Knowledge that Transforms

Risk capital is a resource essential to the formation and growth of entrepreneurial ventures. In a society that is increasingly dependent upon innovation and entrepreneurship for its economic vitality, the performance of the venture capital markets is a matter of fundamental concern to entrepreneurs, venture investors and to public officials. This article deals with the informal venture capital market, the market in which entrepreneurs raise equity-type financing from private investors, (business angels). The informal venture capital market is virtually invisible and often misunderstood. It is composed of a diverse and diffuse population of individuals of means; many of whom have created their own successful ventures. There are no directories of individual venture investors and no public records of their investment transactions. Consequently, the informal venture capital market poses many unanswered questions. The author discusses two aspects of the informal venture capital market: questions of scale and market efficiency. The discussion draws upon existing research to extract and synthesize data that provide a reasonable basis for inferences about scale and efficiency. Private venture investors tend to be self-made individuals with substantial business and financial experience and with a net worth of $1 million or more. The author estimates that the number of private venture investors in the United States is at least 250,000, of whom about 100,000 are active in any given year. By providing seed capital for ventures that subsequently raise funds from professional venture investors or in the public equity markets and equity financing for privately-held firms that are growing faster than internal cash flow can support, private investors fill gaps in the institutional equity markets. The author estimates that private investors manage a portfolio of venture investments aggregating in the neighborhood of $50 billion, about twice the capital managed by professional venture investors. By participating in smaller transactions, private investors finance over five times as many entrepreneurs as professional venture investors; 20,000 or more firms per year compared to two or three thousand. The typical angel-backed venture raises about $250,000 from three or more private investors. Despite the apparent scale of the informal venture capital market, the author cites evidence that the market is relatively inefficient. It is a market characterized by limited information about investors and investment opportunities. Furthermore, many entrepreneurs and private investors are unfamiliar with the techniques of successful venture financing. The author's scale and efficiency inferences, coupled with evidence documenting gaps between private and social returns from innovation, prompt questions about public as well as private initiatives to enhance the efficiency of the informal venture capital market. The article concludes with a discussion of Venture Capital Network, Inc. (VCN), an experimental effort to enhance the efficiency of the informal venture capital market. VCN's procedures and performance are described, followed by a discussion of the lessons learned during the first two years of the experiment.

Venture Capitalists responded to a questionnaire in which they rated a highly successful and a highly unsuccessful venture on 25 screening criteria and on several performance criteria. In all, 150 ventures were rated by 67 venture capital firms. Cluster analysis revealed three broad classes of unsuccessful ventures. The first type is the bane of all venture capitalists—the venture in which the venture team is lacking in experience or staying power, the product has no prototype, and there is no clear market demand for the product, yet the venture somehow slips through the screens and gets funded. The second type is one in which the venture team is very well credentialed, but the venture faces early competition and the team has no staying power and runs out of steam. The third major class of venture is one in which the team has exceptional staying power, so much so that by perserverance it demonstrates that a market exists, only to lose that market to competition because of a lack of protection for the product. Cluster analysis also showed that there are four broad classes of successful ventures. First is the high-tech venture with a well-qualified venture team that has the staying power needed to face competitive attack. Second is the class of venture where the venture team does not have much in the way of credentials, but the product has a very high level of protection and turns out to be highly successful. Third is a class of “market makers”—a venture team with exceptional perseverance that demonstrates that there is in fact a market for the product, but also has some form of product protection once that market has been demonstrated. It can be seen that each of these classes of successes has a look-alike class of failures that is very similar except for some flaw in the venture team. A final class of successful venture is a small group of low-tech products in which distribution skills are critical. We suspect that these ventures tend to be for consumer goods. An important finding is the identification of two major criteria that are predictors of venture success. These are 1) the extent to which the venture is initially insulated from competition and 2) the degree to which there is demonstrated market acceptance of the product. Regression analyses indicate that only these two screening criteria correlate pervasively across several performance criteria. Interestingly, neither of these criteria were rated as essential in an earlier study. Much more importance needs to be attached to these criteria in screening venture proposals. The final analysis was a factor analysis, which indicates that the 150 ventures were screened according to five major classes of criteria, each class corresponding to some facet of risk management of the venture. These were as follows: 1.1. Criteria that screen out ventures where there is a risk of failure due to unqualified management;2.2. Criteria that screen out management that may well be qualified but lack experience;3.3. Criteria that screen out ventures where basic viability of the project is in doubt;4.4. Criteria that screen out ventures where there is high exposure to competitive attack and profit erosion before the investment can be recouped;5.5. Finally, criteria that avoid ventures that lock up the investment so that it cannot be cashed out for long periods of time.

This study examines the association between abnormal returns and five alternative proxies for the market's assessment of unexpected quarterly earnings. We examine the role that measurement error potentially has in multiple regression tests of abnormal returns (occuring around the time of earnings announcements) on an unexpected earnings proxy and other non-earnings variables. The results indicate a potential measurement error interpretation of such multiple regression tests. We examine three procedures which reduce, to an unknown degree, the measurement error problem. Our procedures appear to be more (less) effective at reducing measurement error for small (large) firms and recent (non-recent) forecasts.

During the latter half of the 1930s Australian taxation law changes induced companies to adopt a holding company legal structure which increased agency costs associated with external financing. This paper argues that contracting practices designed to minimize these costs played an important part in the evolution of consolidated financial reporting. Consistent with this view the likelihood of consolidation is found to be a function of the presence of cross-guarantees, management's share of a firm's equity, and the number and type of subsidiaries.

This paper examines cross-sectional analysis procedures common to many market-based accounting research papers. Both the economic and econometric properties of ‘levels’ and ‘returns’ studies are discussed. Topics covered include the relations between the accounting studies and cash flow valuation models, the role of expectations of accounting variables, deflators, spurious inference, risk adjustment and its relation to growth, size and leverage, residual dependence, dependence among explanatory variables, and the effect of scale differences across firms. Major conclusions are that market value is the correct deflator in returns studies, and that levels and returns studies are economically but not econometrically equivalent.

Beaver, Lambert and Morse (1980) suggest that prices may be useful in forecasting future earnings. We explore the information content of prices with respect to earnings by focusing on firm size and its relation to the predictive accuracy of price-based earnings forecasts. Firm size proxies for the amount of information and for the number of traders and professional analysts processing the available information about an enterprise. Our empirical results are consistent with the hypothesis that price-based earnings will outperform univariate time series forecasts by a greater margin for larger firms than for smaller firms.

This paper examines the effect of accounting procedure changes on cash salary and bonus compensation to CEOs. We estimate whether there is an adjustment to the statistical relation between compensation and corporate earnings following changes that lower earnings (FIFO to LIFO inventory valuation) and that raise earnings (accelerated to straight-line depreciation). The results indicate that (1) subsequent to these changes salary and bonus payments are based on reported earnings, rather than earnings under the original accounting method, and (2) the potential compensation effect of the changes is small compared to the effect of economy- or industry-wide changes in compensation.

This paper provides evidence of security analyst (SA) superiority relative to univariate time-series (TS) models in predicting firms' quarterly earnings numbers and shows that SA forecast superiority in our sample is attributable to: (1) better utilization of information existing on the date that TS model forecasts can be initiated, a contemporaneous advantage; and (2) use of information acquired between the date of initiation of TS model forecasts and the date when SA forecasts are published, a timing advantage.

The question of whether the design of the corporate executive pay package reflects an attempt to reduce agency costs between shareholders and managers is addressed. The components of senior executive pay are found to vary systematically across firms in a manner that cannot easily be explained by tax effects, and which would indicate that individual elements of pay are aimed at controlling for limited horizon and risk exposure problems. Managerial decisions and the structure of managerial pay therefore appear to be interrelated.

This paper investigates the extent of intra-industry information transfers associated with the half-yearly earnings announcements of a sample of Australian firms. The ‘omitted factor’ interpretation of Foster's (1981) results is examined using a recursive systems specification of the return generating process to model extra-market return covariation in cross-section. Although some aspects of the results do appear sensitive to the alternative methodologies, the overall conclusion is consistent with Foster (1981) and supports the existence of intra-industry information transfers associated with firms' earnings releases.