Venturing Beyond the IPO: Financing of Newly Public Firms by Pre-IPO Investors

A wide body of literature emphasizes that venture capitalists (VCs) focus on young private companies, generally in high-tech industries.  However, we find that these investors fund companies after the IPO as well.  In a sample of private firms going public for the first time, 15% of the firms that were backed by venture capital prior to the IPO received additional funding from similar sources within the first five years after the IPO.  Press releases of these financings provide suggestive evidence of their importance to the underlying companies.  For example, when Fatbrain.com received funding from their pre-IPO VC (Vulcan Ventures) one year after going public, the company highlighted how the funding would help them to bring their product to market and stated: “We view the increased support of Vulcan as a powerful endorsement of our success.”

While public firms are often considered fundamentally different than private firms, we argue that newly public firms are similar to their private counterparts along many dimensions and that these similarities motivate venture capitalists’ post-IPO investments.  In particular, we conjecture that venture capitalists have a comparative advantage in assessing the true value of recent IPO firms, and as a result, VCs have a unique ability to overcome frictions in the market that prevent investments from other market participants.  As such, we predict that these investments will enable the companies to undertake positive NPV projects for which they otherwise would have been unable to obtain funding.

It is also possible, however, that venture capitalists are instead maximizing the value of their existing positions in a firm or suffer from conflicts of interest that impede optimal investing.

Results provide strong support for the venture capitalists’ comparative advantage hypothesis.  First, we find that these investments are concentrated within companies characterized by particularly high information asymmetry and by low tangible assets, factors that make it difficult for them to raise capital through more conventional means such as an SEO or loan.  Second, venture capitalists with the greatest ability to overcome this information asymmetry, for example, due to prior involvement with the company or industry expertise, are most likely to provide the funding.  Third, these investments appear beneficial for the underlying firms.  Abnormal returns around the announcement of these financings average 7% and are as high as 14% among cases where the VC has the greatest information advantage, for example owning shares or sitting on the Board.  Moreover, unlike most other equity financings, we find no evidence that long-run returns are negative.  Finally, firms with a greater ex-ante probability of obtaining such financing have significantly higher returns over the years following the IPO and they are significantly less likely to delist for poor performance.

Overall, we document a new financing channel. Venture capitalists have a unique ability to identify firm value. We find that they use their informational advantages to serve as an intermediary to fund young firms, and the firms benefit from this source of financing.