Legality and venture capital exits

LegalityandventurecapitalexitsBDouglasCumminga,*,GrantFlemingb,1,ArminSchwienbacherc,2aSchoolofBankingandFinance,UniversityofNewSouthWales,Sydney,NSW2052,AustraliabSchoolofFinanceandAppliedStatistics,FacultyofEconomicsandCommerce,AustralianNationalUniversity,Canberra,AustraliacUniversityofAmsterdam,FinanceGroup,Roetersstraat11,1018WBAmsterdam,TheNetherlandsReceived10December2003;accepted10December2004Availableonline30September2005AbstractThispaperintroducesananalysisoftheimpactofLegalityontheexitingofventurecapitalinvestments.Weconsiderasampleof468venture-backedcompaniesfrom12Asia-Pacificcountries,andthesecountries’venturecapitalists’investmentsinUS-basedentrepreneurialfirms.ThedataindicateIPOsaremorelikelyincountrieswithahigherLegalityindex.Thiscoreresultisrobusttocontrolsforcountry-specificstockmarketcapitalization,MSCImarketconditions,venturecapitalistfundmanagerskillandfundcharacteristics,andentrepreneurialfirmandtransactioncharacteristics.AlthoughBlackandGilson(1998)[Black,B.S.,Gilson,R.J.,1998.Venturecapitalandthestructureofcapitalmarkets:banksversusstockmarkets.JournalofFinancialEconomics47,243–77]0929-1199/$-seefrontmatterD2005ElsevierB.V.Allrightsreserved.doi:10.1016/j.jcorpfin.2004.12.004BAnearlierversionofthispaperwasentitledbALawandFinanceAnalysisofVentureCapital.ExitsinEmergingMarketsQwithapriordatasetinvolvingfewertransactionsandfewerdetailspertransaction.Weoweaspecialthankstoananonymousrefereeformanyhelpfulsuggestions.WealsoowethankstoWilshireAssociates,Inc.forprovidingthedataforthispaperandtoKateHumphreysforresearchassistance.TheviewsexpressedinthispaperdonotrepresentthoseofWilshireAssociates,Inc.WeowethankstotheseminarparticipantsattheEuropeanFinanceAssociationAnnualConference(Glasgow,2003),andinparticulartoSanjivDasforaveryhelpfuldiscussion.ThispaperwasfurtherpresentedattheCAFRSymposium(HongKong,June2004).*Correspondingauthor.Presentaddress:SeverinoCenterforTechnologicalEntrepreneurship,LallySchoolofManagementandTechnology,RensselaerPolytechnicInstitute,1108thStreet,Troy,NY12180,USA.Tel.:[phone];fax:[phone].E-mailaddresses:[e-mail](D.Cumming),[e-mail](G.Fleming),[e-mail](A.Schwienbacher).URLs:(D.Cumming),(A.Schwienbacher).1Tel.:[phone];fax:[phone]Tel.:[phone];fax:[phone].JournalofCorporateFinance12(2006)214–245’slegalsystemismuchmoredirectlyconnectedtofacilitatingVC-backedIPOexitsthanthesizeofacountry’sstockmarket.ThedataindicateLegalityisacentralmechanismwhichmitigatesagencyproblemsbetweenoutsideshareholdersandentrepreneurs,therebyfosteringthemutualdevelopmentofIPOmarketsandventurecapitalmarkets.D2005ElsevierB.V.Allrightsreserved.JELclassification:G24;G28;G31;G32;G35Keywords:Venturecapital;Exits;IPO;Acquisition;Lawandfinance1.IntroductionTherisksandreturnstoinvestinginsmallprivatecompaniesandcompanieswithintangibleassetsarepronounced.3ThisisespeciallythecaseinsmallerandlessdevelopedfinancemarketssuchasthoseintheAsia-Pacificregion.Thelegalrightsandprotectionsaffordedtoentrepreneursandinvestorsareparticularlyimportantinventurecapitalandprivateequitymarkets.Legalstructuresimpacttherightsandprotectionsofpartiesanddistributionoffinancialoutcomesundervariousstatesoftheworld.Thatlawmattersinmanyaspectsoffinanceiswidelyrecognized,withstudiesshowingthatlegalinstitutionsandrulesinfluencecapitalstructure,dividendpayoutratios,repurchasingdecisions,andcapitalmarketreturns.4Muchofthisliterature,however,concentratesonpubliclytradedcompanies.Theimpactoflegalinstitutionsandstructuresonprivateequityinvestments(suchasthoseundertakenbyventurecapitalists)hasreceivedlessattention.Thispaperprovidesafirst-everlawandfinanceanalysisofventurecapitaldispositions.Weconsidertheimpactofthequalityoflegalenvironmentonthechoicebetweenpublicsale(initialpublicofferings)andprivatesaletransactions(includingacquisitions,secondarysalesandbuybacks,eachdefinedinSection2).5Inourcross-countryempiricalanalysis,weconsiderthedlawandfinancevariablesTfromLaPortaetal.(1997,1998,2000),includingtheefficiencyofthejudicialsystem,theruleoflaw,corruption,riskofexpropriation,riskofcontractrepudiation,andshareholderrights[hereafterdthelawandfinancefactorsT].Takentogether,thesefactorscomprisethedLegalityTinacountry(Berkowitzetal.,2003),whichmeasuresthequalityofacountry’slegalsystem.3AmoreextensivediscussionofthiscanbefoundinSahlman(1990),Lerner(1994a,b,1995),Gompers(1995),GompersandLerner(1999,2001a,b),Keuschnigg(2002),LernerandSchoar(2004),Denis(2004),Cummingetal.(2005),andCumming(inpress).4See,e.g.,LaPortaetal.(1997,1998,2000),Berkowitzetal.(2003),Himmelbergetal.(2002),KlapperandLove(2002);forasurvey,seeChoi(2002).5InthispaperwefocusondventurecapitalTinvestmentslooselydefinedasearlyandexpansionstageinvestments(asdefinedintheAsia-