Previous research suggests that Venture Capital-backed firms outperform firms that are not backed by Venture Capital. This, in spite of the overwhelming argument that firm’s seek venture capital only as a last resort and primarily when other options are not available. We suggest that VC-backed firms outperform non VC-backed ventures because they manage risk in a fundamentally different manner. That is, we believe that risk is not a univariate variable available for inclusion in the study of organizations, but is multi-faceted and is managed uniquely by managers/ venture capitalists.

Venture capitalists (VC) and the firms that they support are growing in importance to the economy of every nation. With the vast sums of money involved (especially in recent times), VC-backed ventures have become the grist of every major business press publication. Certainly new ventures are inherently risky as they are entering unknown or potentially highly competitive markets all with a resource collection that is developing as the business establishes itself. However, it has long been assumed that venture capitalists have a unique ability to reduce the risk of investing in new ventures and that their management skills or industry knowledge might allow them to provide new ventures with a significant leg up on the competition. This would, on the surface suggest that Venture Capital Firms are risk-adverse players in a risky environment.

While every investor wishes to avoid failure, VC’s approach the market with a unique perspective that might suggest a different approach to the investment decision. Venture Capitalists invest in a number of ventures hoping for the home-run hit. If they invest in a number of unsuccessful businesses as a means to get to the wildly successful business, then they have succeeded. This suggests that Venture Capitalists manage the inherent risk of new ventures in a completely different manner as compared to companies that are not Venture Capital backed. If the manner in which risk is managed differs significantly, it would suggest that understanding the elements of this difference might make a difference in the type of firms that seek venture capital. Additionally, it would suggest a means for comparing the performance of all new ventures.

The apparent importance of risk evaluation in business investing appears to be universal both in general business practice and in research findings in the academic literature (Arshadi & Lawrence, 1987; Barry, 1994; Ritter, 1984; Sahlman, 1990). However, its systematic examination in the management arena has been less than satisfying despite significant calls for its inclusion (Baird & Thomas, 1985; Hitt & Tyler, 1991; Reger, Duhaime & Stimpert, 1992). Several researchers have examined risk factors related to potential entrepreneurial failure suggesting decision criteria used by VC’s in the evaluation process (Laitinen, 1992; Shepherd, 1999; Tyebjee & Bruno, 1984). We would like to extend this thinking beyond survival criteria to success criteria and develop a technique for incorporating risk into organizational research. We believe all new ventures are somewhat risky, but more importantly, that there is a fundamental difference in the way risk is managed between ventures that are VC backed and those that are not VC backed. We examine these differences in the risk portfolios of new ventures (IPOs) between those VC-backed and those not VC-backed. Karl Vesper (1990) outlined three obstacles to new businesses on the path to success. These are the need for

1. Sufficient profit margin potential,
2. An effective sales scheme, and
3. Operational financing.

Vesper state’s that “It is not sufficient to have a venture idea; the idea must carry an adequate profit margin. It is not sufficient to obtain initial sales orders; a scheme must be introduced that generates continuous orders and reorders. It is not sufficient to provide the seed capital needed to germinate the venture; either that capital must grow fast enough through high initial profits or it must be augmented with additional injections for longer-tem survival.” (1990:120).

In this study we consider these obstacles as sources of risk and examine each of these risks to ventures at the point of IPO, comparing VC-backed to non VC-backed ventures. We hope to shed light on the value of risk assessment in new venture growth as well as systematic differences in the way that risks are managed.

Gupta & Sapienza (1992:349) suggest that venture capital (VC) firms “finance the founding or early growth of new companies that do not yet have access to the public securities market or to institutional lenders.” While we are aware that VC’s fund ventures at every stage of their life prior to IPO, in all cases they appear to be filling a funding/advisor gap in an area endowed with risk and uncertainty (Fried & Hisrich, 1994; Mason & Harrison, 1999; Tyebjee & Bruno, 1984). This financial perspective has been extended to suggest that venture capital firms are more skillful at identifying potentially successful firms (Amit, Brander & Zott, 1998; Sandberg, 1986: Shepherd, Zacharakis & Baron, 1998), which would, on the surface, suggest that venture capital firms might be risk adverse players in a risky environment. They would systematically examine potential investments, meet with the entrepreneurial teams, and presumably cull the vast list of ventures that desire funding down to a very small number that appear to have sound management, strong growing markets and clearly positioned products/services (Fried & Hisrich, 1994; Gladstone, 1988; Hall & Hofer, 1993). The popular view is that venture capital investors want “ample downside protection and a favorable position for additional investment if the company proves to be a winner” (Zider, 1998:134) Unfortunately, these same investors desire very high returns and as such must seek to invest in businesses that have high potential which in many cases, equates to high risk (Sahlman, 1990). Barry emphasizes this when he states that the term venture capital is “capital invested in highly risky ventures” (1994:4). This risk is an inherent component of the resource-based perspective of the firm which suggests that ex ante limits to competition are derived from uncertainty (Peteraf, 1993). That is, the venture capitalist desires to invest in high growth ventures and their opportunity for growth is fundamentally founded in a market and market position that is not well understood. Risk may indeed be a key to understanding venture capital investing although to our knowledge, it has to date only been assumed. In fact, some have suggested that VC firms are extraordinarily capable of reducing uncertainty and thereby leveling the playing field (Amit, Brander & Zott, 1998).

While agreeing that risk is a condition of new venture activity, we believe that this concept needs to be extended to suggest that venture risk is managed differently depending upon the funding source. The overarching approach suggests that VC-backed firms are less concerned with failure (as a component of risk) and more concerned about growth than firms that are not backed by a VC. VC’s fund many deals expecting only a few to pay off (Barry, 1994; Sahlman, 1990; Timmons, 1994). This notion is fundamentally a portfolio approach to investing that allows venture capital firms the luxury of investing in riskier ventures than those who invest in single companies. Alternatively, the risk profile of VCs could be described using an agency argument. Entrepreneurs backed by a VC may over-invest other people’s money in a venture that they themselves are obviously and wholly committed to maintaining. (Amit, Brander & Zott, 1998; Sahlman, 1990)

Thus, this view would suggest that VC-backed firms are riskier as a whole than non VC-backed firms. Needing to be more conservative, with limited portfolios and a concentrated exposure, we suggest that non VC-backed ventures would look to reduce certain risks granting the attendant potential loss of reward.

Risk modeling, while seemingly important in the discussion of venture capital vs. non-venture capital backed ventures, has been conspicuously absent in the venture capital research stream. We use the three-pronged risk evaluation scheme based on the work of Vesper (1990) that examines the three main threats to new venture success. For two of the items (profit margin and sales generation scheme) we suggest that VC-backed firms will be riskier than non VC-backed firms while we suggest the reverse for the last item (operational financing). We explain our rationale in the next sections.

High Margin Ventures

Vesper suggests that a significant threat to the success of a new venture is its ability to establish and maintain a high margin product or service. This criteria has been used in modeling potential outcomes in the Venture capitalist/entrepreneur relationship (Amit, Brander and Zott, 1998) and has been cited as one of the primary focuses of venture capitalists (Fried & Hisrich, 1995). However, VCs manage a group of young ventures, where according to one study (Gorman & Sahlman, 1989), a lead investor might be managing up to nine investments at a time while sitting on five boards of directors. The importance of achieving high sales growth targets that have the potential to yield annualized cash flow returns of fifty percent or more would seem to be an overriding issue for venture capitalists (Sahlman, 1990). Whereas the individual entrepreneurial venture, unable to spread the risk potential and/or the opportunity be less return focused, might feel compelled to expend greater efforts to achieve higher margins with the attendant effect of reducing sales growth. Non VC-backed firms do not have the same financial resources to fall back upon to cover mistakes and their efforts must be geared to reducing this threat, not just for success, but for survival (Bruno, McQuarrie & Torgrimson, 1992; Dean & Giglierano, 1990). New non VC-backed ventures have been advised to view entry in a decision tree format where threats to profit margin are either eliminated or the venture should strongly consider not entering the market (Oster, 1999). Therefore, we propose the following:

Hypothesis 1: Venture Capital-backed firms will have more threats to their profit margin than non venture capital-backed firms.

Sales Generation Scheme

Vesper suggested that a new venture must have the opportunity to sell to many customers and to obtain repeat business. The ability to develop a sales scheme that is broad enough to appeal to a wide variety of customers has been found in substantive past research to lead to higher sales for new ventures (McDougall, et al., 1994; Romanelli, 1989; Sandberg, 1986). This has been extended to suggest that “increasing breadth of production, and increasing geographic coverage improve performance [in entrepreneurial firms] during both the peak and the contraction of the business cycle.” (Pearce & Michael, 1997). Broad sales schemes imply significant differentiation of products/ services that would be consistent with traditional strategic positioning advice (Porter, 1980, 1985). In fact several studies have found that most ventures (at the point of IPO) (over 90% in one study) enter industries characterized by high product differentiation which was considered a necessary ingredient for successful entry (Robinson, 1999). Threats to that sales scheme would appear to be less important to venture capital-backed firms as their confidence in the industry in which they have invested (Barry, et al., 1990; Tyebjee & Bruno, 1984; Zacharakis & Meyer, 1998) or their confidence in the venture’s team (Hall & Hofer, 1993) leads them to accept additional threats to obtain the potentially higher growth. Independent entrepreneurial firms are admonished to have a well developed plan for customer buying (Vesper, 1990) and to reduce potential competitor retaliation (Oster, 1999; Porter, 1980, 1985) or other environmental threats to their sales. As Vesper states, “the folklore that customers will seek out and buy a better mousetrap simply cannot be depended on” (1990:124). Therefore, we propose the following:

Hypothesis 2: Venture Capital-backed firms will have more threats to their sales scheme than non venture capital-backed firms

Operational Financing

Vesper (1990) suggests that there are a number of specific threats to the new venture in financing its growth. High development costs, rapid expansion plans, high inventory needs and/or an entrepreneurial team with a low asset base. Research has shown that firms with higher initial capitalization have the opportunity to grow faster (Cooper & Gimeno-Gascon, 1992; Duchesneau & Gartner, 1990; Eisenhardt & Schoonhoven, 1990). Castrogiovanni stated that “startup capital serves three purposes: 1) to purchase the assets needed to operate a business; 2) to sustain a business during its early period when cash flows are likely to be negative; and 3) to buffer against management mistakes, environmental uncertainties, and other unforeseen difficulties.” (1996:815). VC-backed firms have been provided with equity capital that is often structured to provide a continuing source of funding for the new venture. Indeed, partially as a response to the inherent agency issue dilemma that has been so well documented, VC’s typically structure their deals with new ventures such that they are provided money on a milestone schedule that provides for a continuous cash infusion for the new venture and the opportunity to abandon ventures that are not attaining their projections (Gifford, 1997; Sahlman, 1990). We believe that this implies that VC-backed ventures probably have substantially fewer concerns with operational financing than do non VC-backed firms. Therefore:

Hypothesis 3: Venture Capital-backed firms will have fewer threats to their operational financing than non venture capital-backed firms.

In order to investigate the risk issues developed thus far in this paper, we rely on data from the prospectus of the Initial Public Offerings (IPO) of firms that went public in the period of 1991-1994. While there are some concerns about evaluating venture capital decisions in what is essentially a successful venture, it has been pointed out that “venture capitalists invest in privately held companies that are not visible to the public. At the time of an IPO, however, the offering prospectus identifies venture-capital investors, explains their investment position, and gives some details of their activity within the IPO firm. IPO data, therefore provide a unique opportunity to examine venture capitalists’ activity.” (Barry, Muscarella, Peavy & Vetsuypens, 1990: 448).

Sample Selection Process

We first identify IPOs using Investors Daily Digest (IDD), a weekly finance publication that contains a listing of all new issues offered on the three major U.S. stock exchanges. In the Reference section of the publication, IDD lists the name of the IPO, date of offering, ticker symbol, and initial offering price among other things. Using IDD to identify IPOs is only effective for years 1993 and 1994. Prior to 1993, IDD only provided the names of expected offerings for the upcoming week. For years 1991 and 1992, we use Barron’s to identify IPOs. In the Market Laboratory section of the publication, Barron’s lists the name of the IPO, date of offering, ticker symbol, and initial offering price. Through these two sources we were able to identify an initial set of 623 IPOs from 1991 through 1994. Using this list of IPO names, we extract financial variables from archived Compact Disclosure databases on a quarter-by-quarter basis. Of the 623 IPOs originally identified in IDD and Barron’s, 581 are available on Compact Disclosure.

To obtain the risk proxies and other important control variables we reviewed copies of the S-1 offering registration statement on Laser Disclosure for each IPO.¹ By reading the prospectus section entitled “Risk Factors,” we categorize all risks listed into one of the following categories: risks for profit margin, risks for sales generating schemes, risks for operational financing. Risk factors that can not be grouped into one of these categories are assigned to “other.” A count of the number of risk factors for each of these dimensions of risk is our proxy variable. One of the authors examined the S-1 offering statements for each of the 267 ventures in this study and coded the number of risk factors by category (risk to profit margin, risk to sales generating schemes, and risks to operational financing). Then two independent evaluators examined the S-1 offering statements for approximately one-half of the sample (randomly drawn). Therefore each of the independent evaluators examined approximately 135 firms. We evaluated the inter-rater reliability and computed a coefficient alpha of .80. Next, we identified IPOs that were venture capitalist backed by comparing our sample of firms to a listing of venture-backed IPOs provided in the Venture Capital Journal and the Venture Capital Yearbook. We dropped those IPOs that did not have complete information. Our final sample contains 267 IPOs, 81 of which are backed by a VC, the remaining 186 are not VC-backed.

Descriptive statistics and mean comparisons of all variables between VC-backed and non VC-backed IPOs are presented in Table 1.

All of the mean comparisons of the variables between VC-backed and non VC-backed IPOs are statistically different except FINANCE_RISK and the INDUSTRY control variable. The descriptive statistics suggest that VC-backed IPOs carry less debt, have a smaller asset base, a significantly greater growth in sales during the first year after IPO and have significantly more risk (threats) to both their Operating Margins and Sales Generation Schemes. These univariate comparisons relative to SALESD_, MARGIN_RISK, and SALES_RISK are consistent with our hypotheses.

Table 2 presents the correlation matrix. The only independent variables that exhibited any potential multi-collinearity were LnASSETS with SALES_RISK and AGE with SALES_RISK. In each case, LnASSETS and AGE were negatively related to SALES_RISK. However, even these correlations were considered relatively low and should impart no substantive effect upon our results (Covin, Slevin & Schultz, 1994; Neter, Wasserman & Kutner, 1990).

Table 3 presents the results of our logit estimation. To test the overall significance of the logit model, we compute a likelihood ratio test for the joint significance of the explanatory variables. The chi-square for this test statistic is 66.637 (p-value = 0.0001), indicating the combined independent variables are important in explaining the differences between VC and non VC-backed ventures. We also compute a psuedo-R² to assess goodness-of-fit. In this case, psuedo-R² compares the likelihood of an intercept-only model to the likelihood of the full, specified model. The psuedo-R² of the logit regression is 37.6%, indicating that the independent variables explain a significant portion of the difference between those ventures that are VC-backed and those that are not.

Hypothesis 1 suggested that VC-backed firms would have more threats to their profit margin than non VC-backed firms. The parameter estimate for Margin Risk is both positive and significant (p<.01) suggesting support for this hypothesis. Hypothesis 2 suggested that VC-backed firms would have more threats to their sales scheme than non VC-backed firms. The parameter estimate for Sales Risk is both positive and significant (p<.0001) suggesting support for this hypothesis. Hypothesis 3 suggested that VC-backed firms would have fewer threats to their operational financing than non VC-backed firms. The parameter estimate was positive, but not significant. The finding suggests that VC-backed firms might have more threats to operational financing, but this is not supported statistically and our mean estimates from Table 1 suggest that these two estimates are virtually identical.

We began this study with three goals in mind: 1) to render some insight into VC decision making through the lens of a risk model, suggesting a risk horizon difference between VC-backed and Non VC-backed ventures; 2) an examination of the performance implications of VC backing; and 3) an effort to operationalize risk in a manner that might be effective for future researchers. The explicit use of risk identification and modeling has been conspicuously absent in both the entrepreneurship and venture capital research streams. Furthermore, efforts to operationalize risk have focused on the perceived problems of adverse selection or other moral hazard issues which, while useful, are nonetheless focused upon contracts and image which aids in our understanding of the VC role, but does not assist the researcher a priori to develop effective hypotheses about new venture performance.

This is curious as we generally accept the maxim that there is a risk/reward tradeoff. Without an explicit accounting of the risk portfolio, assumptions and conclusions regarding performance seem potentially flawed. This is never more so than with new/young ventures that have little history, few structures, processes or other inertial forces that would force them down a particular path. Furthermore, there has been little effort to document the relationship between VC participation and longer run success criteria. While efforts have been made to evaluate the effects of under pricing and/or the first day tracking of VC vs. non VC-backed ventures, we believe that this study provides additional weight to the evidence that VC-backed firms’ performance varies in a significant manner from non VC-backed firms.

We utilized the risk framework theorized by Vesper (1990). Our research examined a large group of IPOs during the period 1991–1994 and found that for this group when we compared VC-backed firms to Non VC-backed firms, those firms that had VC backing: 1) had more risk (threats) to the profit margin; 2) had more risk (threats) to their sales generation schemes; 3) were undifferentiated with regard to risk (threats) to operational financing; and 4) grew substantially faster in their first year after IPO. Thus, it appears that these VC-backed ventures had a riskier profile and generally grew faster than non VC-backed ventures.

At first blush this may not appear to be surprising. One might have assumed an inherent risk in IPOs and new ventures in general. However much of the extant research has found (or suggested anecdotally) that VCs have the ability to identify and reduce risk (Amit, et al., 1998; Fried & Hisrich, 1994), in effect choosing those ventures that will succeed. VC backing has been argued to be one of the major signaling criteria for other stakeholders (Megginson & Weiss, 1991; Barry, et al., 1990) If VC-backed firms are fundamentally riskier, then we must assume a different evaluation criteria is in play. Indeed, we find that for this sample of IPO’s, VC-backed ventures manage risks in a fundamentally different manner than either the original risk model would have suggested as well as non VC-backed ventures. Given that the growth of VC-backed firms is greater than non VC-backed firms, perhaps the signal that is being sent is one of high growth (they may also fail faster or more often but our analysis simply does not provide us insight into this issue). As pointed out previously, VCs appear to operate in a portfolio environment where failure is less of a concern than growth.

These results are consistent with our suggestion that VCs are less concerned with bankruptcy and failure and more concerned about growth and reward. VCs, as owners who are also experts in particular fields or markets, can accept more risk to maximize growth. This would suggest the risk portfolio of a business is a critical factor in the evaluation of businesses. Unfortunately, operationalizing risk has been a problem in organizational research. While efforts have been made to utilize measures, they have generally been industry specific and limited in scope (Reger, Duhaime & Stimpert, 1992). An apparent flaw in organizational research in general and entrepreneurship research specifically is the use of raw performance data in which there is no adjustment for risk. We have utilized a framework for incorporating specific (theory-based) aspects of risk and operationalized those risks such that they could be used by future researchers to account for inherent threats to the organization. We believe that more sophisticated studies can emerge from this study on both the conceptual as well as methodological level.

The authors are indebted to both Dean Shepherd and Garry Bruton for their input on earlier drafts of this paper.

1. The S-1 registration statement is filed under the Securities Act of 1933, and is composed of two parts. Part I is the prospectus of an offering, and typically includes information such as: 1) description of the securities to be registered, 2) use of proceeds, 3) risk factors, 4) determination of offering price, 5) potential dilution, 6) selling security holders, 7) plan of distribution, 8) counsel and experts, and 9) various information with respect to the registrant. Part II of the registration contains information not required in the prospectus and typically includes: 1) expenses of issuance and distribution, 2) indemnification of directors and officer, and 3) exhibits and financial statements.

CONTACT: Charles E. Bamford, Texas Christian University, M.J. Neeley School of Business, 365 Dan Rogers Hall, TCU Box 298530, Fort Worth, TX 76129; (T) 817-257-7280; (F) 817-257-7227; c.bamford@tcu.edu

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