‘If the Facts Don't Fit the Theory … ’: The Security Design Puzzle in Venture Finance

• Published date: 01 October 2014
• DOI: http://doi.org/10.1111/ijmr.12032
• Date: 01 October 2014
• Author: Simona Zambelli

‘If the Facts Don’t Fit the Theory . . . ’:

The Security Design Puzzle in

Venture Finance

Simona Zambelli

Department of Management, Piazzale della Vittoria, 15, 47100 Forlì, Italy

Corresponding author email: simona.zambelli@unibo.it

When confronting theory with evidence, divergent results surface with reference to the

optimal securities that should be adopted in venture capital (VC) finance. The vast majority

of the theoretical models on VC consistently predict that convertible securities, especiallyin

the form of convertible preferred stocks, represent the optimal form of finance. While the

theoretical literature seems to be supported by empirical studies in the US, the evidence

outside the US shows the opposite results. Puzzling patterns emerge, especially when

comparing the evidence from the US, Canada and Europe, and an intensive academic debate

is under way. The evidence becomes even more challenging when considering the contrast-

ing financing behaviour of US venture capitalists (VCs) investing in Canada. It has been

documented that US VCs investing in Canada adopt a wide range of securities other than

convertible stocks. If convertible securities truly represent the optimal form of VC finance,

why would US VCs use different types of securities when investing in Canada? At present,

researchers are still arguing about which factors would have the most significant impact on

explaining the different financing behaviour of VCs around the world. The purpose of this

paper is to shed some light on the ongoing international debate on the optimal security

design and contracting behaviour in venture finance. With this review, the authors intend to

contribute to the VC literature by identifying current trends, explanations and determinants

underlying the puzzling empirical evidence on the financing structure adopted by VCs

around the world.

Introduction

‘If the facts don’t fit the theory, change the facts.’

Albert Einstein

The vast majority of theoretical models on venture

capital (VC) consistently predict that convertible

securities, especially in the form of convertible pre-

ferred stocks, represent the optimal form of finance

that should be adopted in VC.1When comparing the

economic theory with the empirical evidence

from the US (e.g. Bengtsson 2012), Europe (e.g.

Cumming 2008; Hartmann-Wendels et al. 2011;

Schwienbacher 2008) and Canada (e.g. Cumming

2012; Cumming 2005a,b,c), inconsistencies emerge.

While the theoretical literature seems supported by

empirical studies in the US, the evidence outside the

US is quite challenging. Inconsistent patterns

surface, especially when considering the contrasting

The author owes special thanks to the Government of

Canada. This study was undertaken with the financial

support of the Foreign Affairs and International Trade

Canada/avec l’appui d’Affaires étrangères et Commerce

international du Canada. The author would also like to

thank the associate editor (Kathryn Haynes) and three

anonymous referees of this Journal for valuable comments

and helpful suggestions, as well as the Fondazione Cariplo

(Milan) for additional financial support.

1For recent overviews of theoretical models on the optimal

security design in VC, see Hirsch and Walz(2013); Andrieu

(2012); Utset (2013); Bienz and Hirsch (2012); Bienz and

Walz (2010).

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International Journal of Management Reviews, Vol. 16, 500–520 (2014)

DOI: 10.1111/ijmr.12032

© 2014 British Academy of Management and JohnWiley & Sons Ltd. Published by John Wiley & Sons Ltd,9600 Garsington

Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA

financing behaviour of US venture capitalists (VCs)

investing in Canada (e.g. Cumming 2012). Why do

US VCs behave differently when financing Canadian

firms? The economic literature has provided various

explanations for this financing puzzle, but without

converging towards a conclusive position.

The main purpose of this paper is to critically

assess how VC organizations finance their invest-

ments, with the hope of putting together the pieces of

the puzzle highlighted above and shedding some

light on the ongoing international debate surround-

ing the security design in venture finance. For the

purpose of this paper, the term ‘venture capital’ is

adopted with a broad connotation, consistent with

the definition commonly employed in Europe and

other countries such as Canada, and refers to any

equity investments in non-quoted firms. From this

perspective, VC includes start-up and early-stage

investments towards new firms, and mid- and late-

stage investments towards existing and mature firms

(e.g. Cumming and Johan 2008b; Wright et al.

2005).2Venturecapitalists raise money from external

investors (mainly from banks, insurance companies,

pension funds and corporations) and provide capital

to private firms in order to support their development

and innovation process (Bertoni and Tykvova 2012).

Venture capitalists provide both capital and manage-

rial assistance to their investee companies and

usually retain various control rights over their port-

folio companies in order to shape their governance

and maximize their value added (e.g. Cumming

2008; Cumming and Walz 2010; Cumming et al.

2010; Hirsch and Walz 2013; Nielsen 2008). Active

involvement byVCs has proved to be one of the most

effective strategies for adding value to their portfolio

companies (e.g. Chemmanur et al. 2010; Cumming

and Johan 2013; Cumming and Zambelli 2013;

Cumming et al. 2004, 2005; Suchard 2009).

The types of securities that are selected by VCs

play a crucial role in the success of the venture (see

Cumming 2007). For example, some securities may

offer a higher downside risk protection or higher

control rights to VCs to minimize potential losses.

Other types of securities (e.g. convertible securities)

may offer stronger incentives to entrepreneurs and

minimize their opportunistic actions.

Regarding the use of convertible securities in VC,

the empirical and theoretical studies are disjointed.

On the one hand, the empirical studies in the US

highlight that convertible securities, especially in the

form of convertible preferred stocks, are the most

commonly used form of VC finance (e.g. Bengtsson

2012; Gompers 1997; Sahlman 1988, 1990). This

evidence is in line with the vast majority of theoreti-

cal models on VC contracting behaviour(e.g. Admati

and Pfleiderer 1994; Berglöf 1994; Casamatta 2003;

Cornelli and Yosha 2003; Hellmann 2006; Ozerturk

2008; Repullo and Suarez 2004; Schmidt 2003). On

the other hand, the empirical evidence from Canada

shows that convertible securities do not represent the

most frequently used financial instrument in VC (e.g.

Cumming 2001; 2002; 2006; 2007; 2008; Cumming

and Walz 2010; Cumming et al. 2010).3

The inconsistencies resulting from the empirical

studies around the world challenge the predominant

theoretical models on the optimal financing behav-

iour in VC and raise various questions: Why do VCs

in Canada use forms of finance other than convertible

preferred stocks? Is this evidence explainable by a

lower level of sophistication ofVCs in Canada com-

pared with US VCs, as Kaplan et al. (2007) argued?

How doVCs outside the US and Canada finance their

investee firms? According to Gilson and Schizer

(2003), tax regulation biases the security choice in

the US towards the selection of convertibleprefer red

securities. Consistent with this view are the data

reported in Cumming (2005a). But is the tax policy

2Note that, in the international literature there is no unique

definition of VC. Overlaps and differences in the definitions

of VC and private equity (PE) emerge, depending on the

geographical context. Sometimes, especially in Europe, VC

is adopted with a broad connotation (e.g. Krohmer et al.

2009; Wright et al. 2005) as a synonym of PE. Other times,

especially in Anglo-Saxon contexts, the term VC is used as

a subsample of the entire industry (PE) to identify the early-

stage and expansion financing (e.g. Metrick and Yasuda

2010, 2011a,b; Tykvova and Schertler 2008). Inconsisten-

cies emerge, especially with the term PE (see Appendix S1,

available in the online version of the Journal). In some

European countries, PE involves the equity financing of

existing firms and includes expansion and late-stage financ-

ing, turnaround, and buyouts (e.g. Cumming and Zambelli

2010). In other contexts, PE is used for buyouts only (e.g.

Acharya et al. 2011; Achleitner et al. 2010; Wright et al.

2009). Since buyouts are structured in a different way rela-

tive to early and expansion investments, papers focusing

only on buyouts are excluded from the survey onVC financ-

ing behaviour. For overviews of buyouts, see Zambelli

(2010); Jensen (2007). For overviews of VC activity, see

Metrick and Yasuda (2011b); Wood and Wright (2009);

Schwienbacher (2008); De Clercq et al. (2006); Fried and

Hisrich (1994); Sahlman (1990).

3Similarly, the evidencefrom Europe shows that convertible

stocks are not used as frequently as in the US VC

market (e.g. Cumming 2008; Cumming and Walz 2010;

Schwienbacher 2008).

Security Design Puzzle in Venture Finance 501

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