Large investors often have market power in private equity markets, such as in venture capital, growth capital, or private placements. The conventional wisdom is that powerful investors can flex their muscles to enforce lower company valuations, at the expense of owners and previous investors. Our paper shows that this logic changes in the context of staged financing where investors shift from being outsiders in their initial investment to becoming insiders in subsequent investment rounds.
We build a theory of staged financing to analyse the effect of investor power on the valuation of a company. We show that whenever there is a powerful investor who is an outsider, he always wants to push down the valuation. However, if a powerful investor already has a stake in the company, there is a trade-off. On the one hand, the powerful investor invests new money and therefore wants a lower valuation, just like an outsider. On the other hand, he already has a stake in the company, and prefers a higher valuation, just like an insider. The net preference depends on the relative sizes of the existing stake versus the new investment. Our theory provides a simple condition that says that a powerful investor prefers a higher (lower) valuation whenever his follow-on investment is below (above) the so-called pro-rata threshold. The important and novel finding is that within a staged financing context, market power may increase, not decrease, company valuations.
This raises the question whether and when a company wants to bring a powerful investor inside? We compare a scenario where the company obtains first-round funding from a powerful investor, with the scenario where the company delays bringing in a powerful investor until a later financing round. We find that first-round valuations are lower when the powerful insider participates in the first round. At first glance this might suggest that bringing in the powerful insider up-front is a bad idea. However, once inside, the powerful investor increases valuations in later financing rounds. The question becomes whether the higher valuations in later rounds can justify the lower first-round valuation? Our formal analysis shows that the company always prefers to bring a powerful investor inside at the first round. The key intuition is that even though the company does not like investor power, if it exists and cannot be averted, it is better to befriend it up-front. This is because once the powerful investor is inside; his market power is used to protect the interest of the company: ‘May the force be with you.’
The model also generates some predictions about investment returns. Looking at the final realized returns of early investors, we note that powerful insiders have the highest returns. In later rounds, however, we find that powerful insiders record lower returns, whereas powerful outsiders record higher returns. The analysis also shows that unrealized interim returns need to be interpreted with caution. For example, smaller early stage investors without market power experience low interim returns when a company is financed by a powerful outsider in a later round. However, these are not realized returns. In fact, these early stage investors achieve higher returns between the late stage financing rounds and the date where value is realized. The theory thus generates a useful warning against using unrealized interim returns as an empirical proxy for expected realized returns.
Thomas F. Hellmann is Professor of Entrepreneurship and Innovation at University of Oxford, Said Business School.
Veikko Thiele is Associate Professor and Distinguished Faculty Fellow of Business Economics at Queen's University, Smith School of Business.