Staging Venture Capital: Empirical Evidence On The Differential Roles Of Early Versus Late Rounds

A characteristic feature of venture capital funding is its staged structure. Startup firms do not receive all the funding they need to achieve profitability in their first round of venture funding. Rather venture capitalists invest in stages and their investment today does not commit them to future funding. The theoretical literature has examined this feature of venture capital investments beyond its signaling value. An important theoretical prediction is that the first round of funding has a different role compared with follow-up rounds. The objective of the first round is to provide capital to a cash-constrained entrepreneur. After this first round, an agency relationship is established between the entrepreneur and the investor or between inside and outside investors. Follow-up rounds are intended to mitigate the agency costs associated with this relationship. While these agency costs may arise for different reasons, in all models these follow-up rounds happen before the startup firm hits its cash constraint. Objectives other than removing a cash constraint take precedence in follow up rounds. The results in this paper provide evidence consistent with this differential empirical prediction. Finally, the paper also examines whether funding rounds have different signaling value within the firm. Staging Venture Capital: Empirical Evidence On The Differential Roles Of Early Versus Late Rounds The fundamental need for funding in startup firms comes from the entrepreneur’s wealth constraints. The entrepreneur needs funds to finance the firm from inception until it becomes cash flow positive. Venture capitalists provide the funds required to overcome cash limitations during the initial stages of a firm’s life, before the uncertainty of the venture is reduced and alternative sources of funding become available. The relevance of venture capital funding events is reflected in their signaling value. While wealth constraints explain the initial funding of a start up firm, they do not explain the need for staged funding. Staged funding is a salient characteristic of venture capital investing. Rather than committing their funding upfront, stage funding allows venture capitalists to periodically update their information about the firm, monitor its progress, review its prospects, and evaluate whether to provide additional funding or abandon the project. Staged financing provides venture capital with a real option. This option can be exercised or abandoned over time as the uncertainty about the startup firm is reduced. Staged financing is also advocated as a control mechanism—theoretical models explain this financing structure as a governance mechanism to reduce the agency costs implicit in venture-backed startups. These theoretical models are important to understand the unique nature of venture financing. However, the empirical literature on entrepreneurial finance has limited evidence on the validity of these arguments. This paper provides empirical evidence informative to these theoretical predictions. It examines two questions related to staged funding in venture-backed startups: (1) Do cash constraints more severely limit growth in early funding rounds than in later rounds? (2) Is