Institutional Frameworks, Venture Capital and the Financing of European New Technology‐based Firms

• Author: Sophie Manigart,Andy Heughebaert,Tom Vanacker
• Published date: 01 May 2014
• DOI: http://doi.org/10.1111/corg.12046
• Date: 01 May 2014

Institutional Frameworks, Venture Capital

and the Financing of European New

Technology-based Firms

Tom Vanacker, Andy Heughebaert, and Sophie Manigart*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We f‌irst study how cross-country differences in shareholder protection against self-dealing and

personal bankruptcy laws affect the f‌inancing of new technology-based f‌irms (NTBFs). Second, we study how venture

capital (VC) investors – as expert monitors and initiators of “good” governance practices in f‌irms – moderate aforemen-

tioned relationships.

Research Findings/Insights: Using a unique longitudinal dataset of 6,813 NTBFs from six European countries, we f‌ind that

better shareholder protection rights increase the probability of raising external equity f‌inancing and allow f‌irms to raise

larger amounts of equity f‌inancing. Less forgiving personal bankruptcy laws decrease the probability of raising debt

f‌inancing and limit the amount of debt f‌inancing thatis raised. VC ownership strengthens the aforementioned relationships.

Theoretical/Academic Implications: This study is one of the f‌irst to provide evidence on the relationship between national

legal systems and the f‌inancing of private NTBFs. We further address a recurring call for more research on the interaction

between country-level legal systems and f‌irm-level corporate governance.In particular, we show that expert monitors, such

as VC investors, strengthen the relationship between national legal systems and NTBF’s access to external f‌inancing.

Practitioner/Policy Implications: Policy makers often focus on increasing the supply of VC f‌inancing as a panacea for

external f‌inancing constraints experienced by NTBFs. This study shows that VC ownership is particularly effective at

increasing f‌irms’ access to external f‌inancing in countries with strong investor protection rights and entrepreneur-friendly

personal bankruptcy laws.

Keywords: Corporate Governance, Financing, Shareholder Protection, Personal Bankruptcy Laws, Venture Capital

INTRODUCTION

New technology-based f‌irms (NTBFs) play a key role in

the creation of employment and wealth in our modern

“knowledge-based” economies (Colombo & Grilli, 2005;

Storey & Tether, 1998). Unfortunately, many of these f‌irms

fail to realize their potential due to f‌inancing constraints,

which hamper f‌irm growth and even threaten f‌irm survival

(Carpenter & Petersen, 2002a; Cooper, Gimeno-Gascon &

Woo,1994). Asymmetric information and agency problems –

compounded by the lack of internal cash f‌lows and collateral

– explain why NTBFs experience diff‌iculties in acquiring the

external f‌inancing they need or why this f‌inancing can be

prohibitively expensive (Carpenter & Petersen, 2002a,

2002b). The importance of external f‌inancing for NTBFs to

form and grow (Robb & Robinson, 2013) explains why aca-

demics and practitioners have a keen interest in better

understanding the factors that increase the availability and

use of external f‌inancing in private NTBFs. In this study,

we contribute to this understanding by addressing how

national institutions and venture capital (VC) ownership, as

an important f‌irm-level governance mechanism, inf‌luence

external f‌inancing decisions in private NTBFs.

Institutional theory argues that institutions shape “the

rules of the game in a society” (North, 1990: 3) for both

investors, who supply external f‌inancing, and f‌irms, who

demand externalf‌inancing.1Investor protection laws – a form

of formal institutions – are crucial because expropriation of

minority shareholders and creditors by controlling share-

holders is a common problem (La Porta, Lopez-de-Silanes,

*Address for correspondence: Sophie Manigart, Vlerick Business School and Ghent

University, Reep 1, 9000 Gent, Belgium. Tel: 9-210-9787; Fax: 9-210-9700; E-mail:

sophie.manigart@vlerick.com

199

Corporate Governance: An International Review, 2014, 22(3): 199–215

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12046

Shleifer, & Vishny, 2000). Investor expropriationincludes, for

instance, the consumption of perquisites and self-serving

f‌inancial transactions by controllingshareholders (Shleifer &

Vishny, 1997). Research on law and f‌inance has shown that

better investor protection laws reduce the risk of expropria-

tion and reduce the monitoring costs of external investors,

which ultimately results in larger public capital markets (La

Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1997). Public

capital markets are often not accessible for NTBFs, however.

Prior research has further shown the importance of cross-

country differences in bankruptcy laws – another form of

formal institutions – for entrepreneurship development (e.g.,

Armour & Cumming, 2008; Lee, Yamakawa, Peng, & Barney,

2011). However, the relationship between personal bank-

ruptcy laws and f‌inancingdecisions at the f‌irm level remains

unclear (Armour & Cumming, 2006). Specif‌ically, stricter

personal bankruptcy laws may cause creditors to provide

more debt f‌inancing on better terms because they may recu-

perate more in the case of failure, which makes lending less

risky.Entrepreneurs, however, may demand less debt f‌inanc-

ing when personal bankruptcy laws are stricter, despite the

availability of more and cheaper debt f‌inancing, because the

costs of failure may be particularly severe for them. Overall,

despite this rich stream of research, our knowledge on how

differences in national laws affect the f‌inancing of private

f‌irms, and private NTBFs in particular, remains limited.

In addition, recent studies argue that investor protection

laws at the country level and corporate governance mecha-

nisms at the f‌irm level may work as interdependent systems

in controlling agency problems, such as self-dealing

(Aguilera, Filatotchev, Gospel, & Jackson, 2008; Strange,

Filatotchev, Buck, & Wright, 2009). In this paper,we focus on

VC investors, which are highlighted as models for gover-

nance in entrepreneurial f‌irms (Jensen, 1993). VC investors

are one of the most important owners in NTBFs, ranked

second behind entrepreneurs themselves (George, Wiklund,

& Zahra, 2005). These investors not only contribute f‌inanc-

ing to their portfolio f‌irms, thereby directly easing f‌inancial

constraints (Bertoni, Colombo, & Croce, 2010), they are also

initiators of “good” governance practices, contributors of

value-adding services and diligent monitors (e.g., Lerner,

1995; Sapienza, Manigart, & Vermeir, 1996; Van den Berghe

& Levrau, 2002; Vanacker, Collewaert, & Paeleman, 2013).

This suggests that VC ownership may also inf‌luence the

relationship between national laws and the f‌inancing of

f‌irms; but how it will inf‌luence this relationship remains

unclear. On the one hand, VC investors can compensate for

weaker investor protection laws, for instance, by writing

extensive contracts that bind entrepreneurs to treatinvestors

well (e.g., Armour & Cumming, 2006; Khoury, Junkunc, &

Mingo, 2012). In this case, VC ownership and strong inves-

tor protection laws may substitute for one another. On the

other hand, stronger investor protection laws and VC own-

ership may mutually enhance each other such that their com-

bined presence increases their effectiveness (e.g., La Porta et

al., 2000). In this case, investor protection rights and VC

ownership operate in a complementary manner.

In sum, we address two important yet underexplored

questions: How do formal institutions, including national

shareholder protection laws and personal bankruptcy laws,

affect the use of external f‌inancing by private NTBFs? Do

these formal institutions and VC ownership, as a f‌irm-level

corporate governance mechanism, have a substitutive or

complementary relationship? For this purpose, we use a

unique hand-collected longitudinal database comprising

data from 1990 up to 2008 for a sample of 6,813 private

NTBFs from six European countries (Belgium, Finland,

France, Italy, Spain, and the UK). While these countries

are geographically close and relatively homogeneous with

respect to economic development, which reduces unob-

served heterogeneity among countries, they are character-

ized by signif‌icant differences in institutional frameworks

(Bruton, Filatotchev, Chahine, & Wright, 2010).

Our paper makes three key contributions. First, to date,

research in the law and f‌inance tradition has primarily

focused on the relationship between investor protection laws

and the development of capital markets at the country level

(e.g., Armour & Cumming, 2006; Djankov, McLiesh, &

Shleifer, 2007; Groh, von Liechtenstein & Lieser, 2010; La

Porta et al., 1997; Li & Zahra, 2012) and the relationship

between nationallaws and the f‌inancing of public f‌irms (e.g.,

Acharya,Amihud, & Litov,2011; Liu & Magnan, 2011; Seifert

& Gonenc, 2012). In line with Zahra and Newey (2009), who

argue that theory development can occur by applying theo-

retical frameworks in new settings, thereby seeking to

improveour understanding of the boundaries of these frame-

works and their robustness, our study is one of the f‌irst to

show how the law and f‌inance framework also applies to

f‌inancing decisions in private NTBFs. Second, we focus on an

important but often overlooked aspect of law, namely per-

sonal bankruptcy law (e.g., Armour & Cumming, 2006). To

our knowledge, only Berkowitz and White(2004) previously

focused on the relationship between personal bankruptcy

laws and the availability and cost of credit for US f‌irms. We

provide new and unique insights into how cross-country

differences in personal bankruptcy lawsinf‌luence the f‌inanc-

ing strategies of private NTBFs from different European

countries. Third, this study addresses the call for more

research by Filatotchevand Boyd (2009) on how nationallegal

systems interact with f‌irm-level governancefactors. Weargue

and show that VC investors, as diligent monitors and initia-

tors of good governancepractices at the f‌irm level, strengthen

the relationship between national laws and the f‌inancing of

private f‌irms. By doing so, this study contributes to a further

integration of institutional theory and agency theory.

THEORETICAL BACKGROUND AND

HYPOTHESES

We start by developing hypotheses on how national legal

systems, including the legal protection of minority share-

holders and personal bankruptcy laws, inf‌luence the use of

respectively external equity and debt f‌inancing in NTBFs.

Next, we discuss how VC investors moderate the relation-

ship between national legal systems and f‌inancing decisions

in NTBFs.

National Legal Systems and the Financing

of NTBFs

Much of corporate governance research is concerned with

the mechanisms through which external investors, includ-

200 CORPORATE GOVERNANCE

Volume 22 Number 3 May 2014 © 2013 John Wiley & Sons Ltd