how do corporate venture capitalists create value for entrepreneurial firms

8/10/2019 How Do Corporate Venture Capitalists Create Value for Entrepreneurial Firms

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How Do Corporate Venture Capitalists

Create Value for Entrepreneurial Firms?

by

Thomas J. Chemmanur*

and

Elena Loutskina**

Current Version: June, 2008

* Associate Professor of Finance, Carroll School of Management, Boston College, 440 Fulton Hall, Chestnut Hill, MA 02467,Tel: (617)552-3980, fax: (617) 552-0431, e-mail: [email protected].

** Assistant Professor of Finance, Darden Graduate School of Business Administration, University of Virginia, CharlottesvilleVA 22903, Tel: (434) 243-4031, e-mail: [email protected].


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ABSTRACT

We analyze how corporate venture capitalists (CVCs) create value for entrepreneurial firms backedby them and how value creation by CVCs differs from that of independent venture capitalists (IVCs).

Making use of a large data set consisting of a sample of CVC-backed and IVC-backed firms (startingfrom their first round of investment in an entrepreneurial firm and going well into the post-IPO market),we explore three related research questions: First, do CVCs exploit their knowledge and industryexpertise when choosing portfolio firms, and invest in significantly different kinds of firms compared toindependent venture capitalists (IVCs)? Second, do they succeed in creating greater product market valuesubsequent to investment compared to IVCs? Finally, do they allow portfolio firms to access the equitymarkets more efficiently? Our empirical findings indicate that there are two ways in which CVCsuniquely create value for entrepreneurial firms. First, CVC create value by investing significant amountsin younger and riskier firms involving pioneering technologies: since many such firms would not havereceived private equity financing from IVCs, these firms may not have been able to grow and maturewithout CVC funding. Second, CVCs seem to play an important role in signaling the true value of firmsbacked by them to three different constituencies: first, to IVCs, prompting them to co-invest in these firms

pre-IPO; second, to various financial market players such as underwriters, institutional investors, andanalysts, allowing them to access the equity market at an earlier stage in their life-cycle compared to firmsbacked by IVCs alone; and third, directly to IPO market investors, allowing CVC-backed firms to obtainhigher IPO market valuations compared to the valuation of firms backed by IVCs alone.


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1. Introduction

US corporations started to establish internal venture capital funds (often referred to as corporate

venture capital) back in the 1960s. Over the years, corporate venture capital investments accounted for

around 7% of venture capital industry reaching 10% in recent years. In the year 2000, corporations

invested in almost 1900 entrepreneurial companies with a total dollar investment of around $16 billion.

Corporate venture capitalists (CVCs) present an interesting case study, since, even though they share a

number of features with independent venture capital firms (IVCs), they are significantly different from

IVCs in many ways, some of which are as follows. First, CVCs are structured as subsidiaries of

corporations and can only have one (corporate) investor as opposed to IVCs, who are traditionally

structured as limited partnerships where general partners invest in entrepreneurial firms on behalf of

limited partners who provide the funds for investment. Second, the performance-based compensation

structure enjoyed by IVC managers is normally not found in CVC funds, where managers are mostly

compensated by fixed salary and corporate bonuses, so that corporate venture capitalists may be less

concerned than IVCs with the immediate financial returns from their entrepreneurial firms. Third, the

presence of a corporate parent may provide CVCs with a unique knowledge of the industry and the

technology utilized by the entrepreneurial firm.1

The venture capital literature has argued that venture capitalists, in general, create value for the

entrepreneurial firms they invest in several ways. For example, Hellman and Puri (2000, 2002)) has

documented that IVCs are able to create product market value for entrepreneurial firms, by

professionalizing firm management and helping them develop contracts with suppliers and customers.2

At the same time, a number of papers in the venture capital and IPO literature have argued that the pricing

1See Gompers and Lerner (2000) for a detailed discussion of the differences in governance and compensation structures betweenCVCs and IVCs.2The assumption that venture capitalists can help entrepreneurial firms perform better in the product market has also becomestandard in the theoretical literature on venture capital: see, e.g., Repullo and Suarez (2001) or Chemmanur and Chen (2003)).


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of IPO shares in venture backed firms is significantly different from that in non-venture backed firms,

either in terms of the extent of underpricing (see, e.g., Megginson and Weiss (1991); Barry, Muscarella,

Peavy and Vetsuypens (1990); or Lee and Wahal (2000)) or in terms of share valuation with respect to

intrinsic value (Chemmanur and Loutskina (2003)). Further, venture backing also seems to affect the age

at which firms are able to go public (see, e.g., Loughran and Ritter (2004)). In other words, venture

backing seems to affect the ease of entrepreneurial firms to access the capital markets, and terms under

which they are able to access these markets. A natural question that arises here is how the significant

governance and other differences between the two kinds of venture capitalists affect result in differences

in value creation by CVCs and IVCs for the entrepreneurial firms backed by them. The objective of this

paper is to answer this question by empirically analyzing differences in value creation by corporate

venture and independent venture capitalists, and thereby to develop a better understanding of the unique

ways in which CVCs are able to create value for entrepreneurial firms backed by them.

We hypothesize that CVCs may differ from IVCs in creating value for portfolio firms in three

important ways. First, CVCs may invest in different kinds of firms compared to IVCs, and may provide

funding to firms at different stages in their life cycle. The terms under which they provide funding may

differ across CVCs and IVCs. These differences may arise from the differences in institutional structure

and the objectives of these two kinds of intermediaries: while IVCs are primarily concerned with the

financial returns from their portfolio firms, CVCs may also be concerned with other benefits to the

corporate parent that may arise from the investment, such as exposure to a pioneering technology and

early establishment of alliances in the product market. Further, the industry and technology expertise of

CVCs may allow them to screen firms better, which may allow them to invest larger amounts in riskier

and more R&D intensive firms (with longer time to achieving profitability) compared to IVC

investments. Finally, there may be differences in bargaining power between CVCs and IVCs, so that the

terms of financing of entrepreneurial firms may differ across these two intermediaries.

Second, CVCs and IVCs may differ in their ability to create product market value for entrepreneurial

firms subsequent to investment. The empirical literature (e.g., Hellman and Puri (2000, 2002)) has


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documented that IVCs are able to create value for entrepreneurial firms, for example, by

professionalizing firms management. On the one hand, specialization by IVCs in making investments in

certain industries may help them develop contracts superior to that of CVCs in the product market (e.g.,

with suppliers and intermediaries) which may be beneficial to entrepreneurial firms backed by them. On

the other hand, the effect of the superior industry expertise of CVC -parent may outweigh the effect of

such industry contacts, allowing CVCs to create greater product market value for entrepreneurial firms

backed by them. Such differences in value creation may potentially be reflected in differences in post-IPO

operating performance for CVC and IVC backed firms.

Third, CVCs and IVCs may have different abilities to help portfolio firms access the capital markets,

and the terms under which they access these markets. One the one hand, IVCs, being more frequent

players in the IPO market, can be expected to have stronger relationships with top-tier investment banks,

institutional investors, and financial analysts which may allow them to better communicate firm value to

the capital market. On the other hand, backing by a corporate parent may convey a credible signal to the

financial market about the future prospects of the entrepreneurial firm. Such differences between CVCs

and IVCs may translate into different probabilities of a successful exit for CVC and IVC backed firms,

and to different proportions of these kinds of exits. These differences may also result in systematic

differences in the IPO market valuation between CVC-backed and IVC-backed firms. 3

In this paper, we make use of data regarding a large sample of CVC and IVC backed firms to

identify some of the aspects of value creation for entrepreneurial firms by corporate venture capitalists

discussed above. Our dataset consists of round by round financing data starting with the very first

investment made by venture capitalists in a private firm, extending through the firms IPO stage, and

ending with post-IPO operating performance and financial market data for five years subsequent to the

IPO. Our data set contains not only the characteristics of entrepreneurial firms, but also various aspects of

the CVCs and IVCs investing in those firms.

3Of course, these differences in exit probabilities and market valuations may also reflect differences in the kinds of firmsinvested in by CVCs and IVCs, and differences in the product market value created by these two kinds of intermediaries.


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Our empirical analysis consists of six parts. First, we study various characteristics of CVC backed

firms and compare them with those of IVC backed firms. Second, we study the probability of a successful

exit (IPO or acquisition) for CVC backed firms, and compare this to that of IVC backed firms. Third, we

study the five year post-IPO operating performance of CVC backed firms, and compare this to that of

IVC backed firms. Fourth, we compare the quality and the extent of participation by financial market

players such as underwriters, institutional investors, and coverage by analysts in the IPOs of CVC and

IVC backed firms. Fifth, we compare equity valuation in the IPOs of CVC backed and IVC backed firms.

Finally, we compare the long-term post-IPO stock returns of CVC backed and IVC backed firms.

Our paper provides a number of new results on the sources of value creation by CVCs. Our results

can be summarized as follows. First, we document (for the first time in the literature) that the investment

patterns of CVC are significantly different from that of IVCs. CVCs tend to invest into younger and

riskier firms and in earlier rounds compared to IVCs. These firms tend to be in less mature industries

which require significantly larger R&D and capital expenditures, and which are more competitive (have

no dominant firm in product market). Further, CVCs are more likely to select portfolio companies in

industries closely related to that of their corporate parent. Finally, CVCs invest significantly large

amounts of money per round than IVCs (even compared to IVC investments in the same firm) and at

higher valuation than IVCs (i.e., the fraction of stock ownership given to CVCs in exchange for each $1

million invested is lower).

Second, we find that the probability of a successful exit (IPO or acquisition) is higher in CVC

backed firms compared to IVC backed firms. Further, the probability of having an IPO rather than

acquisition is greater for a CVC backed firm. However, we find that the time from first venture capital

investment to exit is greater for CVC backed firms, consistent with our earlier findings that CVCs invest

in younger firms, in less mature industries and in earlier rounds (which may take longer time to reach

profitability).

Third, we document (for the first time in the literature) that CVC-backed firms underperform IVC-

backed firms in terms of operating performance for the first five years after the IPO. Even after we


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control for firm industry, size, and year of the issue, CVC backed IPOs underperform IVC backed IPOs

by 23.2% in terms of profit margin and 26.9% in terms of sales margin. Consistent with this, we find that

CVC-backed firms have a greater probability of being delisted (due to liquidation) in the years

immediately after IPO. However, the extent of underperformance of CVC-backed firms declines with the

number of years after IPO: while the average underperformance in the first year post IPO is 23.2 % in

terms of profit margin and 26.9% in terms of sales margin, this underperformance declines to 2.7% and

0.4% respectively in the fifth year post-IPO. Further, the post IPO sales growth of CVC backed firms is

higher than IVC backed firms: this difference in sales growth is highest in the first year post-IPO (35,5%

on average) and becomes smaller with the number of years after IPO (this difference is only 7.7% in the

fifth year post IPO). Finally, we find that CVC backed firms have significantly higher R&D and capital

expenditures than IVC backed firms, consistent with our earlier evidence that CVCs invest in firms in

more R&D and capital intense industries. Overall, our results suggest that CVCs are able to take younger

firms that are further away from profitability public, and that these CVC backed IPO firms have greater

growth options than firms taken public by IVCs.

Fourth, we compare the extent and quality of participation by various market players in the IPO of

CVC and IVC backed firms. In particular, we compare the reputation of the underwriters involved; the

number of institutional investors participating in IPO and institutional investor holding as a fraction of

IPO shares sold; extent of analysts coverage immediately post-IPO; and the reputation of IVCs

participating in CVC and IVC backed IPOs. Contradictory to what one might expect from the fact that

IVCs are more frequent players in the IPO market compared to CVCs, we find that the extent and quality

of participation by various market players is higher for CVC-backed IPOs than for IVC backed IPOs:

thus, underwriter reputation, participation by institutional investors, and analyst coverage are higher for

CVC-backed IPOs compared to IVC-backed IPOs. Even more surprisingly, the reputation of IVCs co-

investing with CVCs in CVC-backed IPO firms is similar (i.e., not lower than) the reputation of IVCs

investing in IPO firms backed by IVCs alone. However, our regression analysis indicates that, even after

controlling for the presence of reputable IVCs co0investing in CVC-backed IPOs, these IPOs are


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characterized by higher reputation underwriters, greater analyst coverage, and large post-IPO institutional

investor holdings. The fact that despite brining younger firms further away from profitability (on average)

to the IPO market, CVCs are able to attract greater participation by more reputable market players

indicates a signaling role for CVC-backing in IPOs: i.e., backing by CVCs with superior industry

knowledge seems to effectively communicate that IPO firm has good future prospects to various market

players.4

Fifth, we compare IPO and secondary market (at first trading day closing price) valuations of CVC

and IVC backed IPOs. We find that various price to value multiples (where value is computed using

comparable firm multiples or using discounted cash flow models using realized earnings) are higher for

CVC backed IPO firms than for IVC backed IPO firms (regardless of whether they are computed using

the IPO price of the secondary market first day closing price). Our multivariate analysis indicates that the

increased presence of various high quality market players such as high reputation underwriters, greater

institutional holdings, and greater analyst coverage results in higher equity market valuations of IPO

firms. However, the higher IPO and secondary market valuation associated with CVC backed firms

persist even after controlling for the presence of various high quality market players, indicating that in

addition to attracting higher quality market players to the IPOs of firms backed by them, CVC-backing

also has a direct role in signaling firm value to the equity market.

Finally, our comparison of the long-term post-IPO stock returns of CVC and IVC backed firms

indicated that CVC-backed firms outperform IVC-backed firms over the five year period after the IPO.

The fact that CVC-backed IPOs do not underperform IVC-backed IPOs in terms of long-run stock return

indicates that the higher valuation we documented earlier for CVC-backed firms is not the result of a

temporary overvaluation of these firms at the time of IPO: one should expect such a temporary

overvaluation to be corrected over a five year period, yielding long run stock return underperformance for

CVC backed firms relative to IVC backed firms.

4See, e.g., Leland and Pyle (1977) for a signaling model where the extent of ownership by firm insiders with private informationconveys the true value of a firm to outside investors in the equity market.


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Overall, our empirical findings indicate that there are two ways in which CVCs uniquely create value

for entrepreneurial firms. First, CVC create product market value by investing significant amounts in

younger and riskier firms involving pioneering technologies: since many such firms would not have

received private equity financing from IVCs, these firms may not have been able to grow and mature

without CVC funding. Second, CVCs seem to play an important role in signaling the true value of firms

backed by them to three different constituencies: first, to IVCs, prompting them to co-invest in these firms

pre-IPO; second, to various financial market players such as underwriters, institutional investors, and

analysts, allowing them to access the equity market at an earlier stage in their life-cycle compared to firms

backed by IVCs alone; and third, directly to IPO market investors, allowing CVC-backed firms to obtain

higher market valuation for these IPOs (in combination with the increased participation by various

reputable market players) compared to the valuation of firms backed by IVCs alone. In summary, we find

that CVCs create significant value for entrepreneurial firms and their shareholders in the above two ways.

The rest of the paper is organized as follows. Section 2 discusses the related literature. Section 3

discusses the data and sample selection. Sections 4 though 8 present our empirical tests and results. We

conclude the paper and discuss the results in Section 9.

2. Related Literature

The empirical literature on corporate venture capital is relatively small.5An important paper in this

literature is Gompers and Lerner (2000), who study how the organizational and compensation structure in

CVC-backed firms affect their performance.6 They find that CVC-backed firms are more likely to go

public compared to IVC backed firms. Further, they find that this result is particularly strong if there is a

strategic fit between a CVC-parent and the entrepreneurial firm backed by it. Coles, Hertzel, and

Santhanakrishnan (2002) also study the impact of complementarities on the likelihood of a successful exit

5See Hellman (2002) for a theoretical model of corporate venture investing. His model predicts that CVCs will invest in andprovide product market support for start-up with greater strategic fit with the CVCs corporate parent.6 See also Gompers (2002), who explores a detailed history of corporate venture investments over the part twenty years. Hedocuments that corporate venture capital investments tend to have higher success rates (in terms going public) than theinvestments on independent venture capital firms.


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for CVC-backed firms. He find that CVC backed firms having a strategic fit with the CVC parent are

more likely to receive product market support from the CVC-parent, which, in turn, increases the

likelihood of a successful exit. While our finding that CVC backed firms have a higher probability of a

successful exit compared to IVC backed firms is consistent with that of the above two papers, this paper

focus on the product market fit as the only reason for this higher success probability. In contrast, our

results suggest that the ability to attract greater participation from reputable players may also contribute to

the higher probability of a successful exit of CVC-backed firms.

There has been no literature so far comparing the participation of various market players in IPOs of

CVC and IVC backed firms. There is also been no literature studying the post-IPO operating performance

of CVC backed firms, nor is there any literature on the post-IPO stock returns of the CVC backed firms.

In other words, ours is the first paper to compare the post-IPO operating performance, extent of

participation by reputable financial market players, and post-IPO stock returns of CVC and IVC backed

firms.7Ours is also the first paper to systematically study the firm, industry, and other characteristics that

prompt CVC to choose a particular firm to invest in.8

3. Data and Sample Selection

3.1 Who Are Corporate Venture Capitalists?

Corporate venture capitalists are stand-along subsidiaries of non-financial corporations who invest in

new ventures on behalf of their corporate parent. To identify these investors we start with the list of

venture capitalists who enjoy investments from corporations provided by SDC Platinum Venture Expert.

Among all venture capital firms, SDC identifies 1846 suspects for being a corporate VC. Using various

sources of information (Factivia, Google, LEXUS/NEXUS, etc.) we then identify (by hand) those with a

unique corporate parent. The original list of 1846 VCs produces: (i) 456 firms that cannot be considered

7Similar to our paper, Maula and Murray (2000) and Ivanov (2003) also compare the IPO market valuations of CVC-backed andIVC-backed firms and find that CVC-backed firms are characterized by higher IPO valuations.8However, Gompers (2002) documents, consistent with our results, that a majority of CVC investments go to firms making useof technologies related to the CVC-parent.


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a CVC since they represent financial companies, partnerships, or funds with multiple corporate parents;

(ii) 466 VC firms have foreign or unknown parent.9This leaves us with 926 distinct corporate venture

capital firms out of which 562 are publicly traded companies. An entrepreneurial firm is considered to be

backed by a CVC if it has at least one CVC investor. Furthermore, to evaluate the degree of participation

in a company by a CVC we compute the share of CVC dollar amount invested in the total amount

obtained by an entrepreneurial firm over all VC investment rounds. Using this measure we separate the

set of CVC backed firms into those with a share of CVC investment above 20% (high-CVC-investment,

HCVC) and those with a share of CVC investment below 15% (low-CVC-investment, LCVC).

Finally, for each corporate venture firm we find the characteristics of the corporate parent such us

industry, size, etc. Specifically we match the sample of CVCs to the Compustat database to identify

publicly traded corporate parents and to the D&B database to identify private corporate parents. This

matching allows us to identify the primary SIC code for the CVC corporate parent. 10We use these SIC

codes to evaluate the industry match between corporate parent and entrepreneurial firms. Specifically, for

each entrepreneurial firm we construct four industry match indices that are equal to the number of CVCs

backing this firm that are in the same industry as measured by 2 digit SIC code, 3 digit SIC code, 4 digit

SIC code, and Fama-French industry classification code, respectively.

3.2

Reputation of Independent Venture Capitalists

In this study we evaluate the value creation of corporate venture capitalists relative to independent

venture capitalists. We obtain the list of IVCs from SDC Platinum VentureExpert database. We obtain

data on 11,556 venture capital firms out of which 10,164 are independent VCs, 926 are CVCs, and 466

are unclassified or foreign investors. For each IVC and a specific date (e.g., financing round date, exit

date, or IPO date) we compute five different reputation measures: (i) the age of the IVC measured as a

number of years since VC firm date of birth; (ii) the amount of funds raised by the VC firm over the 5

9We exclude the CVC funds with foreign corporate backing to eliminate a possible sample selection bias.10In addition we use segment data from Compustat to identify segments SIC codes for public corporations (the data is availablefrom 1992 onwards).


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years prior to the date of interest (similar to Gompers and Lerner (1998)); (iii) total dollar amount raised

by an IVC since 1965; (iv) number of rounds the IVC firm participated in since 1965; (v) total dollar

amount invested since 1965. We use these measures to control for the presence of IVC investment in an

entrepreneurial firm since CVCs tend to co-invest with independent venture capitalists.

3.3

Round Financing Data

To evaluate the investment patterns of venture capitalists we use data on round-by-round investments

by VCs provided by SDC Platinum VentureExpert. Here we can classify the data into two groups. First,

we obtain information about the set of firms that obtained venture capital financing in the period of 1980

to 2004. We exclude financial firms, firms that obtained round financing prior to 1980, firms with

unclassified venture capital investments (e.g., those with foreign VC investors), and those with missing or

inconsistent data. This gives us 24,549 distinct firms. VenureExpert provides us with the following

information: (i) date of first and last round of financing; (ii) number of financing rounds; (iii) firms

development stage at first investment round; (iv) SIC code; (v) date the firm was established; (vi) date

and type of exit (e.g., IPO, acquisition, or write-off). We further update and cross-reference this

information with other databases. Specifically, we update and fill in the missing values for SIC codes

using Compustat data for already public firms and D&B and CorpTech Explore Databases for private

firms. We find that the SIC codes provided by these databases coincide with ones provided by

VentureExpert in 76% of the cases at 3 digit level and in 82% at 2 digit level. We further update and fill

in the missing observations for the date the firm was established. We use Jay Ritters database for the

subset of firms that went public and D&B and CorpTech Explore Databases for firms remaining private.

Second, VentureExpert provides the information about venture round by round disbursements

obtained by entrepreneurial firms. Between 1980 and 2004 there were 140,915 investment rounds by

individual venture capitalists in portfolio firms. Here we can observe numerous characteristics of the

financing round including: (i) identity of the investing VCs; (ii) round number; (iii) amount invested this

round; (iv) total amount invested this round; and (v) post-round valuation.


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Table 1 presents the summary statistics for the round-by-round financing. Panel A and Panel B

present characteristics of round investments by CVCs and IVCs respectively in CVC backed firms.

Panel C on the other hand reports these characteristics for IVC financing rounds in firms that are backed

by IVCs alone. We observe that CVCs tend to invest in younger firms at earlier financing rounds

compared to IVCs both in CVC and IVC backed entrepreneurial firms. Second, they invest significantly

larger dollar amounts reaching on average $3.6 million compared to around $2 million invested per round

by IVCs. Finally, CVC backed firms on average tend to be valued higher than IVC backed firms: $124

million for CVC backed firm versus $55 million for IVC backed firm.

3.4 Sample of IPO firms

Significant section of the paper evaluates how CVCs affect an entrepreneurial firms access to the

secondary market. Specifically, we compare the characteristics of CVC and IVC backed IPO firms. To

accomplish this, we obtain the list of IPOs of equity from 1980 to 2004 from the SDC Platinum New

Issue Database. In common with many other studies of IPOs, we eliminate equity offerings of financial

institutions (SIC codes between 6000 and 6999) and regulated utilities, as well as issues with offer price

below $5. The IPO should issue ordinary common shares and should not be a unit offering, closed-end

fund, real estate investment trust (REIT), or an American Depositary Receipt (ADR).11 Moreover, the

issuing firm must be present on the Compustat annual industrial database for the fiscal year prior to the

offering, as well as on the University of Chicago Center for Research in Security Prices (CRSP) database

within three months of the issue date.

We merge this IPO list with the VentureExpert database to construct consistent venture backing and

corporate venture backing flags. We find that 287 of IPO companies have venture investments as reported

by VentureExpert database but are classified as non-VC backed in SDC Platinum. We consider these

firms to be VC backed. Similarly 365 are classified as VC backed in SDC Platinum but are not recorded

11We do not rely on SDC classifications alone for identifying IPOs of ordinary shares. We independently verify the share typeusing CRSP share codes.


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in the VentureExpert database. We exclude these IPO firms from consideration if the information on the

identity of the investing VCs is unavailable through SDC Platinum. We also exclude IPO firms with

investments from venture capitalists that we were unable to classify in CVC or IVC sub-sets or where the

data on venture investment is inconsistent across two databases. At the end we are left with 5,411 IPO

firms where 2129 are backed by venture capitalists and 462 of latter are backed by corporate venture

capitalists. The characteristics of the IPO firms in our sample are similar to those presented in other IPO

studies (see, e.g., Loughran and Ritter (2003)).12

4. Investment Patterns and Financing Terms of CVCs and IVCs

The first part of our analysis investigates whether the unique institutional features of CVCs prompts

them to invest in different kinds of firms compared to IVCs, and provide funding to firms at different

stages in their life cycle relative to IVCs. Second, we investigate whether the terms of financing offered to

entrepreneurial firms differs across CVCs and IVCs.

4.1

Investment Patterns

There are a number of differences in institutional structure and the objectives of corporate and

independent venture capitalists: while IVCs are primarily concerned with the financial returns from their

portfolio firms, CVCs may also be concerned with other benefits to the corporate parent that may arise

from the investment, such as exposure to a pioneering technology and early establishment of alliances in

the product market. Such non-financial motivations may prompt CVC to invest in younger firms in

familiar industries. Further, the industry and technology expertise of CVCs may allow them to screen

firms better, which may allow them to invest larger amounts in riskier and more R&D intensive firms

(with longer time to achieving profitability) compared to IVC investments. To evaluate these hypotheses

we study the differences in the investment patterns between CVCs and IVCs.

12The characteristics of IPO firms are not reported and are available upon request.


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We start with the probit analysis of round investments. The dependant variable is a dummy equal to

1 for financing rounds backed by a CVC and zero otherwise. The independent variables can be classified

into three groups. First, we analyze individual firm-round characteristics such as age of the

entrepreneurial firm at the round date, round number, total amount required by the firm this round (log of

total amount invested this round), and total amount of prior investment. These variables reflect the

maturity of the portfolio firm as younger firms in the earlier rounds of their development are likely to

have small prior investments and hence require larger investments this round.

Second, we consider the entrepreneurial firm industry characteristics. Since we do not observe

balance-sheet data for the portfolio firms we measure their industry characteristics using aggregate

variables for already public firms. Specifically, based on an entrepreneurial firms SIC code we construct

industry-wide variables by averaging the characteristics of public firms in the same industry in the year

prior to the financing round. First, we consider capital and R&D expenditures that are likely to capture the

growth option features of the industry. Second, sales growth over the three years prior to the financing

round reflects past industry growth. Third, we compute the equal-weighted industry portfolio return over

the six month prior to the financing round date to capture the effect of hot versus cold industries. Forth,

we estimate the beta of the industry portfolio over the 36 months prior to the financing round date to

capture the risk of the portfolio firms. Finally, to evaluate the degree of competition faced by the

entrepreneurial firms we compute industry Herfindahl index and the market share of the largest firm in

the industry based on prior year sales. These variables allow us to compare the industry characteristics of

CVC backed versus IVC backed firms.

Third, we consider the reputation of existing IVCs (discussed earlier). Since the dominant share of

venture investments are follow on investments it is important to understand whether CVC are leaders or

followers in an entrepreneurial firm, whether they invest when there is a high reputation IVC is already in

charge or prefer to make the pioneering investment in a firm.

The results of this probit analysis are reported in Table 2a. Panel A presents the results where the

industry characteristics are constructed based on 2 digit SIC code industry definition. Panel B presents the


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results when industry is defined using the Fama-French industry definition. First, we find that, consistent

with our hypothesis, CVCs tend to invest in younger firms at earlier rounds: the coefficients of firm age

and round number are positive and significant at the 1% level. CVCs also invest in firms that require

significantly larger investments (those with smaller prior investment). Second, CVCs provide funding to

more capital and R&D intensive firms than IVCs. The positive and significant coefficient of industry beta

suggests that CVC-backed firms come from riskier industries. These industries also tend to be more

competitive as the coefficient of the Herfindahl index and market share of the largest firm in the industry

are negative. We dont find robust evidence that prior industry stock return performance or operating

(sales growth) performance significantly affect CVCs choice of portfolio firms. Finally, we find that

CVC tend to invest in firms where the reputation of existing IVCs is relatively low. Since, we control for

the round number of the investment, the positive coefficient of IVC reputation suggests that CVCs are not

followers. Rather, they are more likely to invest in firms that lack high quality independent venture

capitalists: in other words, in firms where their industry expertise will be most appreciated.

In the second part of our analysis of the investment patterns of CVCs and IVCs we evaluate the

match between the CVC and the entrepreneurial firm affects CVCs decision to invest. Specifically, we

attempt to answer two questions. First, are CVCs more likely to invest in firms in an industry related to

that of the CVC parent? Second, does a prior relationship with existing investors in a firm drive CVC

investment in that firm? Again, we evaluate whether CVCs are followers investing in firms with familiar

venture capitalists present or rather invest independent of any prior relationships. To evaluate these

questions we need to observe not only the entrepreneurial firms that obtained CVC investments, but also

those denied such investments. We cannot observe the latter set of firms but we do observe the firms that

obtained IVC (but not CVC) financing. In our analysis we assume that those firms were also potential

recipients of CVC financing. Using these two sub-sets of firms (those receiving CVC investment and

those receiving only IVC investments) we conduct a probit analysis where the dependant variable is

constructed as detailed in Figure 1. We match each CVC round investment with other financing rounds

that occurred within one month of CVC investment date. We assume that this sub-set contains firms that


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could have received CVC financing but did not receive it. Consequently, the dependant variable in our

probit analysis is equal to one for an investment round backed by CVCs, and zero for investment rounds

in firms that could have received CVC funding, but did not.

In addition to firm characteristics and other control variables considered earlier, we construct two

sets of variables of interest. First, to evaluate whether industry match between a CVC parent and an

entrepreneurial firm drives CVC investment, we construct dummy variables that are equal to one if CVC

corporate parent and the portfolio firm are in the same industry as defined by 2 digit SIC code, 3 digit SIC

code, 4 digit SIC code, and Fama-French industry classification respectively. Second, to evaluate whether

prior relationship with IVCs affect the investment pattern of CVCs, we construct three measures of the

relationship between the investing CVC and an IVC who have already invested in the portfolio company

under consideration: (i) the number of entrepreneurial firms CVC and IVC co-invested in before the

round date under consideration; (ii) the number of financing rounds CVC and IVC co-invested in before

the round date; and (iii) the number of years since first joint investment by the CVC and the IVC. We

then aggregate these variables across all IVCs who have already invested in the portfolio firm.

Table 2b reports the results of our probit analysis. We find that industry match is very important in

CVCs choice of portfolio firms. The coefficients of industry match dummies are positive and significant

independent of industry classification (SIC code or Fama-French industry). Further, the coefficient of

proxies of the prior relationship between CVCs and IVCs are negative, this is also the case for

coefficients of the reputation of existing IVCs. This is consistent with the idea that corporate venture

capitalists tend to step in when the existing IVCs lack reputation (and expertise) to evaluate the

entrepreneurial firms product and/or technology.

Overall, our results in this section suggest that the investment patterns of CVC are significantly

different from that of IVCs. CVCs tend to invest in younger and riskier firms and in earlier rounds

compared to IVCs. These firms tend to be in less mature industries which require significantly larger

R&D and capital expenditures, and which are more competitive (have no dominant firm in the product

market). CVCs are more likely to select portfolio companies in industries closely related to that of their


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corporate parent. Finally, CVCs do not seem to be mere followers of independent venture capitalists. In

fact they are more likely to invest when the existing IVCs lack knowledge, so that CVCs expertise is

most valuable.

4.2 Terms of Financing of CVC Backed and IVC Backed Firms

The unique features of corporate venture capitalists as compared to independent venture capitalists

might not only generate the investment patterns differences but also lead to different terms of financial

contracting. In this sub-section we compare two characteristics of the CVC and IVC financing rounds:

First, we compare the amount invested by two kinds of venture capitalists in portfolio firms. Since

managers of CVC funds do not enjoy the performance based compensation to the same degree as those of

IVC funds, one might argue that CVCs are likely to exhibit less caution in selecting portfolio companies

and hence invest significantly large amounts of money. Second, we directly evaluate contracting terms by

comparing the valuation across financing rounds with CVC backing with those backed by IVCs alone.

Specifically, we study the difference in the company post-round valuation relative to the amount invested.

This ratio is equivalent to the entrepreneurial firms equity share transferred to VCs for $1million

invested in each round.

Panel A of Table 3 reports the results of the regression analysis of the round amount invested by

various venture capitalists. The dependant variable is the log of the total dollar amount invested in an

entrepreneurial firm by an individual venture capitalist each round. Thus, the unit of observation is firm-

round-VC. Our main variables of interest are the characteristics of CVC backing: (i) CVC backing

dummy and (ii) CVC-portfolio firm industry match dummy. The latter is equal to one if the corporate

parent for the CVC investor and the portfolio firm are in the same industry as defined by the Fama-French

industry classification. We use a number of control variables in our analysis. First, we control for

entrepreneurial firm-round characteristics: age at the round date, relationship to the internet technology,

round number, and presence of prior CVC investments. Second, we control for the quality of the IVCs

that have already invested in the firms before the round date. Finally, we include year and entrepreneurial


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firms industry dummies to account for trends in the venture capital industry (e.g., aggregate funding

availability and hot or cold industry preferences).

Consistent with our univariate analysis results, we find that corporate venture capitalists tend to

invest significantly more money than IVCs in a given financing round. This effect is most pronounced for

the sub-set of entrepreneurial firms that are in the same industry as the CVCs corporate parent. This

evidence suggest that CVCs create value for the entrepreneurial firm by providing them with large capital

inflows and showing a significant bias toward financing companies that they can potentially screen and

monitor better (those in an industry related to their corporate parent). In addition, we observe that venture

capitalists, both CVCs and IVCs, tend to invest more in younger, less developed firms, in the later rounds

of their financing. The positive coefficients of the various IVCs reputation proxies is likely to reflect the

fact that more reputable IVCs tend to have larger portfolios (in terms of dollar amount) and hence are

better positioned to invest in firms that require larger capital injections.

Panel B of Table 3 presents the results of our regression analysis of the firm equity share transferred

to the venture capitalists in return for each $1 million investment. The dependant variable is the post-

round firm value divided by the dollar amount invested by all venture capitalists this round. Thus the unit

of observation is firm-round. The set of the independent variables is similar to that of Panel A. The main

variable of interest is the CVC backing dummy that is equal to one if at least one CVC participated in this

financing round. Since the post-round firm valuation is only available at the firm-round level and there

are a number of rounds with multiple CVCs investing in a firm we cannot disentangle how corporate

venture capitalists value firm in a related industry.

We find that corporate venture capitalists value entrepreneurial firms backed by them significantly

higher than IVCs. Per million dollar invested they receive on average 4.1% less of the entrepreneurial

firms equity than IVCs. Thus, the effect is not only statistically but also economically significant. These

result might reflect the lower bargaining power that CVCs may have with respect to portfolio firms

compared to that of VCs. It is also consistent with CVCs having non-financial motivations as well as

direct financial motivations in investing in portfolio firms.


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5. Exit Strategies of CVC and IVC Backed Entrepreneurial Firms

This section presents the first set of results pertaining ability of corporate venture capitalists to aid

the entrepreneurial firms in efficiently accessing the equity market. Here we compare the abilities of

CVCs and IVCs in bringing firms backed by them public or in helping them in being acquired.

Specifically we compare CVC and IVC backed firms in terms of going public (IPO firms), being

acquired, being written off (writeoffs), and active investments.13

5.1

Univariate Analysis

Table 4a presents the average characteristics of the CVC backed and IVC backed entrepreneurial

firms by the type of exit. All characteristics are recorded at the date of the exit for IPO firms, acquired

firms, and writeoffs or at the last investment date for the active investments. The table documents a

number of interesting results.

First, we find that CVC backed entrepreneurial firms enjoy higher rates of successful exit (IPO or

acquisition) when compared to IVC backed firms. Over the period from 1980 to 2004, 18.3% of CVC

backed firms went public and 10.2% were acquired while the number for IVC backed firms were 13.3%

and 8.3%, respectively. At the same time, CVCs are associated with a larger share of companies written

off: 22.3% versus 17.9% for IVC backed firms.

Second, consistent with the results documented earlier, we find CVC backed entrepreneurial firms to

be 2.5 to 4 years younger at the exit date (both IPO and acquired firms) than IVC backed firms. The CVC

backed firms also enjoy significantly higher venture capital inflows compared to IVC backed firms:

$56 mil versus $31 mil for IPO firms, $45 mil versus $19 mil for acquired firms, and $38 mil versus

$18 mil for write-offs. Not surprisingly, this higher investment amounts are associated with the larger

number of rounds and the larger number of distinct venture capitalists involved with CVC backed

entrepreneurial firms compared to IVC backed firms. Nevertheless, both CVC and IVC backed firms

13We consider a firm to be written off if it hasnt received any venture round financing for five years in a row.


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experience similar time from first venture investment till exit 2.7-2.9 years for acquired firms and 4.2

years for IPO firms.

Third, the reputation of existing IVCs is similar across CVC and IVC backed entrepreneurial firms

that went public; it is also higher for CVC backed firms that were acquired or written off compared to

IVC backed firms. This suggests that CVCs prompt high reputation IVC to co-invest with them.

Finally, Table 4a allows us to compare the characteristics of CVC backing for various sub-samples

of entrepreneurial firms. We find that CVCs on average enter later both in terms of entrepreneurial firms

age and entrance round number into IPO firms compared to entrance into firms that were later acquired or

written off. Further, CVCs invest more in companies that later go public than in those that were later

acquired or written off. In addition, we observe that IPO companies backed by CVCs enjoy a higher

number of VC corporate parents in a related industry compared to IVC backed acquired firms. The latter

suggests that industry match with the corporate parent aids the entrepreneurial firm in going public and

accessing the secondary market.

5.2 Multivariate Analysis of Exit Strategies

The univariate analysis suggests that CVC backed entrepreneurial firms have a higher probability of

successful exit as measured by IPO or acquisition. In this section we present a more rigorous analysis of

the exit strategies where along with CVC backing we control for a number of other firm characteristics

that can potentially affect the likelihood of a firm to have having a successful exit.

Panel A of Table 4b presents a probit analysis of the propensity for a successful exit. The dependant

variable is a dummy equal to 1 if the entrepreneurial firm has an IPO or acquisition and 0 if it is written

off by the venture capitalist. To evaluate the effect of CVC backing, we consider various measures of the

degree of firm backing by corporate venture capitalists (e.g., we want to discriminate between

entrepreneurial firms entirely financed by CVCs versus those that only obtained 5% from CVCs and the

remaining investment was provided by IVCs). Here we control for the reputation of existing independent

venture capitalists, log of total dollar amount invested by all VCs, and the age of the entrepreneurial firm.


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Further we include a dummy indicating whether the firms product is related to an internet technology and

also include the 6 month equal-weighted return on a portfolio of already public firms in the same Fama-

French industry as the entrepreneurial firm. The latter variable captures the hot market effect (i.e. internet-

bubble period or hot or cold IPO market year).

While CVC backing does not directly affect an entrepreneurial firms propensity to have a successful

exit, the CVCs presence improves the entrepreneurial firms chances for successful exit indirectly. We

find that the higher the total amount invested by all venture capitalists and the higher the reputation of

existing IVCs, the higher is a firms likelihood of having an IPO or an acquisition. Earlier, we showed

that CVCs tend to invest significantly larger amounts than IVCs. In addition, we can see that CVCs attract

high reputation IVCs to co-invest with them.

In Panel B of Table 4b we conduct a similar probit analysis where we evaluate the propensity of a

firm to have an IPO versus acquisition. We find that CVC backing positively affects the likelihood of a

firm going public both directly (through a number of CVCs) and indirectly (through investing larger

amounts). In Panel C we evaluate the time from first VC investment to exit (IPO or acquisition) for CVC-

backed and IVC backed firms. The results show that it takes longer for a CVC backed entrepreneurial

firm to go from the first venture investment to a successful exit.

Overall, our evidence suggests that CVC backed companies are more likely to go have successful

exit than IVC backed firms. Further, the probability of having an IPO rather than an acquisition is greater

for a CVC backed firm. The longer time from first venture capital investment to exit attributed to CVC

backed firms is consistent with our earlier findings that CVCs invest in younger firms, in less mature

industries, and in earlier rounds (which may take longer time to reach profitability).

6. Post-IPO Performance of CVC and IVC Backed Firms

In this section we investigate whether corporate venture capital backing generates higher product

market value for entrepreneurial firms by comparing the post-IPO operating performance of CVC and

IVC backed firms. Our objective here is to determine whether the pool of firms going public with CVC


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backing is of higher quality (in other words, having the ability to generate superior operating

performance) compared to the pool of firms going public with IVC backing. We also want to conduct a

similar comparison between IPOs with high and low amounts invested by CVCs. In order to study

whether the pool of firms backed by CVCs is different from that of firms backed by IVCs, we use two

measures: post-IPO operating performance and post-IPO delisting probabilities.

6.1 Post-IPO Operating Performance

We compare the operating performance of various IPO sub-samples using two approaches. First, we

compare unadjusted operating performance measures for the full samples of CVC backed versus IVC

backed firms, and high-CVC-investment versus low-CVC-investment firms. Second, we use a matching

approach where each CVC backed (high-CVC-investment) company is matched to an IVC backed (low-

CVC-investment) firm based on year, Fama and French (1997) industry, and size measured by total

assets. In doing so, we ensure that each CVC backed (high-CVC-investment) company receives a unique

match. We then compare the operating performance of the two samples of matched firms.14

To measure operating performance, we use the following characteristics: (1) profit margin (net

income including extraordinary items (Compustat item 172) divided by sales); (2) EBITDA as a

percentage of assets (Compustat item 6); (3) EBITDA sales margin; (4) return on assets (net income

including extraordinary items over book value of assets); (5) share of capital expenditures (Compustat

item 128) in assets; (6) share of R&D (Compustat item 46) in assets; and (7) growth in sales.

Tables 5a presents our analysis of the operating performance of various IPO sub-samples. We report

the operating performance characteristics for the pre-IPO year (year 0) and five years post-IPO (1 through

5). Panel A provides median non-adjusted operating performance characteristics calculated using full IPO

sub-samples. Panel B on the other hand gives statistics for the pair-matched sub-samples.

14 It is important to note that, in our setting, it is inappropriate to use the matching firm approach suggested by Barber andLyon (1996), which advocates choosing a matching (benchmark) firm based on prior profitability and size. Matching on prior

profitability would be appropriate only if we wished to determine whether there is a change in operating performance of firmssubsequent to the IPO. Since our objective here is to detect differences in the quality (performance) of the pool of firms going

public with CVC backing and those going public with IVC backing, matching on pre-IPO operating performance would beinappropriate, since this is equivalent to minimizing the quality difference we are attempting to detect.


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Surprisingly, we find that CVC backed IPOs exhibit significantly lower profitability margins pre-

and post-IPO (years 0 to 4) than do IVC backed companies. However, even though the CVC backed IPOs

are losing money dramatically in the year prior to IPO and in the post IPO years their profitability

improves significantly over four years post-IPO and is statistically insignificant from that of IVC backed

firms five years post-IPO. In addition, CVC backed firms have consistently higher R&D and capital

expenditures as well as sales growth in post-IPO years when compared to IVC backed firms. However,

we find no significant differences in the operating performance characteristics of high-CVC-investment

and low-CVC-investment IPO firms.

Our evidence is inconsistent with the premise that corporate venture capitalists help the

entrepreneurial company to develop product market alliances and reach profitability at an earlier stage in

their life (possibly before the IPO date). It is, however, consistent with CVC backed entrepreneurial firms

being able to go public at a younger stage in their life, and having longer gestation periods prior to

profitability. Further, the higher capital and R&D expenditures as well as higher sales growth that we

document indicate that CVC backed IPO firms have greater growth options compared to IVC backed IPO

firms.

6.2 Post-IPO Delisting Probabilities of CVC Backed and IVC Backed Firms

In addition to the operating performance characteristics of IPO companies, we analyze the

probabilities of delisting of CVC backed and IVC backed firms within 5 years post IPO. Panel A of

Table 5b reports the percentage of IPO companies de-listed due to liquidation (delisting code DLSTCD

between 400 and 499 or between 520 and 600). Panel B reports the share of IPO companies de-listed due

to merger or acquisition (delisting code DLSTCD between 200 and 299). The delisting data comes from

the CRSP Daily Events file. The probability of delisting should be negatively correlated with IPO firms

quality, while the probability of being acquired should be positively correlated with IPO firms quality.

Consistent with our operating performance results, we find that CVC backed IPO firms are more

likely to be delisted within three years post-IPO compared to IVC backed firms. In addition, high-CVC-


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investment IPO firms are more likely to be delisted than low-CVC-investment IPO firms within five years

post-IPO. The likelihood of being acquired is similar across CVC and IVC backed firms as well as across

high-CVC-investment and low-CVC-investment IPO firms. Similar to our operating performance results,

this evidence does not directly support the notion that CVCs add greater product market value to the firms

backed by them compared to IVCs. These results, however, are consistent with CVC backed firms going

public at an earlier stage of their development compared to IVC backed IPO firms.

7. Participation of Reputable Underwriters, Institutional Investors, and Analysts in CVC Backed

and IVC Backed IPOs

In this sub-section we analyze CVCs ability to ease entrepreneurial firms access to the secondary

market. Specifically we analyze whether the presence of corporate venture backing in an IPO company

attracts participation by better quality and larger number of various market players in the IPO of CVC

backed firms compared to their participation in IPOs backed by IVCs alone. On the one hand, we

anticipate that IVCs, being more frequent players in the IPO market, will be able to attract better quality

and higher extent of participation by underwriters, institutional investors, and analysts. On the other hand,

CVC backing may signal higher firm quality to these market players, prompting them to participate in the

firms IPO in larger numbers. To evaluate these hypotheses, we compare CVC and IVC backed IPOs in

terms of the reputation of the underwriters involved; the number of institutional investors participating in

IPO; and institutional investor holding as a fraction of IPO shares sold; the extent of analyst coverage

immediately post-IPO; and the reputation of IVCs investing in the firm (recall that many CVC backed

firms also have IVCs coinvesting with them)..

7.1

Participation by Reputable Underwriters

In this sub-section we study the reputation of underwriters associated with CVC and IVC backed

IPOs. Panel A of Table 6a reports the summary statistics of average underwriter reputation associated

with different IPO sub-samples. We use two measures of underwriter reputation. First, we analyze the


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measure of underwriter reputation used by Loughran and Ritter (2003). Second, similar to Loughran and

Ritter (2003), we use a dummy for the underwriter reputation that takes a value of 1 if the reputation

measure is 8 or higher.

Our results show that the average underwriter reputation for CVC backed firms is higher than that

for IVC backed firms (8.02 versus 7.45). The percentages of the companies with a high-reputation

underwriter are 82% for CVC backed issuers versus 67.9% for IVC backed issuers. The evidence clearly

suggests that CVC backed IPOs are associated with higher quality underwriters compared to IVC backed

IPOs. The differences are statistically significant at the 1% level.

In addition to the univariate analysis we conduct a regression analysis that allows us to control for

various other factors affecting quality of underwriters. Along the traditional control variables such as size

(log of total assets) and share of the firm equity sold in IPO we include: (i) reputation of existing IVCs;

(ii) operating performance characteristics. We argue that presence of IVCs co-investing with CVCs might

affect quality of underwriters (as well as other reputable market players). In addition, higher quality

underwriters might be more selective in choosing IPO companies to run books for and are likely to back

higher quality (as measured by profitability and/or growth) firms. Panel A of Table 6b presents the results

of the regression analysis. Consistent with the univariate analysis results we find that CVC backing

improves quality of underwriters for IPO firms. Furthermore, the higher the CVC share of total venture

investment in an IPO firm, the better the underwriters quality.

7.2 Participation by Institutional Investors

In this sub-section we analyze the influence of corporate venture capitalists on institutional investors

participation in IPOs backed by them. We study two measures of institutional investors involvement in

IPOs. First, we evaluate the number of institutional investors investing in an IPO firm. Second, we look at

first quarter post-IPO institutional investor holdings as a percentage of the number of shares sold in the

IPO. We obtain institutional investors holdings data for IPOs in years 1980 to 2004 from the Spectrum

Institutional (13f) Holdings Database of Thomson Financial.


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Panel B of Table 6a reports the results of our analysis of institutional investors participation

measures. The measures are unanimous. Relative to IVC backed IPOs, CVC backed IPOs have around

19% higher percentage of shares sold in the IPO held by institutional investors, and 7.6 more institutional

investors involved. These differences are not only statistically but also economically significant.

Since the degree of institutional investors participation may also be affected by better quality

underwriters (in addition to venture capital backing), IVC backing, and quality of an IPO firm going

public, we control for these effects through a regression analysis of institutional investor participation

reported in Panel B of Table 6b. In this analysis we find that the presence of corporate venture backing

adds 3.37 additional institutional investors to the IPO firm; each additional CVC investor brings on

average of 2 more institutional investors. Furthermore, the degree of participation by institutional

investors is positively related to the CVC amount invested in a company normalized by total venture

investment, and the presence of a CVC parent(s) in an industry related to the IPO firm. The positive sign

of the size coefficient suggests that institutional investors are indeed more likely to invest in bigger IPOs.

7.3 Analyst Coverage of IPO Firms

In Panel C of Table 6a we present a univariate analysis of analyst coverage of IPO firms. The data is

taken from the I/B/E/S database. We evaluate a percentage of IPOs with analysts coverage as well as the

number of distinctanalysts issuing annual forecasts within a year after a firms IPO date.15The number of

analysts is assigned to be zero if there is no information about the company in I/B/E/S.

We find that a significantly larger percentage of CVC backed firms receive analyst coverage and that

these firms are followed by a larger number of analysts compared to IVC backed IPO firms. We find that

analysts follow 93% of CVC backed IPOs versus 86% of IVC backed IPOs. CVC backed firms also enjoy

roughly 1.7 more analyst following than IVC backed firms.

15We also conduct the analyst coverage analysis based on quarterly earning forecasts in I/B/E/S and obtain qualitatively similarresults.


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In the regression analysis presented in Panel C of Table 6b, we control for numerous factors that are

likely to affect analyst coverage along with CVC backing. Here the dependent variable is the number of

analysts following the firm within a year after its IPO date. We find that the presence of corporate venture

capitalists, number of CVCs, share invested by CVC relative to total venture investment, and the presence

of a corporate parent in an industry similar to that of the IPO firm positively affect analysts following.

The effects are both economically and statistically significant.

7.4 Participation of IVCs in CVC Backed IPO Firms

Finally, we analyze the quality (reputation) of independent venture capitalists co-investing with the

CVC in IPO firms. We compare four distinct measures of the independent venture capitalist reputation

across CVC and IVC backed IPOs: (i) average age of IVCs backing an IPO firm; (ii) dollar amount

invested by these IVCs since 1965; (iii) average number of rounds the IVCs participated in since 1965;

and (iv) dollar amount of funds raised over 5 years prior to IPO. To construct these IVC reputation

proxies we use data reported in the VentureExpert database of SDC Platinum. We find that the average

reputation of IVCs co-investing with corporate venture capitalists is no different from that investing in

firms backed by IVCs alone.

7.5 Summary and Interpretation of Results

Contradictory to what one might expect from the fact that IVCs are more frequent players in the IPO

market compared to CVCs, we find that the extent and quality of participation by various market players

are higher for CVC backed IPOs than for IVC backed IPOs. The underwriter reputation, participation by

institutional investors, and analyst coverage are higher for CVC backed IPOs compared to IVC backed

IPOs even after we control for various other factors that can potentially affect the participation of

reputable market players. Furthermore, the reputation of IVCs co-investing with CVCs in CVC backed

IPO firms is similar (i.e., not lower than) the reputation of IVCs investing in IPO firms backed by IVCs

alone. The fact that despite bringing younger firms, further away from profitability (on average) to the


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IPO market, CVCs are able to attract greater participation by more reputable market players indicates a

signaling role of CVC backing in IPOs: i.e., backing by CVCs with superior industry knowledge seems to

effectively communicate to various other market players that the IPO firms backed by them are high

quality firms with good future prospects.

8. Valuation of CVC Backed and IVC Backed Firms at IPO

In this section we study stock valuation of CVC backed and IVC backed IPOs. In an IPO market

characterized by significant asymmetric information between firms issuing equity and outside investors,

the ability of financial intermediaries such as venture capitalists to credibly communicate information

about the true values of firms backed by them becomes very important. The analysis of the valuations of

CVC and IVC backed IPO firms allows us to compare the ability of these two kinds of venture capitalists

to reduce the degree of asymmetric information in the IPO market. One would expect firms backed by the

intermediary with a greater ability to communicate their private information about the future prospects of

the firm going public to equity market investors to be awarded higher valuations.

8.1 Methodologies Used to Compute Intrinsic Firm Value

The first approach we use to estimate the intrinsic value of IPO companies is a matching technique

based on an industry peer with comparable Sales and EBITDA profit margin (EBITDA/Sales) similar to

that used by Purnanandam and Swaminathan (2005). Here we limit our consideration to the subset of IPO

(and matching public firms) that have positive EBITDA and Sales. We first consider all firms in

Compustat that were active and present on CRSP for at least three years at the end of the fiscal year

preceding the IPO. We then eliminate firms that are REITs, closed-end funds, ADRs, not ordinary

common shares, and firms with stock prices less than $5 at the report date. We separate the remaining

population of Compustat firms into 48 industry groups based on the industry classification introduced by


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Fama and French (1997).16For each year, we divide each industry portfolio into three portfolios based on

sales, and then separate each sales portfolio into three portfolios based on EBITDA profit margin

(EBITDA/Sales). This procedure gives us nine portfolios for each industry-year.17Each IPO firm is then

placed into an appropriate year-industry-Sales-EBITDA margin portfolio based on an IPO firms sales

and EBITDA in year prior to IPO. Within the portfolio, we find a matching company that is closest in

sales to the IPO firm being valued. We then estimate the intrinsic value of the IPO firms based on the

price multiples of their matching firms.

The offer price to the intrinsic value ratio for each IPO firm (OP/IV) is calculated by dividing the

offer price multiple by the comparable firm multiple. The offer price multiples are computed as follows:

SalesYearalPrior FiscgOutstandinSharesCRSPeOffer Pric =

IPOSalesOP (1.1)

DAYear EBITalPrior Fisc

gOutstandinSharesCRSPeOffer Pric =

IPOEBITDA

OP (1.2)

ingsYear EarnalPrior Fisc

gOutstandinSharesCRSPeOffer Pric =

IPOE

OP (1.3)

In the above, CRSP shares outstandingrefers to the shares outstanding of the IPO firm at the first

secondary market trading day as recorded in CRSP. The price multiples for a matching firm are computed

as follows:

SalesYearalPrior Fisc

gOutstandinSharesCRSPceMarket Pri =

MatchSales

P (2.1)

DAYear EBITalPrior Fisc


MatchEBITDA

P (2.2)

ingsYear EarnalPrior Fisc


MatchE

P (2.3)

16 The industry portfolios are constructed using 4 digits SIC codes from Compustat. For robustness, we also implement thismethodology using 2-digit SIC codes as industry classification criteria.17We insist, however, that at least three firms should be in each portfolio. If the number of firms in the industry does not allow usto form 9 portfolios, we limit the separation to two portfolios based on Sales with further separation into two portfolios based onEBITDA profit margin, sometimes we consider only one portfolio.


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Market priceis CRSP stock price and CRSP shares outstandingis the number of shares outstanding

of the matching firm at the close of the day closest to the IPO offer date. OP/IV ratios for each IPO firm

based on various multiples are then computed as follows:18

Match

IPO

(P/Sales)

(OP/Sales)=

SalesIV

OP (3.1)

Match

IPO

(P/EBITDA)

)(OP/EBITDA=

EBITDAIV

OP (3.2)

Match

IPO

(P/E)

(OP/E)=

EarningsIV

OP (3.3)

In addition to the comparable firm approach discussed above, we compute the intrinsic value of IPO

firms using the discounted cash flow method introduced by Ohlson (1990). Here we do notrequire IPO

firms to have positive sales and EBITDA in the year preceding the IPO. Thus, the discounted cash flow

approach we implement only requires the book value of equity and earnings (whether positive or

negative) to be available for three years post IPO. It also requires the calculated intrinsic value to be

positive. Following Ohlson (1990), the fair value of a firms shares is calculated as follows:

TVr

BrEPS

r

BrEPSBIV +

+

+

+

+=

2

1201

0)1(

*

1

*. (4)

Here0

B is the book value of issuer at the end of IPO year (annual Compustat item 60) divided by

CRSP end of year number of shares outstanding; EPS is income before extraordinary items available to

common shareholders (annual Compustat item 237) divided by CRSP number of shares outstanding; ris

the required rate of return on firms equity. We assume a constant required rate of return rof 13%. TV,

the terminal value is calculated as follows:

)(*)1(

1*

2

)*()*(

2

2312

grr

BrEPSBrEPSTV

+

+= (5)

The terminal value is calculated as an average to avoid the effect of unusual performance in year 3.

Constant earnings growth g (5% and 0% are considered) is assumed after year 3 and the terminal value of

18If earnings are missing or negative for the matching firm (in the case of earnings based valuation), the closest Compustat firmwith no missing data is used as the matching firm.


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the stock is calculated as a perpetuity. If the terminal value is negative, we set it equal to zero, since

managers are unlikely to continue negative NPV projects forever.

8.2

Univariate Analysis

Table 7a reports the relationships between the IPO firms valuation at the offer price (OP), the first

trading day secondary market price (SMP), and the estimated intrinsic value ratio (IV) across various sub-

samples of IPOs. Panel A presents median underpricing (SMP/OP), Panel B median offer price to

intrinsic value ratio (O/IV), and Panel C median secondary market price to intrinsic value ratio

(SMP/IV). The size of the sample changes for the valuations using different price multiples due to

unavailability of data on the balance-sheet variables for the IPO companies.

Our results show that regardless of the methodology used to compute the intrinsic value for IPO

firms, both OP/IV and SMP/IV ratios are significantly higher for CVC backed firms than for IVC backed

firms. Median CVC backed IPO is valued higher than median IVC backed IPO by 40 to 216 percentage

points at the offer price and by 50 to 300 percentage points at the first day secondary market price. These

differences are statistically significant at the 1% level.

8.3

Multivariate Analysis

In addition to the above univariate analysis, we also implement a multivariate regression analysis of

IPO valuation both at the offer price and at the first trading day secondary market price to investigate the

combined influence of corporate venture capitalists, independent venture capitalists, and various other

market participants on the valuation of IPOs. Table 7b reports the results of this analysis. The dependent

variable is the log of the OP/IV ratio. To analyze the influence of CVC backing on the valuation of IPO

companies, we consider four independent variables reflecting the degree of CVC participation in the

entrepreneurial firm: CVC backing dummy, number of CVCs, CVC share of total VC investment, and the

number of CVCs corporate parents in the same 2 digit SIC code with that of an IPO firm. These variables

are set to zero for IPO firms backed by IVCs alone. The set of independent variables also includes the


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IVC backing dummy, and the reputation of existing IVCs, and measures of participation by various other

market players.. As control variables we employ size (log of total assets), share of firm equity sold in the

IPO, various operating performance characteristics of IPO firms, industry dummies, and year dummies.

We find that the presence of CVC backing an IPO firm increases the valuation of this firm at the

offer price (relative to an industry peer) by 35% on average. Similarly, each additional CVC backing the

entrepreneurial firm going public causes on average 13% increase in valuation. Finally, the backing by an

additional CVC with its corporate parent in the same Fama-French industry as the IPO firm increases this

firms valuation by roughly 11%.

Our univariate and multivariate analysis of IPO firms valuation at both offer price and the secondary

market price suggest that corporate venture capitalists are able to credibly convey the information about

future prospect of the IPO firms backed by them to both IPO and secondary market participants. Further,

the higher valuation assigned by the IPO market to CVC backed firms may reflects the higher value of

their growth options relative to that of IVCs backed IPO firms.

8.4 Long-Run Post-IPO Stock Returns of CVC Backed and IVC Backed Firms

The higher valuation awarded to CVC backed firms relative to IVC backed firms at the IPO and

secondary market may arise from temporary misvaluation in the equity market rather than from the

superior ability of CVCs to communicate the true value of firms backed by them to various equity market

participants. In the former scenario, however, one would expect CVC backed firms to underperform IVC

backed firms in terms of long-run stock returns, as the temporary misevaluations are corrected over time.

We therefore compare the five year stock return performance of CVC backed and IVC backed firms to

rule out the misvaluation scenario.

We compare the intercepts of the Fama and French (1993) three-factor model based on the calendar-

time monthly portfolio returns of CVC backed and IVC backed IPO firms. We construct the calendar-

time portfolio returns by averaging monthly returns of firms that went public within 60 month of the

return date. Table 8 present the results of our analysis. Following earlier stock return studies, along with


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the portfolios of CVC backed firms and IVC backed firms we consider a hedge portfolio consisting of a

long position in CVC backed IPOs and a short position in IVC backed IPOs (CVC-IVC portfolio).

Similarly we construct LCVC-HCVC portfolio that corresponds to a long position in low-CVC-

investment firms and a short position in high-CVC-investment firms. Panel A presents the OLS

coefficient estimates for equal-weighted portfolios of IPO firms. Panel B presents the coefficient

estimates from the WLS regression for the value-weighted portfolios of IPO firms.

The results are qualitatively and quantitatively similar across panels. We find that over the five-year

horizon post IPO CVC backed firms outperform IVC backed firms by 1.1 percentage point on a monthly

basis. This translates into 13.2% better stock performance annually. We find no evidence that the sub-set

of IPOs with larger investment by corporate venture capitalists experience significantly higher/lower

stock return performance within six years post-IPO.

Overall, our evidence supports the idea that the higher valuation we documented earlier for CVC-

backed firms is not the result of a temporary overvaluation of these firms at the time of IPO. Rather, our

evidence indicates that CVCs are able to better convey the true value of firms backed by them to various

participants in the equity market.

9. Conclusion

In this paper we have analyzed how corporate venture capitalists (CVCs) create value for

entrepreneurial firms backed by them and how value creation by CVCs differs from that of independent

venture capitalists (IVCs). Making use of a large data set consisting of a sample of CVC-backed and IVC-

backed firms (starting from their first round of investment in an entrepreneurial firm and going well into

the post-IPO market), we explored three related research questions: First, do CVCs exploit their

knowledge and industry expertise when choosing portfolio firms, and invest in significantly different

kinds of firms compared to independent venture capitalists (IVCs)? Second, do they succeed in creating

greater product market value subsequent to investment compared to IVCs? Finally, do they allow

portfolio firms to access the equity market more efficiently?


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Our findings can be summarized as follows. First, compared to IVCs, CVCs invest in smaller,

younger, more R&D intensive firms, and in earlier rounds; CVC portfolio firms are typically in industries

related to their corporate parents. Second, CVCs invest significantly larger amounts while getting smaller

equity fractions in return compared to IVCs. Third, even though CVC backed firms have a higher

probability of a successful exit (IPO or acquisition), they exhibit significantly lower post-IPO operating

performance compared to IVC backed firms, and are more likely to be de-listed in the years immediately

after IPO. However, CVC backed firms are characterized by greater growth rates in the post-IPO period

than IVC-backed firms. Fourth, CVC-backed firms enjoy greater analyst coverage, higher reputation IPO

underwriters, and larger post-IPO institutional investor holdings: even the reputation of the IVCs co-

investing in CVC backed firms is no less than that of IVCs investing in firms backed by IVCs alone.

Finally, CVC-backed firms have higher IPO market valuations and long-term post-IPO stock returns

compared to IVC backed firms.

Overall, our results indicate that CVCs uniquely create value in two different ways: First, by

investing in earlier stage firms involving pioneering technologies which may not otherwise be able to

obtain private equity funding. Second, by giving CVC backed firms more efficient access to the equity

market by credibly communicating the true value of firms backed by them to three different

constituencies: first, to IVCs, prompting them to co-invest in these firms pre-IPO; second, to various

financial market players such as underwriters, institutional investors, and analysts, allowing them to

access the equity market at an earlier stage in their life-cycle compared to firms backed by IVCs alone;

and third, directly to IPO market investors, allowing CVC-backed firms

how do corporate venture capitalists create value for entrepreneurial firms

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