Explaining returns to acquirers of venture capital backed information technology firms : bargaining or the real option hypothesis

The purpose of this thesis is to determine whether the presence of venture capital has an effect on the announcement returns of a US acquirer of a US private information technology (IT) firm, and to determine whether this effect can be explained by either of two hypotheses taken from the literature. Venture capitalists have extensive experience in the IT sector, having placed over 50% of their funds into IT firms, which have accounted for approximately 75% of their revenue. Furthermore, venture capitalists sell almost twice as many IT firms to acquirers as they take public in IPOs. While the literature on venture capital involvement in IPOs is extensive, there is no published work on the role venture capitalists in acquisitions and little consideration given explicitly to the importance of the IT sector. The bargaining hypothesis proposes that bargaining may influence the distribution of surplus value in an acquisition (the difference between the value of a firm as a standalone entity and its value in the hands of an acquirer). It states that venture capitalists will bargain effectively on behalf of their investments so that the portion of the swplus accruing to the acquirer, which is reflected in their announcement returns, will be reduced. The real option hypothesis proposes that venture capital backed firms are more R&D intensive and less mature at acquisition than other entrepreneurial firms, having created but not commercialized their technologies, such that they closer represent real options. In a multiple bidder context, as valuations of real options suffer fiom an increased information asymmetry, the winner’s curse should be amplified with a venture backed target causing an acquirer’s investors to believe that their firm has overpaid. This too would act to reduce announcement returns. Using an event study methodology to examine acquisitions from the period 1980 to 2004, this research finds that announcement returns for acquisitions of venture backed IT firms are reduced. The effect of venture capitalists’ reputations, and the finding that venture capital backed firms may be less R&D intensive, lends more support to the bargaining hypothesis as an explanation of this result.Business, Sauder School ofGraduat