Abstract
Problem statement: There is no general theory analyzing how the time-varying cash flows of venture capitalist financing affect the likelihood of success of a new venture. This research addressed that lacuna in the literature. Approach: Research in the area of venture capital financing was needed because of the importance of new ventures as germinators of technological innovation. The research in this study developed a general economic theory quantifying the risk of venture failure associated with time-varying cash flows of financing. Each occasion when an entrepreneur made an overture to a venture capitalist to elicit a financing commitment was defined to be a distinct "solicitation event". The series of financial commitments elicited from venture capitalists were assumed to have the characteristics of independently distributed random variables. It was assumed that the entrepreneur must secure a minimal aggregate commitment in order to ensure development of the project; failure to secure that amount caused the venture to be aborted. The theory of stochastic processes was applied to derive the practical implications as regards the risk of abortion. Results: It was shown that the aggregate financing commitment secured by an entrepreneur in a finite time had stochastic properties corresponding to those of a statistical renewal process. The research derived limiting conditions on the probability that entrepreneur’s venture will be aborted because of his failure to secure the minimal aggregate commitment. The main result was that if the number of solicitations by the entrepreneur is large and the financial commitments were independently distributed random variables with finite means and variances, the probability distribution governing venture survival is the Normal distribution. Conclusion: The study derived four analytical propositions quantifying the trade-offs between the risk and the expected return associated with venture capital financing. The policy implications of the results imply the benefits of mitigating information asymmetry. Some of the risk faced by the entrepreneurs could be attenuated if information about the risk/return preferences of venture capitalists were known to the entrepreneurs prior to solicitation. Some of the risks faced by the venture capitalists could be attenuated if information about the risk/return characteristics of the proposed investment project could be accurately and transparently communicated to the venture capitalist during the solicitation event. If either or both of these information deficits were palliated, the market for venture capital would operate more efficiently.
Highlights
The germination of corporate vitality via venture capital is growing rapidly
This study describes the series of solicitation events as the realization of random variables
Part (a) of Proposition 4 has a counterintuitive sense; it suggests that as the entrepreneur’s aversion to risk increases, ceteris paribus, he will carry out the solicitation activities in such a way as to result in an increase in the expectation and the uncertainty of the aggregate capital commitments. This inference is strictly true only in the unrealistic cases where the correlations between the time allocated to the solicitation events is not positively correlated with the capital commitments secured by those events
Summary
The germination of corporate vitality via venture capital is growing rapidly. By the end of year 2001, companies financed with venture capital since the 1970s accounted for 5.9% of the jobs in the United States and 13.1% of US gross domestic product in year 2000 (National Venture Capital Association). In view of the growing significance of the venture capital industry in the US, it is odd that so little attention has been given to the development of a formal theory of entrepreneurial behavior in the venture capital solicitation process. This study establishes a theory of the venture capital funding by focusing attention on the activities of the entrepreneur at the incipiency of the investment process: Namely the solicitation event. A “solicitation event” is a series of activities wherein the entrepreneur (or the entrepreneurial group) searches for a venture capitalist to solicit, proposes an investment to a venture capitalist and elicits a financial commitment or, more frequently, a rejection. I exploit some of the properties of such processes to derive behavioral implications as well as inferences pertaining to the probability distributions governing the success of the funding solicitations
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