The Effects of Venture Capitalists' Characteristics on the Structure of the Venture Capital Deal

Previous research has found that venture capitalists seek to specialize. Such specialization occurs by way of geographical, industry, and investment stage preferences (Bygrave 1987, 1988; Gupta and Sapienza 1988; Tankersley 1989; Timmons 1990). Rosenstein, Bruno, Bygrave, and Taylor (1990) discovered the perceived contribution of the lead venture capital investor is greater if the lead investor is one of the top 20 venture capital firms that specialize in high-tech investment. Cluster analysis of survey data by MacMillan, Kulow, and Khoylian (1989) finds differences among venture capitalists with respect to their philosophy toward managing their portfolio firms; they detect three distinct philosophies which they label as "laissez faire," "moderate," and "close tracker." If venture capitalists possess different specializations and management philosophies, the same may be true regarding preferences for investment vehicles. Unlike the typical capital structure decision addressed in the finance literature, casual empiricism implies the venture capital investor, rather than the firm, plays the major role in determining the pricing and type of security to be purchased by investors. Thus, an analysis of venture capitalists' use of different investment vehicles is warranted. Venture capitalists face three basic investment vehicles: common equity, preferred equity, and debt. While it is true that many provisions and covenants can be attached to any investment vehicle, the research discussed in this article, as part of an initial empirical study, focuses solely on these three deal structures. The analysis in this article will extend the study of deal structure influences contained in Norton and Tenenbaum (1992). PRIOR EMPIRICAL RESEARCH The main thrust of Norton and Tenenbaum (1992) was to gather and examine quantitative evidence on influences affecting the choice of deal structure by venture capital investors. By examining mean responses from 98 venture capitalists on 26 survey items, Norton and Tenenbaum provide empirical evidence on the positive and negative impacts of external and internal deal specific factors on the choice of common equity, preferred equity, and debt as financing structures. Norton and Tenenbaum found that survey respondents favored the use of preferred stock as a financing vehicle regardless of the presence or absence of various deal specific influences. They found that items encouraging the use of debt investments by venture capitalists included expectations that the portfolio firm would soon generate taxable income; the presence of collateralizable assets; production of a good or service that is resistant to economic cycles; and an investment involving a latter financing stage. Positive influences for common equity investments were expectations of a strong initial public offering market at cashout; expectations of a capital gains tax cut; a strong economy; venture capitalist control of a majority of the investee's voting stock; and a firm producing a recession resistant good or service. Whereas this earlier work focused on deal specific influences affecting deal structure, the contribution of this present study is to examine the impact of venture capitalists' characteristics on deal structure. Driscoll (1974) and MacMillan, Siegel, and SubbaNarasimha (1985) state that a goal of venture capitalists is to control and manage risk. This article develops and tests hypotheses regarding the potential use of preferred equity and common equity investments as a means to do so. DOES THE FORM OF INVESTMENT VEHICLE MATTER? It is a fair question to ask if choice of an investment vehicle has any practical importance to the venture capitalist. If, by selecting various structures and covenants, the cash flow, security provisions, and voting rights are identical between two investment vehicles, the name given the investment contract is irrelevant; all investment structures are merely benign mutations of a standard contract. …