Exit Timing of Venture Capitalists in the Course of an Initial Public Offering

Abstract

We analyze the disinvestment decision of venture capitalists in the course of the initial public offering (IPO) of their portfolio firms. Due to informational asymmetries, the capital market learns of the project quality only in the period following the IPO. Venture capitalists with high-quality firms face a trade-off between immediately selling their stake in the venture at a price below the true value and having to wait for an additional period until the true value is revealed. The latter strategy, however, entails opportunity costs in the form of forgone investment in another attractive venture. We investigate this trade-off and show that the dilemma may be resolved via a reputation-acquiring mechanism in a repeated game set-up. In this set-up we can explain, for example, the advent of hot-issue market behavior involving early disinvestments and a high degree of price uncertainty. Furthermore, we provide a new rationale for underpricing in the course of an IPO. We show that young venture capitalists may use underpricing as a device for credibly committing themselves to acquiring reputation.