1. Venture Capitalists As Benevolent Vultures: The Role of Network Externalities in Financing Choice http://campus.hec.fr/profs/leshchinskii/externalities.pdf Dima Leshchinskii, HEC

2. FMC, May 2nd, 20022 Objective  To study how entrepreneurs’ choice of active investors to finance entrepreneurial projects is affected by: interaction between projects control rights of potential investors where potential active investors are VCs and angels  In other words, to show “how and when VCs create more value than other investors”

3. FMC, May 2nd, 20023 Example  You are an entrepreneur with a new project: R&D required investment of 2 M $; Probability of success  = 0.3; Project’s gross payoff is 4 M $;  Another entrepreneur with a similar project. In case of her success, you can borrow her technology investing much less;  Whom should you ask for funding? Who would agree to invest?

4. FMC, May 2nd, 20024 Professional angels Back a single firm in the industry (no deep pockets or no time to support more firms) VCs Invest into portfolio of companies same industry or stage Some Facts About Investors Both VCs and angels: Have control rights not linked to cash flow rights Advise the entrepreneurs –Invest more than just money (time, effort, knowledge) Practice stage financing But

5. FMC, May 2nd, 20025 Main Results  VCs can create more value for their portfolio companies … Through investment coordination and portfolio approach (internalizing positive externality) investment decision based on  NPV i >0, not on  NPV i >0) Through early project termination (as vultures eliminating negative externality)...Only if ex-ante entrepreneurs are better off with VCs than with angel investors (benevolent vultures)

6. FMC, May 2nd, 20026 Related Literature  Sahlman (JFE 1990), Gompers & Lerner, Hellmann & Puri (RFS 2000), Kaplan & Stromberg (1999), Stuart & Robinson (1999)  Bhattacharya & Chiesa (JFI 1995), Cabral (1998), Economides (EJPE 1996); Cestone & Fumagalli (2000)  Hellmann (2000), Ueda (2000)

7. FMC, May 2nd, 20027 Model  Two entrepreneurs with own projects  Two-stage projects: R&D stage: investment I i, I i = {0, , I} If I i = I, then R&D success of the project with probability  Outcomes of R&D stage are independent Market stage: If I i = , then free technology transfer from a rival project net payoff i V (if both projects continue) or V (if only one continues) ( 1 + 2  1, 1 < 2 )

8. FMC, May 2nd, 20028 Model  Entrepreneurs with projects  Externalities: R&D (technology transfer) Payoff externality  Competitive Investors: angels (can invest only into one project) VC (can invest into two projects) In return for investment ask for share  i in a project i. Non-zero investment is not verifiable (time, effort etc.) Investors have control rights even for  i < 0.5

9. FMC, May 2nd, 20029  1-  i V Angel funds project i I  I j = I I j < I 0 VC (funds 2) 2I 0 I+  (1-  ) 2 1-(1-  ) 2 (1-  )  0 0 Max{( 1 + 2 )V;V} Externality and Investment

10. FMC, May 2nd, 200210 Timeline t = -1Investors ask for share  i in return for investment. Entrepreneurs choose investors, who get zero expected return t = 0I i, I i = {0, , I} are invested t = 1R&D results are observed. (Technology transfer, if possible). Projects are continued/terminated t = 2Final payoffs are realized

11. FMC, May 2nd, 200211 Projects’ Payoffs With Angel Investment

12. FMC, May 2nd, 200212 Projects’ Payoffs With Angel Investment

13. FMC, May 2nd, 200213 Positive Externalities ( 1 + 2 >1): First Best Result

14. FMC, May 2nd, 200214 Angel financing  Entrepreneurs choose angels if: E [ NPV Entr. |Angel ]  E [ NPV Entr. |VC ]  Participation constraint for angels: E[NPV Angel ]  0 One possible pair of contracts

15. FMC, May 2nd, 200215 VC financing  Entrepreneurs choose VCs if E [ NPV Entr. |VC ]  E [ NPV Entr. |Angel ]  Participation constraint for VC: E[NPV VC ]  0  Incentive compatibility for VC (Deviation- proof) Continuum of contracts Everybody wants higher stakes

16. FMC, May 2nd, 200216 Example: Positive externalities, investment in both project is the first-best  (1-  )( 1 + 2 )V>I-   Angel investment is optimal if  (1-  ) 1 V>I-  VC cannot improve  Angel investment is suboptimal if  1 V<I or  (1-  ) 2 V<I VC can improve (except when  1 V<I and  (1-  ) 2 ( 1 + 2 )V<I) by investing into both projects  Angel financing is impossible if  2 V<I VC always reaches the first best

17. FMC, May 2nd, 200217 1 Lambda,  (market externality) 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 0.51.52.53.54.5 Beta,  (R&D externality)     Improvement No advantage for VC (I;I) resuscitation by VC Positive Externality, I/V = 0.5, 1 = 2 >0.5. First Best is (I, I)

18. FMC, May 2nd, 200218 1 Lambda,  (market externality) 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 0.51.52.53.54.5 Beta,  (R&D externality)     No investment zone resuscitation by VC Improvement No advantage for VC (I;I) Positive Externality, I/V = 0.5. 1 = 2 >0.5

19. FMC, May 2nd, 200219 Negative Externalities ( 1 + 2 <1): First Best Result

20. FMC, May 2nd, 200220 VC contracts  Participation constraint for entrepreneurs VC’s share in firm 1 = VC’s share in firm 2 “Face” NPV i  2  E[NPV i |Angel]  Incentive compatibility for VC (Deviation-proof): Prefers to continue only one project One single contract. At t = 1 each entrepreneur wants to get formally less! 0 V 1/2

21. FMC, May 2nd, 200221 Example: Negative externalities, investment in both projects is the first best  (1-  )V>I-   Angel investment is never optimal  Angel investment is suboptimal if  (1-  ) 1 V>I-  or  1 V<I or  (1-  ) 2 V<I VC can improve (except when 2 >0.5 and  (1-  ) 1 >I) by investing into both projects  Angel financing is impossible if  2 V<I VC always reaches the first best

22. FMC, May 2nd, 200222 Negative ExternalityI/V=0.05 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 00.10.20.30.40.5 Lambda,  Beta,      No investment zone Improvement Resuscitation by VC

23. FMC, May 2nd, 200223 Empirical implications  We should observe more VC investment in the industries with high externalities, especially negative ones  VCs invest more than angels into risky projects (low  ) … with high profitability (V/I)  Portfolio companies of the same VC should have similar characteristics (size and i )

24. FMC, May 2nd, 200224 Conclusion High externalities give VCs potential to create more value for their portfolio companies than angel investors By better coordinating investment By influencing project continuation Their actions increase the value of the portfolio, sometimes at the expense of individual companies Interests of individual entrepreneurs and possible opportunistic behavior of VCs may prevent from getting the optimal outcome

25. FMC, May 2nd, 200225 Question:  Can entrepreneurs achieve VC-like results with angel investment... by cross-holding stakes in each other projects?