A software services company looking for an early-stage round of investment from venture capital funds gets four offers. Two of them value the company at $10 million, one at $12.5 million and one at $20 million. Any of the offers would net the software company approximately $8 million in cash inflows.
It would seem to be a no-brainer. Accept the investment at the highest so-called “pre-money” valuation. So why did the company pick the $12.5 million offer? The highest financial offer came from a venture capital firm that had done the fewest previous deals – nine in all – in software services. The fund whose offer was accepted had a history of 33 deals.
In the minds of entrepreneurs working to grow their fledgling technology companies, the intangibles brought to the table by their investors – experience and contacts – often are worth a lot more than money itself, Wharton management professor David Hsu writes in a paper scheduled for publication in the August issue of the Journal of Finance. The paper is titled, What Do Entrepreneurs Pay for Venture Capital Affiliation?
If a company borrows from a bank and the terms are similar, it does not matter what bank it gets the money from. In seeking venture capital investment, however, a company is hungry not just for cash but also for the venture firm’s “reputation and access to a network of relationships – with customers, suppliers, investments bankers and other important constituents in the universe that the entrepreneur cares about,” Hsu says.
This may not be a startling insight to technology entrepreneurs who are familiar with venture capitalists. What Hsu’s paper does, however, is provide “a scientific measurement” of the magnitude of this phenomenon. He found that offers from more reputable venture capitalists are three times more likely to be accepted by entrepreneurial companies and that, on average, these favored investors acquire start-up equity in the companies at a 10-14% discount.
Hsu’s paper is based on a detailed survey, done in 2000, of 51 small companies that among them received a total of 148 offers. Because each of these startups had at least two offers, Hsu was able to hold all startup characteristics constant in the analysis, only allowing differences in venture capital qualities (such as reputation) to explain variation in valuation offers. The companies were among about 300 that had participated in the Entrepreneurship Laboratory at MIT, a program that brings together MIT and Harvard graduate students to study business-related issues at start-ups. The companies get a free business development analysis; the students get an opportunity to interact with company executives. One of the criteria for the companies to be part of the program is to have completed a Series A, or early stage, round of financing.
What Hsu discovered is that “a lot of money is left on the table” by the companies, both in absolute terms and as a percentage of the pre-money valuation accepted by the companies. Less than half of the firms surveyed accepted their best financial offer. The startups that did not accept the most generous offer they received let go of a combined $173.9 million. “For the group of multiple-offer firms declining their best financial offer, the foregone pre-money value as a fraction of the accepted offer ranged from a low of 3.6% to a high of 217%, with an average of 33.2% for the sample,” Hsu writes in his paper.
What makes VCs reputable? Experience, Hsu says. “As a venture capitalist gains more investment experience in a particular industrial sector, he or she is more likely to gain the expertise needed to help startups in their portfolio acquire resources for successful development, which is a powerful contributor to VC reputation,” he writes in his article. “Each additional investment extends the VC’s information network, either acquiring important social contacts and/or gaining experience in effectively structuring deals or monitoring entrepreneurs in the industrial sector.”
For example, “Kleiner Perkins Caufield & Byers, a prominent venture capital firm, claims to facilitate inter-organizational cooperation among its network of portfolio companies by ‘brokering’ strategically important information among them. As evidence, the firm claims that there are over 100 strategic alliances among its portfolio companies,” according to Hsu.
He quotes from the firm’s web site: “We borrow the term ‘keiretsu’ from Japan’s powerful networks of companies. However, unlike Japan, Kleiner’s ‘keiretsu’ is a particularly western, entrepreneurial, loosely coupled web of relationships. Kleiner doesn’t control any ventures; they’re each independent, run by strong, outstanding entrepreneurs. There’s no central controlling bank or interlocking board of directors. But the executives in the KPCB ‘keiretsu’ often share experiences, insight, knowledge and information. This network, comprised of more than 175 companies and thousands of executives, has proven to be an invaluable tool to entrepreneurs in both emerging and developing companies.”
Reputable venture capital firms also play an information brokerage role that is vital to young companies, Hsu says. In their early stages, companies are insecure and opt for secrecy to protect their competitive position. Venture capitalists, in their role as trusted intermediaries, can act in a variety of ways on behalf of the company – from assisting in recruiting executive officers to striking up strategic alliances.
The main measure of VC reputation used by Hsu’s study is the number of deals the VC firms previously completed within the startup’s industrial sector. The results do not change if alternative measures of VC reputation are used. Two such measures may be the number of prior VC funds raised, and entrepreneurs’ subjective ratings of the venture capitalist’s network resources. These resources could include, for example, quality of contacts to important customers, suppliers, and investment banks.
That investments often are made by syndicates of venture capital firms did not affect his analysis, Hsu says. He used the reputation status of the lead VC firm. “Suppose you had three VCs in syndication. It is unlikely that you are going to have three vastly different reputations in that syndicate. High-reputation VCs primarily syndicate with other high-reputation VCs.”
So what practical conclusions should entrepreneurs and venture capital investors draw from his dissection of their behavior? Affiliating with the right venture capital partner can certify the merits of a company to other parties, such as other investors. “Outsiders may say, ‘I don’t know the entrepreneur, but I know the venture capital firm through its prior deals’” and make inferences about the quality of the company they are looking at, Hsu says. Venture capitalists, on the other side, have a clear financial interest in acquiring and preserving their reputation even before they invest a single dollar in a company.
As for that software services company that decided to take the second-best offer, leaving $7.5 million in pre-money valuation on the table when it was a startup, “it is now a public company with a market capitalization of over $1.5 billion,” Hsu says.