Venture capital has developed as an important intermediary in financial markets, providing capital to firms that might otherwise have difficulty attracting financing. These firms are typically small and young, plagued by high levels of uncertainty and large differences between what entrepreneurs and investors know. Moreover, these firms typically possess few tangible assets and operate in markets that change very rapidly. Venture capital organizations finance these high-risk, potentially high-reward projects, purchasing equity or equity-linked stakes while the firms are still privately held. The venture capital industry has developed a variety of mechanisms to overcome the problems that emerge at each stage of the investment process. At the same time, the venture capital process is also subject to various pathologies from time to time, which can create problems for investors or entrepreneurs.
A lengthy literature has discussed the financing of young firms. Uncertainty and informational asymmetries often characterize young firms, particularly in high-technology industries. (1) If the firm raises equity from outside investors, the manager has an incentive to engage in wasteful expenditures (like lavish offices) because the manager may benefit disproportionately from these but does not bear their entire cost. Similarly, if the firm raises debt, the manager may increase risk to undesirable levels. If all the outcomes of the entrepreneurial firm cannot be foreseen, and effort of the entrepreneur cannot be ascertained with complete confidence, it may be difficult to write a contract governing the financing of the firm.
These problems are especially difficult for companies with intangible assets and whose performance is difficult to assess, such as early stage, high technology companies with a heavy reliance on R&D. Entrepreneurs might invest in strategies research, or projects that have high personal returns but low expected monetary payoffs to shareholders. For example, a biotechnology company founder may invest in a certain type of research that brings great personal recognition in the scientific community, but provides little return for the investor. (2) Entrepreneurs may receive initial results from market trials indicating little demand for a new product, but may want to keep the company going because they receive significant private benefits from managing their own firm. (3) In addition, entrepreneurs have incentives to pursue highly volatile strategies, such as rushing a product to market when further testing may be warranted, because they benefit from success but do not actually suffer losses from failure. As a result, external financing for these firms is costly or difficult to obtain.
Specialized financial intermediaries, such as venture capital organizations, can alleviate these information gaps and thus allow firms to receive the financing that they cannot raise from other sources. The tools that venture capital firms have to address these information issues are to scrutinize firms intensively before providing capital and then to monitor them afterwards.
(4) In fact, venture capitalists do concentrate investments in early-stage companies and high technology industries where informational asymmetries are likely to be most significant and monitoring most valuable. When venture capitalists learn negative information about future returns, the project is cut off from new financing.
Lerner (1994a) tests this “second opinion” hypothesis in a sample of 271 biotechnology venture capital investments. He finds that in the early rounds of investing, experienced venture capitalists tend to syndicate only with venture capital firms that have similar experience. This finding supports the second opinion hypothesis, since a venture capitalist looking for a second opinion would want to get a second opinion from a firm of similar (or better) ability, rather than just looking for money from any other firm.