Venture Capital and Underpricing: Capacity Constraints and Early Sales

Abstract

I present a model of the venture capital (VC) and public markets in which VCs suffer from capacity constraints, given the shortage of skilled professionals able to work as VC managers. Such constraints imply that VC firms can only handle a limited number of new projects at once, having to take current projects public in order to take advantage of new opportunities that arrive. This framework is able to match key features presented by the VC and IPO empirical literatures: 1.) VC-backed issuing rms are younger, smaller, and less pro table at the IPO than their non-VC backed counterparts; 2.) VC-backed IPOs are more underpriced than non-VC backed IPOs, 3.) There is a positive relationship between underpricing and VC fundraising. Extending the model to allow firms that have di¤erent levels of capacity constraints shows that the more constrained a VC fi rm is, the ealier it needs to take companies public on average. Such reasoning can explain the different IPO patterns for rms backed by young VC rms compared to the ones backed by older VCs. Finally, based on a database of 3,050 US IPOs from 1987 to 2007, I show that the distribution of some fi rm characteristics at the IPO of VC-backed issuing fi rms in hot issue markets has fatter tails than its counterpart for cold markets. Based on the model, this result is derived by the optimal reaction of VC fi rms to changes in the market tightness of VC markets.