DOES SECURITY CHOICE MATTER IN VENTURE CAPITAL? THE CASE OF VENTURE DEBT (SUMMARY)

The switch from equity to debt in venture capital-backed entrepreneurial firms is rare, but uniquely informative. Using a novel dataset of financing decisions, we find that entrepreneurial firms that raise debt financing suffer from an average 40% post-debt valuation drop and a 26% lower probability of successful exit (IPO/acquisition). Venture capitalists with equity stakes lend to lower quality entrepreneurial firms compared to outside lenders, and debt from both precedes deterioration in firm quality. Our results do not imply that debt causes negative outcomes. Rather, we argue that debt helps maintain incentive alignment after adverse shocks to firm quality. ∗Cox School of Business, Southern Methodist University and Tepper School of Business, Carnegie Mellon University. Corresponding author contact information: Michael Ewens (mewens@cmu.edu), Tepper School of Business, 5000 Forbes Ave. Pittsburgh, PA 15221, 412-423-8203. We thank Richard Green, Thomas Hellmann, Doron Levit, Nadya Malenko, Matthew Rhodes-Kropf, David Robinson, Luke Taylor, Rex Thompson, Michael Vetsuypens, Rebecca Zarutskie, and seminar participants at the 3rd Entrepreneurial Finance and Innovation Conference, Arizona State University, Darden Entrepreneurship Conference, Financial Intermediation Research Society Conference, MidAtlantic Research Conference, Harvard Business School, Southern Methodist University, and Tepper School of Business for their helpful comments. Chris E. Fishel and Paul Jaewoo Jung provided excellent research assistance. We are grateful to VentureSource and Correlation Ventures for access to the data. Empirical studies on the relationship between a firm’s prospects and its financing policy traditionally focus on publicly-traded firms. Due to data availability, the determinants of the security choices of young, private entrepreneurial firms are relatively unexplored. The financing environment of such firms is unique. Venture capital (VC)-backed entrepreneurial firms receive financing from inside investors who are informed about firm quality and help determine firm financing decisions. The environment contrasts with the setup of public firms that raise financing from arm’s length investors who face information asymmetry about firm prospects. In this paper, we seek to determine how these differences affect financing decisions and firm outcomes of VC-backed firms in particular and firms in general. Traditional explanations for debt financing do not easily apply in the VC setting. Since the investor is also an insider, the entrepreneur need not signal firm quality to the VC. Moreover, such firms rarely have taxable income, ruling out tax shield benefits as the motivation for debt issuance. Why then do VC-backed firms issue debt? Empirical research on capital structure suggests that leverage increase is positively related to firm value. In contrast, our analysis reveals that entrepreneurial firms that issue debt exhibit a reduction in firm value after obtaining debt and a lower probability of a successful exit (an initial public offering (IPO) or a private sale of the firm). We distinguish between two sources of debt: insiders, who are existing equity holders, and outsiders, who are new investors. Inside investors provide debt financing to lower quality firms than outside investors and debt from the former precedes significantly larger falls in valuation. If debt were causing the deterioration in firm prospects, then inside investors would not jeopardize their own firms more Brav (2009) studies private firm capital structure in the UK. Robb and Robinson (forthcoming) find that startups rely heavily on formal debt sources, such as bank financing. Venture capitalists possess in-depth knowledge of firm operations and industry expertise (see Lerner (1995) and Hellmann and Puri (2002)). See Masulis (1980) and Asquith and Mullins (1986), among others.