The Risk of Investment and the Venture Capital Exit Market

Abstract

The factors that drive the financing available to start-ups is a key issue for entrepreneurs, venture capitalists (VCs), and other investors in new ventures, especially in light of the difficult exit market the industry has faced over the last decade. We examine how the dollars gained and lost in recent exits and failures of venture-backed companies affect VCs’ risk allocations (proportion of early- versus late-stage investment) and returns over 1986-2008. Consistent with perceptions of lower profit-to-loss potential for risky investments, we find that VCs have significantly decreased the proportion of early stage investment over time. Conditional on exit, lower risk allocations at the time of investment initiation reduce the future returns from these exits, with its impact seemingly large enough to offset the positive effects of industry downsizing since 2001. In sum, we show empirically that risk allocation is an important channel by which VCs respond to market signals.