all x ∈ [1/2, 1] and ρ > vG. Hence, by continuity, when ρ > σ, the sign of (4) is negative for α, which is sufficiently high.

Case 3: ρ ≤ σ. In this case, Pr(s ∈ AGI| s ∈ SGI) = 1, which implies that its derivative with respect to ρ is zero.

By the union of the three cases, we have that, when α is sufficiently high,

$$ \frac{d\Pr \left(s\in {A}_{GI}|s\in {S}_{GI}\right)}{d\rho}\le 0 $$

for all ρ ∈ [0, 1]. Q.E.D.

Proof of Corollary 1

When α = 0, vG = ρ. Then,

$$ {\displaystyle \begin{array}{l}\Pr \left(s\in {A}_{GI}|s\in {S}_{GI}\right)=\frac{1}{3\rho {\left(1-\rho \right)}^2}\left(1-{\left(1-\rho \right)}^3-3{\rho}^2+2{\rho}^3\right)=\\ {}=\frac{1}{3\rho {\left(1-\rho \right)}^2}\left(1-2\rho +{\rho}^2\right)=1.\end{array}} $$

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Abrardi, L., Croce, A. & Ughetto, E. The dynamics of switching between governmental and independent venture capitalists: theory and evidence. Small Bus Econ 53, 165–188 (2019). https://doi.org/10.1007/s11187-018-0047-z

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