When Equity is Not Enough:

Signaling through Venture Capital Debt

Indraneel Chakraborty and Michael Ewens∗

May 18, 2011

Abstract

We analyze the signaling content of the capital structure decisions of venture capital-
ists and entrepreneurs. Debt financing provided by inside investors (specifically venture
capital investors) conveys negative information regarding the firm to outside investors.
This relationship contrasts with positive signal of debt obtained from external investors
for public firms. Using a comprehensive database of venture capital transactions from
1990-2010, we find empirical support for the role of VCs as information providers. Firms
that issue debt have a 45% lower probability of an non-liquidation exit which is not
driven by defaults. The growth prospects of a firm, as measured by market to book,
falls on an average approximately 20% after a debt round. The signaling role of the VCs
is less important for firms that may have other mechanisms to convey quality, such as
positive revenues and profitability.

∗
Edwin L. Cox School of Business, Southern Methodist University (ichakraborty@cox.smu.edu) and Tep-
per School of Business, Carnegie Mellon University (mewens@cmu.edu). Chris E. Fishel provided excellent
research assistance. We are grateful to VentureSource and Correlation Ventures for access to the data and
participants at the Tepper School finance seminar for their helpful comments.

1
 Venture capitalists and entrepreneurs chose equity investments for over 85% of financ-

ing events from 1990 - 2010. According to received theory, outside investors – less informed

than insiders – interpret debt financing as a positive signal of investment opportunities.1

The signaling content of the choice of debt by venture capitalists and entrepreneurial firms

is not as well understood. Classical models such as the pecking order and trade-off theory

are not suited for this environment as entrepreneurial firms interact with inside investors

and often have little benefit from interest tax shields. The preference for equity in venture

capital financed firms mimics the security choice of small, publicly-held growth firms and

non-dividend payers.2 Understanding the capital structure decisions in the venture capital

market can shed light on the role of inside investors, information asymmetry and signaling

in entrepreneurial finance outcomes such as IPOs and acquistions.

As an inside investor, the venture capitalist not only provides capital to a firm, but also

works closely with the management as an adviser and monitor. Specifically, venture capital

providers generally have an in depth knowledge of the entrepreneur’s industry and firm op-

erations (see Lerner (1995) and Hellmann and Puri (2002)). This paper asks the following

questions: (i) Does the choice of financing contract (debt, equity seniority, liquidation prefer-

ence) between the inside investor and entrepreneur signal information to outside investors?

(ii) If so, what is the mapping between information and contract features? Answers to these

questions shed light on how inside investors such as venture capitalists and banks bridge

information asymmetry between firm management and outside investors. VCs bridge infor-

mation asymmetry regarding firms’ prospects through their choice of financing contracts in

consecutive stages of capital infusion - debt, liquidation preference and equity seniority.3
1
Seminal work includes Ross (1977), Leland and Pyle (1977) and Myers and Majluf (1984).
2
See Frank and Goyal (2003) and Fama and French (2002).
3
Another financing contract choice available to an inside investor is to finance the firm completely through

equity at a discounted rate. This paper focuses on explaining why do we observe VC debt contracts in prac-

tice, and how should we interpret the relation between VC debt and future outcome of the firm. Most VC

2
 We make two departures in terms of modeling assumptions: (i) The financier is an in-

side investor, who does not suffer from information asymmetry with the entrepreneur. (ii)

Due to severe information asymmetry with external markets, the inside investor and en-

trepreneur make a joint decision regarding financing contracts. The intuition behind the

negative signal associated with debt is as follows: If the inside investor learns about a large

drop in prospects of a firm going forward, then she prefers financing the firm with a smaller

equity stake and providing the remaining financing through debt. Here, the expected re-

turn on debt, which is a senior claim to the firm’s cash flow, exceeds sharing a fraction of

the firm’s return to its equity holders. The entrepreneur accepts such an offer because she

is better off by continuing firm operations and the large information asymmetry with out-

side investors restrict their ability to infer the quality of these nascent firms. The outside

investors receive a negative signal about the firm when VCs finance the firm through debt.

We document empirical evidence in support of the signaling channel and find that indeed,

firms that obtained VC debt in earlier rounds of financing suffer from lower prospects going

forward even though all debt is paid off in the subsequent round.

We start with a simple two-period model where an entrepreneur has an idea for a project

and seeks capital to fund it. An important assumption is that there are several stages of

financing necessary for the project to continue. The severe information asymmetry with

external financiers leaves the internal investor, the VC, as the only feasible source of capi-

tal. The amount of investment necessary in each stage is pre-determined. If the project is

continued, the VC chooses the payoff contract for providing the necessary capital and offers

it as take-it-over-leave-it to the entrepreneur. We assume that the inside investor observes

financing is equity financing, but when the deterioration in firm quality is large, we argue that this financing

method would require taking away a large fraction of equity from the entrepreneur that may create incentive

incompatibility between the inside investor and entrepreneur. Debt contracts, equity seniority or liquidation

preference reduce incentive incompatibility while allowing the firm to obtain financing.

3
private information about the project’s quality at each stage. The entrepreneurs always

chooses to continue the project since she has no capital invested and shares the equity re-

turns. The entrepreneur can improve the quality of the project through costly effort. The

VCs provide the signal through a choice of financing contract that evolves as they them-

selves learn more about the firm prospects. Outsiders interpret inside investors preference

for debt over equity as a signal of lower expectations for the firm’s future growth. Further-

more, to motivate entrepreneurs to exert higher effort after downward revision of quality,

the inside investors reduce entrepreneur’s payoff in mediocre outcomes. Outside investors

use such signals to reduce adverse selection problems when firms seek public equity or debt.

The model makes several testable predictions regarding project quality and VC financ-

ing contract features observed in practice: (i) If a venture capital provider chooses a con-

tract that is more or less sensitive to firm’s prospects than the equity contract, then the

venture capital provider expects the project’s quality to be worse or better respectively than

previously anticipated. (ii) The increase in an entrepreneurial firm’s debt to equity ratio

is proportional to the revision in quality of the project. So the future performance of the

project and probability of external financing can be anticipated by the debt to equity ratio

of the firm. (iii) The higher the liquidation preference of the new VC, the more incentive

he seeks to provide to the entrepreneur to increase effort. If the new VC is apprehensive of

information asymmetry with the firm, industry or the incumbent VCs, he requests a higher

liquidation preference and/or senior equity position.

We use VentureSource, a comprehensive database of venture capital transactions that

covers 1990-2010 to obtain empirical evidence in support of our inferences. VentureSource

collects their data on venture-capital backed companies with surveys of venture capital-

ists and entrepreneurial firms. VentureSource claims near perfect coverage of 1992 to the

present for all entrepreneurial firms that received capital from a venture capitalist. We ex-

ploit the financing-level information on entrepreneurial firms that include equity, debt and

4
exit (i.e. acquisitions and initial public offerings (IPOs)) events. The sample has 22, 179

firms out of which 11.7% had a debt round. Firms that have a debt round have a 45% lower

probability of an IPO or acquisition compared to the mean likelihood of 34%. We also find

that the valuation of a firm, as measured by market to book, falls on an average approxi-

mately 20% after a debt round. However, if the firm has positive revenue, then the reduction

in firm valuation is much less. Furthermore, if the firm is profitable, then the reduction in

firm value is negligible. Thus, the signaling role of the VCs is less important for firms that

may have other mechanisms to convey quality, such as positive revenues and profitability.

We also find a positive and significant correlation between past downward movements in

firm value and increases in liquidation preference or the use of senior equity. These rela-

tionships suggest that investors shift to debt-like contract features in the face of negative

revisions to firm quality.

This paper contributes to the extensive literature on venture capital financing and sig-

naling through capital structure decisions. Green (1984) analyzes the use of conversion

features and warrants to control distortionary incentives in a general framework. Lerner

(1994) finds that the timing of initial public offerings and private financings by venture cap-

ital firms are pro-cyclical and countercyclical respectively. Kaplan and Stromberg (2003)

compare the characteristics of real-world financial contracts to their counterparts in finan-

cial contracting theory. The distinguishing characteristic of VC financings is that they allow

VCs to separately allocate cash flow rights, board rights, voting rights, liquidation rights,

and other control rights. They find that the allocations of cash flow and control rights

and the use of contingencies are related in systematic ways and call for additional the-

ory. Our paper postulates that the state contingent contracts between inside investor and

entrepreneurs signals information about revision of probabilities of respective states.

Schmidt (2003) and Hellmann (2006) provide explanation for the use of convertible se-

curities in venture capital. They build a model with double moral hazard, where both the

5
entrepreneur and the venture capitalist provide value-adding effort. The optimal contract

in Hellmann (2006) gives the venture capitalist more cash flow rights in acquisitions than

IPOs. This explains the use of convertible preferred equity, including automatic conversion

at IPO. Our paper does not address a moral hazard issue with respect to VCs, but rather fo-

cuses on the signal provided by the choice of contracts. Bengtsson and Sensoy (2009) analyze

the evolution of venture capital contracts and find the majority of cash flow provisions in a

new round contract are recycled from the previous round contract, even when the company

has evolved substantially. Their findings suggest that the tradeoff relevant for changing a

company’s set of financial contracts is different from the tradeoffs relevant for the initial

structuring of this set. We do not analyze the cost of change of contract type through a

firm’s life cycle. In our paper, we focus on the role of inside investors in signaling future firm

prospects to outsiders when they choose to change contract type.

This paper also contributes to the literature on signaling through capital structure de-

cisions. Compared to traditional theories of financing (see Myers and Majluf (1984) and

DeMarzo and Duffie (1999)), where issuance of debt by a firm is considered a signal of bet-

ter future prospects, we show that debt financing by inside investors signals worse future

prospects. The driving force behind this result is the ability of the inside investor negoti-

ate the financing contract with the entrepreneur. We believe this departure in assumption

is justified, because severe information asymmetries prohibit outside investors competing

with VCs. VCs negotiate the financing contract composition and features based on updated

assessment of firm quality. A VC will drive the decision of capital structure with the en-

trepreneur towards higher debt in case the expected payoff of a fraction of equity returns is

lower than the expected payoff from a debt contract. The expected return on a debt contract

can be higher even though the coupon is smaller than return on equity because of higher

probability of mediocre outcomes.

Section I presents a simple two-period model and provides testable predictions. Sec-

6
tion II describes the data used in this work. Section III provides supporting empirical evi-

dence. Section IV concludes.

I Model

A Model Intuition

Why should a VC financed firms finance use debt at all? The two dominant theories regard-

ing determinants of firm capital structure are Tradeoff theory and Pecking Order Hypothe-

sis.

Most VC financed firms in early stages of firm life-cycle lack revenues or profits, and

hence any tax shield benefits of debt (See Modigliani and Miller (1963)). Such firms appear

to fit in the classic world of Modigliani and Miller (1958). VC financed firms also have

limited tangible assets that can be pledged as collateral and furthermore, since most of the

firm value is due to growth options, distress costs are severe. These deficiencies reduce

the willingness of both lenders and borrowers to agree to debt financing4 which results in

inapplicability of the tradeoff theory of capital structure for this setting.

The choice of equity financing by VCs is well established as optimal in literature. Tirole

(2005) suggests that “informationally sensitive” securities provide incentive to investors to

value firms accurately and this is especially important for firm with larger uncertainty re-

garding value such as VC backed firms. Admati and Pfleiderer (1994) show that a fixed frac-

tion contract and new outside VC investors can align the interest of existing VC investors

and eliminate the under-investment problem. Existing VC investors in an entrepreneurial

firm making new investment decisions face sharing only part of the upside while paying the

full cost of new investment. This exacerbates the initial puzzle of why do we observe VC
4
See, for example Rajan and Zingales (1995).

7
debt at all.

Modigliani and Miller (1958) assumes that market possesses full information about the

activities of the firm. If information asymmetry between markets and firm managers ex-

ist, then in equilibrium managers transmit information about the firm to external investors

through choice of incentive and financial structure. Myers and Majluf (1984) consider ex-

ternal financing with asymmetric information about firm quality, and show that a firm is

better off issuing safe securities over risky ones in such a setting due to adverse selection.

Thus, a pecking order is established between financial securities where debt is preferred to

equity. As Ross (1977) argues, the models in this literature predict that the cross-section

value of firms will rise with leverage. However, in case of VC firms, we document that firms

that are debt-financed have lower firm value and worse future prospects than firms that

are equity financed. This raises a second question: Why is it that VC backed firms with

debt have worse prospects than their equity financed counterparts? We suggest a possible

explanation of this puzzling fact in this work.

VC backed firms eventually seek capital from external markets, but the source of fund-

ing in the initial stages of firm life cycle are the VCs. VCs possess in-depth knowledge of

firm operations and industry expertise (See Lerner (1995) and Hellmann and Puri (2002)),

and hence cannot be considered uninformed external investors. This is our departure from

Myers and Majluf (1984) setup: Firms financed through VC debt are obtaining financing

from an internal investor rather than an external investor. Eventually, they will seek exter-

nal financing as in Myers and Majluf (1984) setup, but this paper studies the motivations

behind debt raised from an internal investor.

A second departure from Myers and Majluf (1984) setting is the ability of the internal

investor to negotiate the security issued to her by the manager. In contrast to a manager-led

security issue, in this setting the manager and internal investor make a joint determination

on security issuance. We show that when inside investors negotiate to hold less “informa-

8
tionally sensitive” securities, they convey a negative signal about firm quality to outside

investors. The risk neutral internal investor assesses the quality of the firm, and if she real-

izes the quality of the firm is sufficiently worse off than expected by the entrepreneur, then

she negotiates a contract with less equity stake and more debt-like securities to finance

the firm’s liquidity needs. The model does not assume rent extraction, in fact it assumes

zero profit condition for the VC. Hence the VC’s expected payoff in this contract is the same

payoff under entrepreneur’s expectation of firm quality with lower information sensitivity.

Finally, the nature of the entrepreneurial firm contrasts sharply with the typical corporate

finance setting. Finally, unlike the typical representative corporation facing an investment

decisions, entrepreneurial firms are themselves an investment opportunity and often must

make an investment to survive. The typical venture capital investment decision is made in

a staged, real option environment.

B Agents and Investment Opportunities

Assume a risk-neutral world an entrepreneur has a project idea. If the project is successful,

it generates x dollars and in case of failure generates y dollars for unit dollar investment.

The project needs investment at date 0, and further investment at date 1. The project

outcome is realized at date 2, and is successful with probability q and fails with probability

1 − q.

On date 0, the entrepreneur has an expectation of the quality of the project q 0 which

determines if the project is successful. The entrepreneur invests I 0 from her own pocket at

date 0. The entrepreneur approaches other sources of financing for additional investment

I 1 at date 1. On date 2, just before the project outcome is realized, the entrepreneur and

investor at date 1 seek external financing. This timeline assumption allows us to analyze

the determinants of the valuation of the firm by an external financier before the realization

9
of project outcome - which is the main point of this paper. Figure 1 shows the timeline.

We also make the following assumptions:

y≤λ≤1≤r≤x (1)

r ≤ xq 0 + y(1 − q 0 ) (2)

The first assumption is simply that projects when successful pay equity holders x, which

is more than debt holders who get r ≥ 1, i.e. r ≤ x. Similarly, in failure debt holders get λ

where λ ≤ r , which is more than equity holders’ payoff y, i.e. y ≤ λ. The second assumption

implies that the project has an expected positive net present value for the entrepreneur in

this risk-neutral world.

C Finance

Venture capital investors are the intermediate source of finance in this market. This is

the case in practice, because banks are not allowed to take equity stakes in firms due to

regulatory reasons, and arm’s length investors suffer from severe information asymmetry

with respect to the entrepreneur. However, we assume perfect competition between VCs to

abstract from any rent extraction motives. The VCs operate on zero profit.

On date 1, venture capital investors assess the quality q v of the project and finance

the firm. The assumption that the initial round of financing of a VC backed firm is done

by a Venture Capital investor, as compared to public equity or debt markets is empirically

justified. Another way to justify this assumption is that the firm is free to finance itself

anyhow, but the Venture Capital investors can provide cheaper source of financing as they

are able to obtain inside information about the firm that an arm’s length investor is unable

to obtain. This allows the Venture Capital investors to avoid adverse selection and provide

cheaper financing in the initial stages of firm life cycle (See Diamond (1991)).

10
 In practice as well, eventually firms receive financing from external investors, but that

is only after a few rounds of financing from Venture capital investors. On date 2, the firm

receives capital from external investors such as public equity markets.

The financing process is as follows. The entrepreneur goes to a VC and indicates how

much investment she seeks for one period. The VC responds by negotiating a contract

xv , yv that stipulates the payoffs in case of success or failure of the project. If no agreement

is satisfactory to the entrepreneur and the VC, then the project receives no financing. In

what follows, we determine what contract is chosen in terms of the quality of the project q v

assessed by the VC, and how that choice signals firm quality to external investors.

D Solving the Model

On date 1, the entrepreneur obtains financing I 1 from the VC to continue the project.

We represent the contract negotiated between the VC and the entrepreneur as a com-

bination of a debt and equity contract. The firm can borrow debt that pays off r in case of

success and λ in case of failure of the project.

Proposition I.1 The alternate contract sought by the VC is equivalent to a combination of

a debt and equity contract, where the weight of the debt contract is:

∆y ∆x
wd = = , (3)
λ− y r− x

The VC’s preferred contract is less sensitive to success or failure than an equity contract,

i.e. xv ≤ x and yv ≥ y if and only if wd ≥ 0. Similarly, the contract chosen by the VC firm is

more sensitive than an equity contract to the fortunes of the project i.e xv > x and yv < y, iff

wd < 0.

The VC chooses the contract xv , yv to maximize his payoff π:

π∗ = max q v x + (1 − q v ) y = q v xv + (1 − q v ) yv , (4)
x,y

11
 Thus, if the VC prefers a different contract xv , yv over x, y, which is the standard equity

contract, then the payoff must be highest for him with this alternate contract, given the

assessed quality of the project:

q v xv + (1 − q v ) yv ≥ q 0 x + (1 − q 0 ) y (5)

q v xv + (1 − q v ) yv ≥ q v x + (1 − q v ) y (6)

Since the competition between VC’s is perfect, the zero profit condition binds. Thus, the

expected payoff of the VC as perceived by the entrepreneur must be equal to the negotiated

contract, i.e. equation 5 will hold with equality.

Proposition I.2 If a venture capital provider chooses different payoffs xv , yv than the en-

trepreneur x, y then the minimum quality of the project as assessed by the VC q v , in terms of

the previous quality q 0 is given by:

q 0 x + (1 − q 0 ) y − yv
qv ≥ (7)
xv − yv

The risk neutral internal investor assesses the quality of the firm, and if she realizes

the quality of the firm is sufficiently worse off than expected by the entrepreneur, then she

negotiates a contract with less equity stake and more debt-like securities to finance the

firm’s liquidity needs.

The capital structure wd of new financing of a firm conveys information regarding the

revision in quality q − q v of the project.

Proposition I.3 The minimum debt ratio of the financing wd is proportional to the change

in assessed quality of the project:

( x − y)( q 0 − q v )
wd ≥ . (8)
q v ( r − x) + (1 − q v )(λ − y)

12
Debt ratio wd > 0 if q v r + (1 − q v )λ ≥ q v x + (1 − q v ) y, i.e. the expected return of debt given

the quality of project q v is higher than the expected return of equity. The amount of debt is

proportional to the downward revision q 0 − q v in the quality of the project.

Proposition I.3 is a key point of the paper. If VCs estimate that the project quality needs

to be revised downwards then they may prefer contracts that have more debt than equity.

The action of taking debt rather than equity stake, signals lower quality of the firm to

outside investors. This may lead to lower probability of arm’s length financing in the future

as these investors rely on the signals provided by the VCs about the quality of the project.

The higher debt in the capital structure of a firm conveys the signal that internal financiers

are apprehensive of future prospects of the firm.

Thus, the inside investors negotiate to hold less “informationally sensitive" securities.

On date 2, this conveys a negative signal about firm quality to outside investors, which

the external investors take into account in valuing the firm when the firm eventually seeks

external financing. Since the inside investors are showing reluctance to bet on state contin-

gent growth of the firm, the outside investors when their turn eventually comes learn from

this signal and revise the value of the firm downwards compared to an all equity financed

VC firm.

E Empirical Implications

The model makes the following predictions about the relationship between new financing

and project quality: (i) If a venture capital provider chooses a contract that is more or less

sensitive to firm’s prospects than the equity contract, then the venture capital provider ex-

pects the project’s quality to be worse or better respectively than previously anticipated. (ii)

The increase in an entrepreneurial firm’s debt to equity ratio is proportional to the revision

in quality of the project. So the future performance of the project and probability of external

13
financing can be anticipated by the debt to equity ratio of the firm. (iii) The higher the liqui-

dation preference of the new VC, the more incentive he seeks to provide to the entrepreneur

to increase effort. If the new VC is apprehensive of information asymmetry with the firm,

industry or the incumbent VCs, he requests a higher liquidation preference and/or senior

equity position.

The next section provides empirical evidence in support of the model.

II Data and Methodology

A Data

VentureSource

The main data source is VentureSource, a comprehensive database of venture capital trans-

actions that covers 1990-2010. VentureSource collects their data on venture-capital backed

companies with surveys of venture capitalists and entrepreneurial firms. The dataset does

not include financings where corporations or institutions are the only investors in a par-

ticular company. VentureSource claims near perfect coverage of 1992 to the present for

all entrepreneurial firms that received capital from a venture capitalist. Authors such as

Cochrane (2005) and Hall and Woodward (2010) use a variant of VentureSource to study

venture capital and entrepreneurial returns. We exploit the financing-level information on

entrepreneurial firms that include equity, debt and exit (i.e. Acquisitions and initial public

offerings) events.

Data Characteristics

The major variables of interest in VentureSource are type of financing (equity, debt or exit),

financing date, amount invested and valuation. Although recognized as a major source of

14
comprehensive data on venture capital financings,VentureSource suffers from missing val-

uations for equity and exit events. The lack of valuations hinders calculations of market-to-

book ratios or changes in valuation. Cochrane (2005) uses a selection correction methodology

to deal with missing valuations. We use the estimated model in Hall and Woodward (2010)

to impute equity valuations when it is missing. Hall and Woodward (2010) address the prob-

lem using an outside database of approximately 1,000 venture capital financings with full

and correct information. The sample allows estimation of a model that relates basic features

of financings such as the sequence number and dollars invested to reported valuations.5

The authors compare imputed valuations to those reported and find no significant bias. The

relatively strong relationship between a small set of observables and entrepreneurial firm

valuations confirms Bengtsson and Sensoy (2009) finding of significant contract inertia in

venture capital term sheets over the life of a firm’s investments. Approximately 26, 000 or

51% of the financings require this treatment.

Using a set of 190 financings provided by a large venture capital firm, we are able to

compare the predicted valuations from the model to valuations used in practice. A regres-

sion analysis with controls such as industry, year and firm region shows insignificant bias

(mean, median difference of 0). Furthermore, a comparison of the reported valuations in

VentureSource to the predicted valuations also shows no significant bias. The only way the

predicted valuations could impact our empirical results is if the model systematically mis-

predicts values before and after debt events with different bias. We find no evidence of such

misspecification, and hence are confident with our imputation methodology that follows Hall

and Woodward (2010).

5
See the Appendix in Hall and Woodward (2010) for the details.

15
Debt event

The model’s main empirical predictions about debt in venture capital contracts requires a

measure of leverage. VentureSource provides a financing classification that can separate

equity and debt events. The latter include straight debt, credit, venture leasing (i.e. capital

leases) and bridge loans. We focus only on the first three debt types, as VentureSource’s

methodology in recording historical bridge loans has changed over time. Table I provides a

count of debt events since 1997. Prior to 1997, debt was a less common feature of venture

capital investments. Figures 2 and 3 show that debt issuance has increased dramatically

since its fall in 2002. Over the last 5 years, debt accounted for about 6% of all venture capital

dollars. Lerner (1994) finds that the timings of initial public offerings and private financings

by venture capital firms are procyclical and countercyclical respectively. Kaplan and Schoar

(2005) investigate the performance and capital inflows of private equity partnerships, and

find that at the industry level, fund performance is procyclical. Following this literature, we

also note in Figure 3 that financing is procyclical and debt financing as a fraction of total

financing is countercyclical in our sample.

Debt raised by venture capital-backed firms have some features unique to the asset class.

First, most debt contracts include warrant coverage. The main risk faced by lenders in this

market is financing risk, i.e. will the entrepreneurial firm raise another equity round. If

another financing round follows, the debt holders will receive their capital back and poten-

tially redeem their warrants. Next, entrepreneurial firms borrow the money from firms that

specialize in lending to VC-backed firms. In the model, we combine the financing contract

of all new investors, however in practice the financing may be done by multiple investors

with varying contracts. This paper is silent on the issue of information asymmetry between

various outside investors, and treats them as one combined entity. Last, the interest rates

16
on the debt typically range from 10-15% and have 3-4 year payment schedules.6

B Sample Description

Figure 4 shows the number of financings per year (non-exits) since 1990. A large increase

in the fraction of debt financings occurred in 2010. The breakdown of debt is in basic debt,

venture leasing (i.e. collateralized debt) and credit lines. Credit lines are offered by existing

investors in the entrepreneurial firm, while debt and venture leasing is typically lent by

firms that specialize in such securities.

Table II summarize the three measures of firm quality for firms that did and did not

receive debt: M /B, post-money valuation and pre-money valuation. If an exit event has a

known valuation, we include it in the sample (including liquidations). None of the measures

differ across the sub-samples, however, there is a slight difference in post-money valuations.

The table also details the had debt variable for the firms that ever received debt. The

variable “After Debt” is equal to one for all equity or exit events after a firm’s first debt

event. Thus the 47% shows that almost half of the equity events of the average firm that

raises debt occur after the debt round.

We apply the following filters on the sample of firms before testing the model. First,

we exclude firms whose only financing is a debt round, because their capital structure is

degenerate. We remove firms that raised over $100m in debt as over 70% of all their capital

raised came from large PE or hedge funds. There are six such firms. We are left with 2602

firms that ever received debt out of total of 22179 (11.7%). If we focus on the post-1997

era, 12.5% of entrepreneurial firms raised debt. The average amount borrowed is $6.3m,

which compares to a average equity investment of $8.3m. Table III provides further detail

on the sample of firms, by industry, number of financings and geography. The difference
6
Lerner (2000) discusses many of the typical features of venture debt.

17
test column in Table III presents the t-tests of the means of the variables by debt and non-

debt firms where a negative values implies firms that issue debt had a larger value. Firms

that issue debt are more likely to be biotech, still private and located outside of California

and New York. Moreover, such firms are older and raise more capital, suggesting that VCs

may use debt to sustain their investments. Table IV shows that firm characteristics remain

similar even if only post-1997 sample is considered.

C Empirical Specification

The empirical implications of the model regarding venture capital investments is in terms of

a ratio of debt and equity contracts. To test the implications, we focus on financing rounds

where firms issue straight debt. This allows us to clearly identify the change in capital

structure in such periods. To test the implications of the model, we will use the binary

variable that is switched on when a firm takes debt, and also the amount of capital raised

as debt. Both of these information are available for each financing round.

Evidence from Cross-Section

The simplest test of debt’s signaling role is a comparison of the set of entrepreneurial firms

that ever borrowed money and those that did not. The model predicts that the firms that

raised debt had a downward revision in quality. If the downward revision is permanent

or does not mean-revert, then we would expect firms that ever raised debt to have worse

exit outcomes. Exits include initial public offerings, acquisitions or liquidation. The first

two outcomes are positive for venture investors and a sensible measure of performance.7

Consider the variable “Had Debt” which equals one if the firm ever raised debt. We expect

that a simple regression of exit status on the variable to show a negative relationship. Of
7
The IPO event is often used to study the cross-section of VC fund performance (e.g. Hochberg, Ljungqvist,

and Lu (2007)

18
course, any significant relationship is merely evidence of the model and not an estimate of a

casual relations. A negative relationship could be explained by time-invariant, unobserved

heterogeneity between firms with and without debt.

Evidence from Time Series

A panel regression where the unit of observation is the financing event of the entrepreneur-

ship is a more rigorous test of the empirical implications derived in Section I. There, a

change in the firm’s debt to equity D /E ratio correlates with a change in firm quality. We

will estimate the following econometric specification for each entrepreneurial firm i :

Vi,t+1 = α i + βD /E i,t + γ Z i,t + ν i,t , (9)

where Vit is a measure of firm quality at time t + 1, α i is the firm fixed effect, D /E i,t is

the firms debt-to-equity ratio at time t and Z i,t is a series of time-varying firm and market

characteristics. ν i,t is the idiosyncratic error that varies across firms and time. Each firm

financing event is indexed by t; however, the time period between two financing events is not

constant. The duration between financing events depends on the change in firm value. The

empirical predictions (i) and (ii) suggest the sign of the coefficient β on firm leverage. If an

increase in the D /E is a negative signal generated by inside investors regarding firm quality,

then β < 0. Empirical implications derived from Section I suggests that the inside investors

choose to finance the firm through a claim less sensitive to equity, or through higher debt

to equity ratio if they expect the firm’s future prospects to diminish. The panel event study

estimates from equation (9) control for any time-invariant differences between firms that

issue debt such as industry, VC quality or location.

Estimation of equation (9) requires a measure of sensitivity of inside investor financing

contract to equity (Implication (i)). We use an indicator variable for the debt event as a mea-

sure of sensitivity of inside investor’s financing contract to equity. We also use a continuous

19
variable of debt to measure the incremental impact of higher debt offered by inside investors

on future firm prospects (Implication (ii)). If debt is offered by the inside investor, then the

sensitivity to equity investment is lower. The estimation also requires a measure of firm

quality. We employ two different variables to proxy firm quality. The first is growth oppor-

tunities as measured by market-to-book: M /B. We calculate M /B at each equity event using

the reported or imputed valuation and define book assets B as the lagged capital stock. An

alternative measure of quality is valuation of the firm. In a venture capital setting, this is

either the pre- or post-money valuation, the latter reporting the value of the firm after an

equity investment. Regardless of the measure of quality, Testable Implication (i) predicts a

negative relationship between current quality and past debt issues. A statistically and eco-

nomically significant coefficient on β captures the average reduction in quality before and

after debt.

III Empirical Evidence

A Cross-Section of Debt Rounds and Outcomes

We start by asking if venture capital debt a bad signal for entrepreneurial prospects as

measured by exit opportunities. Table V reports the results of a probit estimation of a

positive outcome variable on the existence of a debt round. The dependent variable is equal

to one if the entrepreneurship exited via an initial public offering (IPO) or acquisition. All

regressions include controls for firm industry. The variable “Had debt” is equal to one if

the entrepreneurial firm had at least one debt round during its lifetime. For the first three

specifications, the unreported marginal effects suggest that a debt round is associated with

an approximately 45% lower probability of an IPO or acquisition outcome (compared to the

mean likelihood of 34%). Column (3) considers all firms founded prior to 2003 so as to ensure

20
ample time for either liquidation or positive exit.

Column (4) replaces the simple binary variable of a debt event with the debt as a fraction

of all capital raised.The coefficient of −.9 shows that a firm with the median fraction of debt

(12%) has a 11% lower probability of an IPO or acquisition than a firm that never issues

debt. This supports implication (ii).

To address any possible unobserved differences in firms that receive debt such as their

quality or the types of investors, we use panel regression to identify the impact of choice of

debt financing by inside investors in the following section.

Liquidation preference

To obtain empirical evidence in support of Implication (iii), we test the relationship between

liquidation preference and outcomes. For this, we hand-collect data regarding contract fea-

tures of VC-backed entrepreneurial firms for a random sample of over 300 firms. The source

of this data is the actual VC contracts in each stage of financing obtained from VC Experts.

Table VI presents the basic correlation between financing contract features and valuation

changes. Table VII focuses on the sub-sample of firms that raised debt. The binary vari-

able “Had liquid. > 1×” equals one if the entrepreneurial firm ever had a financing contract

with greater than 1× liquidation preference. A liquidation preference of x units implies that

in case of liquidation, the VC firm will have claims to $ x for each dollar invested in the

firm. Thus, liquidation preference in a typical equity financed VC contract is similar to debt

in case of firm liquidation. Bengtsson and Sensoy (2009) and the VC Experts Inc. report

that approximately 25% financings have such features. We also include a contract feature

of preferred stock “Participating Preferred” which is a VC-friendly structure that includes

both downside protection and conversion rights (rather than the choice). “Senior equity”

and “Equal equity” represent the capital structure hierarchy between the current equity

investors and existing investors.

21
 A correlation of 12.5% between firms that had a down round in the past and firms with

higher liquidation preference suggests that investors demand higher downward protection

by adding debt-like features to contracts going forward if the firm has had a financing round

where the firm’s prospects were revised downwards. Similarly, we find that incidences

of past falls in valuation predict presence of equity contracts with seniority over existing

shareholders in the future of the firm. These evidences supports implication (iii) that if the

new VC is apprehensive of the firm’s ability to succeed, he requests a higher liquidation

preference and/or seniority.

B Signaling through Changes in a Firm’s Contract over Time

The estimation technique in this case will ensure that the identification of impact of debt

financing on quality is made purely through within firm change in quality between the the

rounds when debt financing takes place as compared to the previous round.

Growth Opportunities

Table VIII presents the estimates from equation (9) using firm’s growth opportunities M /B

as a measure of firm’s quality. The dependent variable is the current firm valuation over

the lagged capital stock, while the independent variable of interest is the indicator that a

debt financing occurred in the past. Columns labeled “Debt” include only the sub-sample of

firms that ever issued debt. Specifications with the full sample of firms introduce a set of

firms where “after debt” is zero for all observations and thus introduce noise in the relevant

estimate. The variables “Profitable” and “Positive revenue” are binary variables to indicate

such states at each of a firm’s financing events. The “1 year Wilshire” return attempts to

capture and time-varying relationship between the market and entrepreneurial firm valu-

ations. The first two columns effectively repeat the cross-sectional estimation in Table V

22
with all financing events and firms. As before, debt correlates with bad outcomes, which in

this setting are lower market-to-book values. The fixed effects estimate of −1.6 in Column

(4) suggests that for firms that obtain debt financing, M /B falls approximately 20% after

the debt financing round.8 The estimation technique in this case ensures that identification

of impact of debt financing is made purely through within firm change in quality between

the the rounds when debt financing takes place as compared to the previous round. This

result confirms implication (i), i.e. that inside investors finance the firm through debt before

a significant fall in growth opportunities that represents firm quality.

To assess the incremental impact of debt on firm’s prospects, Column (6) introduces a

series of interactions of the “after debt” and control variables. The coefficients on “Debt

x Age” and “Debt x Profitable” show that the negative relationship between debt issuance

and firm quality is stronger for younger, non-profitable firms. By noting the coefficients of

“After Debt”, “Profitable” and the interaction term, we infer that the signaling ability of

debt is statistically insignificant for profitable firms. This supports an signaling hypothesis

as manifestly profitable firms have less information asymmetry with the markets than firms

which aspire to be profitable at some point in the future.

The final column addresses any concerns that we include a large sample of firms founded

prior to the era when debt became a significant feature of venture financing (see Figure 4).

Results are similar to all other specifications. We conclude that the evidence regarding

changes in M /B after a debt financing are consistent with the testable implications.

Firm Valuation

Table IX presents estimates from model (9) with the log pre- and post-money valuation as

the measure of firms quality. The sample excludes exit events such as IPOs because the

valuations were not imputed. We focus on the debt sub-sample estimates in columns (2)
8
Note that by construction a post-debt event is an equity financing and thus the debt raised was paid back.

23
and (4). The latter column includes the same interaction terms used in Table VIII. Each

specification indicates that after debt issuance, firm valuation falls. The estimate of −0.9 in

column (2) shows that post-money valuations fall by approximately 35% over all post-debt

equity financings.

The unreported interaction estimates predict that the negative correlation between debt

and valuation falls for profitable firms, although the signal of debt is still significant. The re-

sults for pre-money valuations are similar. The exclusion of exit events from the sample also

provides a robustness check on earlier estimates that could be driven by the large downward

revisions in firm value or M /B in liquidation. Combined with the estimates in Table VIII,

we provide robust evidence consistent with testable implications obtained from Section I,

i.e. the choice of debt financing by inside investors and an increase in an entrepreneurial

firm’s debt-to-equity ratio predicts a fall in firm value or growth opportunities.

C Robustness Tests

The estimates of “After debt” in Table VIII and IX are the average fall in valuation for all

equity events after debt financing. Table X attempts to pin down the timing of the fall

in M /B after a debt issue. The introduction of an additional independent variable “2nd

round after debt” is one for the second equity after after the debt issue. The estimate for

“After debt” in column (1) of −1.5 and for “2nd round after debt” of −1.2 in column (3) are

statistically indistinguishable, suggesting that the fall in valuation after debt financings

typically occurs two or more rounds after the debt financing. Table XI repeats the exercise

for the estimations with valuation as the dependent variable. The same conclusions hold:

the fall in post-debt valuations occur over a series of equity events.

The results in Table VIII using the M /B did not include first equity events because a

lagged capital stock is unavailable. To address any potential small-sample bias due to drop-

24
ping of lagged capital for the first observation, we assume that the capital stock of the

entrepreneurial firm prior to the first VC investment is one quarter the smallest capital

infusion over the firm’s history.9 Since the growth opportunities of VC-backed firms are

highest when they are young, setting a small initial capital stock is a reasonable assump-

tion for robustness tests.10 Table XII shows the estimates with the imputed initial capital

stocks and M /B. The coefficient estimate for the debt sub-sample without interactions are

−1.4 for the non-imputed sample and −1.9 for those with initial capital stocks. Thus, the

addition of first financing capital stocks produce results consistent with those in Tables VIII

and IX.

Table XIII repeats the estimation of (9) with the sample of firms that have an exit as

of 2010. The coefficients on “after debt” remain statistically significant and negative. In

fact, the estimate of −2.3 in column (4) of Table XIII exceeds the corresponding estimate in

Table VIII. We conclude that a survival bias of still-private firms is not driving the estimated

relationships between firm quality and debt.

Finally, the observed within-firm changes to market to book and valuations could be

driven by two other factors. First, during the financial crisis of 2008-2009 the dollars avail-

able to venture-backed firms fell dramatically as venture capitalists reacted to a weaker

exit environment. Venture debt often acts as a secondary source of capital in such liquidity

shocks and could thus introduce correlation between lower post-debt valuations stemming

from the weaker public markets. Introducing dummies or explicit controls for the years of

the financial crisis have no impact on the results in Tables VIII and IX. The second issue

concerns the type of institution loaning capital to the entrepreneurial firm. In unreported
9
The average minimum investment across all entrepreneurial firms is $5.2, so this assumption sets the

initial capital stock to $1.3m. In practice, a pre-VC book asset value $1.3m is high. The results remain robust

to all fractions less than $1.3m which is one quarter of minimum capital raised.
10
See Korteweg and Sorensen (2010) for evidence of early stage entrepreneurial firm returns and growth

stocks.

25
results, we separate venture lenders in observed debt rounds from inside investors loan-

ing money to the entrepreneurial firm. Sub-sample regressions using these two loans types

again shows no statistical differences in post-debt valuation or growth opportunities. We

conclude that the empirical relationships are driven neither by time nor lending institution

effects.

IV Conclusion

We study the signaling content of the capital structure decisions of venture capitalists and

entrepreneurs. In contrast to traditional financing theory of debt overhang where a new

financier is apprehensive of providing debt to a firm since he is junior in the capital structure

of the firm, we argue and provide evidence that a venture capital provider may in some

cases avoid taking an equity stake in the firm. The VCs provide the signal through a choice

of financing contract that evolves as they learn more about the firm prospects. The signal is

that the inside investor (VC) projects the firm’s future growth to be lower than previously

anticipated. Here, the assured returns of debt outweigh a fraction of less assured returns

from growth. The external capital markets use such signals to reduce adverse selection

problems when firms seek public equity or debt.

We present a simple-two period model that makes an important assumption: venture

capitalists and entrepreneurs jointly decide the financing contract because the latter lacks

other sources of financing due to large information asymmetries. The model makes several

testable predictions regarding project quality and VC financing contract features observed

in practice: (i) If a venture capital provider chooses a contract that is more or less sensitive

than the equity contract, then the venture capital provider expects the project’s quality to be

worse or better respectively than previously anticipated. (ii) The increase in debt to equity

ratio of an entrepreneurial firm is proportional to the revision in quality of the project.

26
Thus, the future performance of the project and probability of external financing can be

anticipated by the debt to equity ratio of the firm. (iii) The higher the liquidation preference

l of the new VC, the more incentive he seeks to provide to the entrepreneur to increase

effort. If the new VC is apprehensive of information asymmetry with the firm, industry

or the incumbent VCs, we infer from the model that he will request a higher liquidation

preference and/or senior equity position.

Using a comprehensive database of venture capital transactions from 1990-2010, we

find empirical support for the role of VCs as information signal providers. A debt round is

associated with a 45% decline in the probability of a IPO or acquisition, which is not driven

by defaults. The valuation of an entrepreneurial firm backed by VC, as measured by market

to book, falls on an average approximately 20% after a debt round. However, if the firm

has positive revenue, then the reduction in firm valuation is much less. Furthermore, if

the firm is profitable, then the reduction in firm value is negligible. We also find a positive

and significant correlation between past down rounds and increased liquidation preference

or more senior equity. This relationship suggests that investors demand higher downward

protection by adding debt-like features to contracts going forward if the firm has had a

financing round where the firm’s prospects were revised downwards. Thus, we document

that if debt financing is provided by inside investors (specifically venture capital investors),

then this conveys negative information regarding the firm to outside investors.

27
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29
 Appendix
A VC Contract Features
In this section, we will discuss some key features of VC financing used in practice and link
them to previous discussion of a debt and equity contract. We will also exploit these features
to derive additional testable implications.
First, we will make an additional assumption regarding the payoff of the model. The
project if successful generates extreme return x e with probability θ and with remaining
probability 1 − θ generates mediocre return xm even when successful. Thus, return x in case
of success is an expected return of extreme and mediocre return states:

x = θ x e + (1 − θ ) xm (10)

Financing contracts through VCs have the following unique features:

Liquidation Preference

Suppose that a new VC invests in the firm. If the contract employs an l times liquidation
preference clause, then it means that in case of failure, the VC has a claim on the assets of
the firm as if he lent l I 1 and not I 1 .

Equity Seniority

Suppose that a new VC invests in the firm. If the contract employs an equity seniority clause
then the new VC has full claim to the value of the firm until his investment I 1 is recovered.
Thus even though the VC seems to have a claim on the equity of the firm, the seniority
clause ensures that the VC is paid at least I 1 , as if the firm has issued a convertible debt
to the investor. This allows the investor to hold a senior debt position in the firm while also
giving him the option of a converting the debt to equity if that is more valuable. When the
firm has medium success it allows the investors to still gain higher returns at the cost of the
incumbent investors and entrepreneurs.
Thus the payoffs of these two features for the new VC can be written as:

 xv I 1 if Extreme Success,


Payoff = xv I 1 if Mediocre Success,

lλI1

if Failure.


30
 Both of these features can be represented as a combination of simple debt with weight
wd and simple equity contract with the remaining weight for the new investor:

wd rI 1 + (1 − wd ) xI 1 = xv I 1 if Success
wd λ I 1 + (1 − wd ) yI 1 = l λ I 1 if Failure (11)

In the case of mediocre outcome, the new VC still manages to obtain return x due to
seniority clause. Hence, for him there are only two possible outcomes, success and failure.

A A Case of Equity Overhang

After new financing is obtained on date 1, the conversion of debt to equity provision embed-
ded in the equity seniority clause leads to lower returns for the incumbent investors and
entrepreneurs in the states of mediocre success on date 2. The liquidation preference clause
reduces the payoff of the incumbent VCs and entrepreneurs in case of failure of the project.
Thus the payoffs for I 0 invested on date 0 in presence of these two features for the
incumbent equity holders can be written as:

xe I 0 if Extreme Success,


Payoff = x m I 0 + ( x m − x) I 1 if Mediocre Success,

λ I 0 + (1 − l )λ I 1

if Failure.


The four types of contracts have the following payoffs per dollar invested for the incum-
bent equity holders of the firm where the incumbents invest I 0 on date 0 and new VCs invest
I 1 on date 1:

Equity: qx + (1 − q) y
Equity + Liq. Pref.: qx + (1 − q)(λ − ( l − 1)λ II 10 )
I
Equity + Sen. Eqty.: θ qx e + (1 − θ ) q[ xm − ( x − xm ) I 1 ] + (1 − q) y
0
I I
Equity + Liq. Pref. + Sen. Eqty.: θ qx e + (1 − θ ) q[ xm − ( x − xm ) I 1 ] + (1 − q)(λ − ( l − 1)λ I 1 )(12)
0 0

We now make an assumption about the agent’s cost of effort to compare the optimal
effort expended by the agent in each case:

Assumption A.1 The entrepreneur can affect the probability of success q( e) by expending
effort e, where q0 > 0, q00 < 0. The cost of effort e by the entrepreneur is given by the convex
function ce2 /2.

31
 Under this assumption, using first order condition on effort, the optimal amount of effort
is given by the following respective implicit equations:

c
Equity: q0 / e =x− y
c
Equity + Liq. Pref.: q0 / e = I
x−λ(1−(l −1) I 1 )
0
c
Equity + Sen. Eqty.: q0 / e = I
θ (x e −[xm −(x− xm ) I 1 ])− y
0
0 c
Equity + Liq. Pref. + Sen. Eqty.: q / e = I I (13)
θ (x e −[xm −(x− xm ) I 1 ])−(1−(l −1) I 1 )λ
0 0

When the payoff in failure of the entrepreneurs is less than with simple equity i.e. λ(1 −
( l − 1) II 10 ) < y, then the amount of optimal effort increases for the entrepreneur (by single
crossing property as q’ is strictly increasing and since q00 < 0). This is true for the Senior
Equity case when the payoff of the entrepreneur is reduced in the mediocre case of the firm
I
θ ( x e − [ xm − ( x − xm ) I 1 ]) > x as well. The combined case follows as both the cases work in the
0
same direction of increasing optimal effort by entrepreneur. The new VC is thus inducing
the incumbent equity holders to obtain extreme success outcome.
This is the a key point of the paper. Compared to debt overhang where the new financiers
are apprehensive of the firm taking risk, in this contract the new financiers are apprehen-
sive of muted success and want the firm to aim for extreme outcomes by suppressing the
payoff of the incumbents in the other two states. We use the term Equity Overhang to refer
to this provision of contractual incentives by new VC investors to incumbent entrepreneurs
and VCs to aim for the extreme success outcome.
Since λ(1 − ( l − 1) II 10 < y or θ ( x e − [ xm − ( x − xm ) II 10 ]) > x for optimal effort by entrepreneur to
increase, an empirical inference is that the higher the liquidation preference l or investment
I 1 / I 0 of the new VC, the more incentive he seeks to provide to the entrepreneur to increase
efforts.
Thus, the new VC uses the contract to ensure incentive alignment with the incumbent
VCs and entrepreneur. If the new VC is apprehensive of information asymmetry with the
firm, industry or the incumbent VCs, we infer from the model that he will request a higher
liquidation preference and/or senior equity position.

B Proofs of Propositions
Proof of Proposition I.1: In case of success and failure, the VC’s return xv can be written
as:

wd r + (1 − wd ) x = xv
wd λ + (1 − wd ) y = yv (14)

32
The project pays off r for the debt investment in case of success and λ < r in case of fail-
ure. Also the project pays off x, y respectively in case of success and failure for the equity
investment portion. This yield the weight of the debt contract:

∆y ∆x
wd = = , (15)
λ− y r− x

where the notation ∆ x, y represents the difference in payoffs in the respective states sought
by the VC compared to the previous stage investors, i.e. ∆ x = xv − x, ∆ y = yv − y.
Proof of Proposition I.2:

q v xv + (1 − q v ) yv ≥ q 0 x + (1 − q 0 ) y (16)

We use the notation ∆ q for q v − q 0 to denote the difference in assessed quality of the firm.
By adding and subtracting q v x, q v y respectively on the right hand and left hand side of the
equation, we get:
q v ( xv − yv ) ≥ q 0 ( x − y) − ∆ y (17)

Thus the upper bound on the quality q v perceived by the venture capitalist as compared to
the entrepreneur that will result in the venture capitalist seeking a change in contract in
terms of xv , yv is as follows:
q 0 x + (1 − q 0 ) y − yv
qv ≥ (18)
xv − yv
Proof of Proposition I.3: Given equation 3, we get from equation 18:

q( x − y) − wd (λ − y)
qv ≥ (19)
wd ( r − λ − x + y) + ( x − y)

Finally, we get:
( x − y)( q − q v )
wd ≥ . (20)
q v ( r − x) + (1 − q v )(λ − y)

33
C Figures and Tables

Figure 1: Model Timeline

x Success

qV

$1

1 – qV y Failure

t=0 t=1 t=2

Initial Project Financing Additional Financing Project Return Realized

by Entrepreneur by Inside Investor

Anticipated quality of project q0 Assessed quality of

project qV Additional Financing
By Outside Investor

34
 Figure 2: Debt over Time

Billions of dollars raised in various debt instruments by entrepreneurial firms. “V.L.” is venture leasing. “basic
Debt” is the sum of debt raised by entrepreneurial firm from their own investors and outsiders. “Credit” are
lines of credit typically made available by entrepreneurial firm investors.

35
 Figure 3: Relation between Debt Volume and Debt as a Fraction of Overall Financing

Billions of dollars raised in various debt instruments by entrepreneurial firms. “Fraction Debt” is the total
debt raised in a given year divided by the total amount of capital raised in equity investments.

36
 Figure 4: Total Financings over Time

Count of total equity and debt financings. Source is VentureSource.

37
 Table I: Debt Rounds over Time

Debt type 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total
Credit 0 0 0 3 2 1 23 30 25 17 15 13 21 150

Debt 109 128 144 154 135 132 142 181 187 199 147 344 462 2464

Loan 0 0 0 1 1 0 11 20 11 24 27 15 23 133

VL 10 61 53 49 23 7 16 17 16 10 10 6 3 281

38
Total 119 189 197 207 161 140 192 248 239 250 199 378 509 3028

N 3028
Notes: Count and proportions of debt rounds since 1997. “Credit” applies to all credit lines, credit facilities, and bank loans that the
company receives. Note that there is no exchange of equity, but instead open lines of credit with a fixed or floating interest rate on
the balance. “Loan” is a loan offered to the company, usually by management or one of its investors. “Debt” is a loan offered to the
company from a venture bank or others not currently linked to the firm. “VL” or venture leasing includes investments in companies
that have received at least one round of professional venture capital by corporate leasing agents who take payment in equity as well
as debt. This is usually a debt round that includes a traditional debt structure and may include an equity component in the form of
warrant coverage.
 Table II: Valuations of Debt vs. Non-Debt Firms
No Debt Had Debt Total
M/B 6.932 6.132 6.788
(12.53) (13.38) (12.69)

lagged log K 2.031 2.514 2.118

(1.388) (1.431) (1.408)

log post-$ 2.713 3.277 2.814

(2.197) (1.694) (2.126)

log pre-$ 2.460 2.969 2.551

(2.166) (1.698) (2.099)

After debt 0 0.471 0.0845

(0) (0.499) (0.278)
Observations 37309

Notes: Summary of various valuation measures for entrepreneurial firms. “M/B” measures the
market to book ratio where M is the post-money valuation and K is the lagged capital stock.
“lagged log K” is the summary of the log of this denominator. “log post-$” is the log of the
valuation of the entrepreneurial firm immediately after a VC equity investment, while “log pre-
$” is the valuation immediately prior. “After debt” is equal to 1 for all equity events that occur
after a firm’s first debt financing.

39
 Table III: Characteristics of Firms that obtain Debt and those that do not.
No Debt Had Debt Total Difference Test
Year founded 2000.5 2000.8 2000.6 -0.185
(5.944) (4.756) (5.810) [-1.45]

CA 0.395 0.344 0.389 0.0441∗∗∗

(0.489) (0.475) (0.488) [4.29]

MA 0.104 0.111 0.105 -0.00874

(0.305) (0.315) (0.307) [-1.36]

NY 0.0621 0.0376 0.0591 0.0272∗∗∗

(0.241) (0.190) (0.236) [5.40]

Number financings 3.070 4.054 3.193 -1.078∗∗∗

(1.699) (2.019) (1.772) [-29.38]

Information Technology 0.518 0.457 0.510 0.0581∗∗∗

(0.500) (0.498) (0.500) [5.51]

Biotech 0.203 0.291 0.214 -0.0925∗∗∗

(0.402) (0.454) (0.410) [-10.81]

Publicly-held 0.0977 0.0756 0.0949 0.0158∗∗

(0.297) (0.264) (0.293) [2.64]

Out of Business 0.213 0.127 0.203 0.0779∗∗∗

(0.410) (0.334) (0.402) [9.34]

Acquired 0.279 0.252 0.276 0.0391∗∗∗

(0.449) (0.434) (0.447) [4.09]

Still private 0.392 0.508 0.406 -0.113∗∗∗

(0.488) (0.500) (0.491) [-10.95]

Age at exit or end of sample (yrs) 3.313 5.207 3.550 -1.988∗∗∗

(3.065) (3.448) (3.178) [-29.55]

Total capital raised (log $) 2.286 3.069 2.384 -0.783∗∗∗

(1.561) (1.453) (1.569) [-23.54]
Observations 19790
∗
t statistics in []. p < 0.05, ∗∗ p < 0.01, ∗∗∗ p < 0.001
Notes: Negative differences implies firms with debt had greater mean.
40
Table IV: Characteristics of Firms founded post-1997 that obtain Debt and those that do not.

No Debt Had Debt Total

Year founded 2003.2 2002.5 2003.1
(3.901) (3.326) (3.838)

CA 0.392 0.351 0.387

(0.488) (0.478) (0.487)

MA 0.0985 0.111 0.100

(0.298) (0.314) (0.300)

NY 0.0726 0.0401 0.0682

(0.259) (0.196) (0.252)

Number financings 2.809 3.849 2.948

(1.524) (1.869) (1.614)

Information Technology 0.510 0.465 0.504

(0.500) (0.499) (0.500)

Biotech 0.182 0.283 0.196

(0.386) (0.451) (0.397)

Publicly-held 0.0248 0.0411 0.0270

(0.155) (0.199) (0.162)

Out of Business 0.205 0.105 0.191

(0.404) (0.306) (0.393)

Acquired 0.245 0.225 0.242

(0.430) (0.418) (0.429)

Still private 0.505 0.592 0.517

(0.500) (0.492) (0.500)

Age at exit or end of sample (yrs) 2.733 4.709 2.997

(2.550) (2.997) (2.699)

Total capital raised (log $) 2.164 3.049 2.282

(1.553) (1.449) (1.569)
Observations 14758

41
 Table V: Debt and Exit Outcomes

Notes: Probit regressions where dependent variable is 1 if the entrepreneurial firm exited via IPO
or acquisition as of the end of 2010. “Had debt round” is equal to 1 if the firm ever issued debt.
“Debt/K” is the total debt issued divided by total equity capital raised (= 0 for “had debt round” =
1). “Total capital raised” is the sum of all capital raised by the entrepreneurial firm. “Age at exit
or end of sample” assumes the first observed investment is the founding date of the entrepreneurial
firm and define age as the number of years to an exit or end of the sample (12/31/2010). “Num-
ber financings” is the log total number of financings. All regressions include controls for region and
industry. Column 3 considers only firms founded prior to 2003 so as they time to exit by the end
of the sample period. Standard errors in parentheses. Significance: ∗ p < 0.10, ∗∗ p < 0.05

All All Founded < 2003 All, Debt/K

(1) (2) (3) (4)
IPO or acq.
Had debt round -0.397∗∗ -0.468∗∗ -0.443∗∗
(0.0313) (0.0324) (0.0375)

Debt/K -0.910∗∗
(0.159)

Total capital raised (log $) 0.0495∗∗ 0.223∗∗ 0.0374∗∗

(0.0120) (0.0129) (0.0119)

Age at exit or end of sample (yrs) 0.0730∗∗ 0.0506∗∗ 0.0678∗∗

(0.00440) (0.00439) (0.00434)

Number financings 0.851∗∗ 0.498∗∗ -0.167∗∗ 0.488∗∗

(0.0176) (0.0302) (0.0370) (0.0301)
Observations 18930 18928 12075 18928
Pseudo R 2 0.106 0.120 0.060 0.112

42
 Table VI: Contract Features

Notes: Table reports correlations between each variable for the the equity contract features of 318 firms
(193 which raised a debt round) where we could collect information. “Partic. Pref.” is one if the preferred
stock in a round is participating preferred (a VC-friendly contract), “Senior equity” indicates that current
equity investors have preference over earlier investors and “Equal seniority” (Pari Passu) is equal prefer-
ence. “Past down round” is one if a past financing event was a down round (i.e. fall in valuation) and “Liq.
Pref >1X” is one if the equity event’s contract had a liquidation preference greater than one (i.e. large down-
side protections). The small sample restricts a more thorough regression analysis. ∗ p < 0.10, ∗∗ p < 0.05

(1)

Partic. Pref. Liq. Pref >1X Past down round Senior equity Equal equity
Partic. Pref. 1
Liq. Pref >1X 0.0132 1
Past down round 0.0316 0.125∗∗ 1
Senior equity 0.145∗∗ 0.200∗∗∗ 0.145∗∗ 1
Equal equity -0.0549 -0.241∗∗∗ -0.114∗ -0.765∗∗∗ 1
Firms 318

43
 Table VII: Contract Features: Firms that Raised Debt

Notes: Table reports correlations between each variable for the the equity contract features of 193 firms that raised a debt round where
we could collect information. “Before debt round” is 1 if the financing is before the first debt round. “Partic. Pref.” is one if the pre-
ferred stock in a round is participating preferred (a VC-friendly contract), “Senior equity” indicates that current equity investors have pref-
erence over earlier investors and “Equal seniority” (Pari Passu) is equal preference. “Past down round” is one if a past financing event
was a down round (i.e. fall in valuation) and “Liq. Pref >1X” is one if the equity event’s contract had a liquidation preference greater
than one (i.e. large downside protections). The small sample restricts a more thorough regression analysis. ∗ p < 0.10, ∗∗ p < 0.05

(1)

44
Before debt round Partic. Pref. Liq. Pref >1X Past down round Senior equity Equal equity
Before debt round 1
Partic. Pref. -0.0234 1
Liq. Pref >1X -0.123∗ -0.0878 1
Past down round -0.117 0.0294 0.114 1
Senior equity 0.0208 0.108 0.0718 0.106 1
Equal equity -0.0698 -0.0287 -0.154∗ -0.0634 -0.738∗∗∗ 1
Firms 193
 Table VIII: Market to Book Regressions
Notes: Regressions of entrepreneurial firm market to book (valuation/capital stock) on a series of controls.
Sample includes all equity financings for venture capital-backed firms founded after 1990. The dependent
variable is the entrepreneurial firm’s market to book ratio where valuation is the post-money valuation. If
unavailable, the valuation is imputed using the model of Hall and Woodward (2010). Book in market to
book is the lagged capital stock of the firm. Columns “OLS Debt” and “FE Debt” only include firms that
had at least one debt financing. “FE > 2001” only includes firms founded after 2001. “After debt” is equal
to one for all equity financings or exit events that occur after a debt financing. “Firm” is the age in years
of the entrepreneurial firm at a financing event. “Profitable” is equal to 1 if the firm reported profits and
“Positive Revenue” is equal to 1 if the firm reported revenues. The variable “1 year Wilshire return” is the
return on the Wilshire 5000 from one year prior to the financing. Standard errors in parentheses, clus-
tered at the firm level to address serial correlation in the error term. Significance: ∗ p < 0.10, ∗∗ p < 0.05
OLS All OLS Debt FE All FE Debt FE All FE Debt FE > 2001
(1) (2) (3) (4) (5) (6) (7)
After debt -1.560∗∗ -4.919∗∗ -0.183 -1.371∗∗ -7.027∗∗ -8.062∗∗ -2.613
(0.719) (0.825) (0.515) (0.595) (0.989) (0.988) (1.878)

Profitable 5.174∗∗ -0.582 2.888∗∗ 1.683 2.504∗∗ -1.832 1.184

(0.441) (0.938) (0.594) (2.020) (0.481) (1.684) (1.490)

Positive revenue -0.371∗∗ -3.035∗∗ -1.326∗∗ -3.140∗∗ -1.354∗∗ -3.763∗∗ -1.600∗∗

(0.137) (0.404) (0.236) (0.582) (0.241) (0.688) (0.531)

Firm age (years) -0.899∗∗ -1.251∗∗ -1.435∗∗ -1.072∗∗ -1.523∗∗ -1.669∗∗ -2.075∗∗
(0.0394) (0.0837) (0.0428) (0.0928) (0.0444) (0.117) (0.0867)

1 year Wilshire ret. 5.338∗∗ 5.946∗∗ 3.206∗∗ 2.855∗∗ 3.236∗∗ 2.675∗∗ 0.705
(0.304) (0.832) (0.321) (0.633) (0.346) (0.965) (0.501)

Debt x Age 0.260∗∗ 0.612∗∗ 0.844∗∗ 0.974∗∗ 0.153

(0.0941) (0.116) (0.122) (0.152) (0.273)

Debt x Profitable 0.683 6.438∗∗ 4.107∗ 6.859∗∗ 1.322

(2.055) (2.209) (2.406) (2.228) (4.200)

Debt x Positive Rev. -0.210 2.454∗∗ 2.085∗∗ 3.559∗∗ 2.840∗

(0.498) (0.622) (0.673) (0.792) (1.453)

DebtxWilshire return -1.487∗ -2.095∗ -0.392 0.129 0.961

(0.872) (1.168) (0.903) (1.298) (1.174)
Observations 37601 6756 37601 6756 37601 6756 8883
R2 0.046 0.065 0.105 0.094 0.110 0.112 0.187
Firms 15924 2175 15924 2175 15924 2175 4636
45
 Table IX: Valuation Regressions

Notes: Fixed effect regressions of entrepreneurial firm pre- and post-money valuations on a series of controls. Sample includes all eq-
uity financings (excluding exits) for venture capital-backed firms founded after 1990. The dependent variable is the entrepreneurial
firm’s pre- or post-money valuation . If unavailable, the valuation is imputed using the model of Hall and Woodward (2010). Columns
“Pre$, Debt” and “Post$ Debt” only include firms that had at least one debt financing. Variable definitions as in Table VIII. Standard
errors in parentheses, clustered at the firm level to address serial correlation in the error term Significance: ∗ p < 0.10, ∗∗ p < 0.05

Post$, All Post$, Debt Post$, All Post$, Debt Pre$, All Pre$, Debt Pre$, All Pre$, Debt
(1) (2) (3) (4) (5) (6) (7) (8)
After debt -0.447∗∗ -0.963∗∗ -2.099∗∗ -1.927∗∗ -0.409∗∗ -0.869∗∗ -1.847∗∗ -1.688∗∗
(0.0498) (0.0525) (0.0847) (0.0978) (0.0479) (0.0513) (0.0835) (0.0944)

46
Profitable 0.623∗∗ 0.246∗∗ 0.642∗∗ 0.142 0.591∗∗ 0.205∗∗ 0.618∗∗ 0.153
(0.0544) (0.100) (0.0571) (0.118) (0.0530) (0.100) (0.0557) (0.119)

Positive revenue 0.209∗∗ 0.102∗∗ 0.198∗∗ 0.0331 0.216∗∗ 0.0953∗ 0.208∗∗ 0.0444
(0.0212) (0.0485) (0.0212) (0.0497) (0.0215) (0.0508) (0.0215) (0.0518)

Firm age (years) -0.459∗∗ -0.198∗∗ -0.501∗∗ -0.325∗∗ -0.409∗∗ -0.172∗∗ -0.447∗∗ -0.285∗∗
(0.00873) (0.0140) (0.00950) (0.0213) (0.00803) (0.0134) (0.00870) (0.0200)
Observations 52658 8653 52658 8653 52552 8638 52552 8638
R2 0.461 0.474 0.475 0.503 0.481 0.489 0.493 0.510
Firms 20301 2485 20301 2485 20301 2485 20301 2485
Interactions? N N Y Y N N Y Y
 Table X: Market to Book Regressions: Post-Debt Valuation

Notes: Fixed effect regressions of entrepreneurial firm market to book (valuation/capital stock)
on a series of controls for all firms that ever received debt. Sample includes all equity financ-
ings for venture capital-backed firms founded after 1990. The dependent variable is the en-
trepreneurial firm’s market to book ratio where valuation is the post-money valuation. If un-
available, the valuation is imputed using the model of Hall and Woodward (2010). Book in
market to book is the lagged capital stock of the firm. “Just after debt” is equal to one for the eq-
uity financing or exit event immediately after the debt financing. “2nd round after debt” is equal
to 1 for the second equity event post-debt. Other variables as defined in Table VIII. Standard
errors in parentheses, clustered at the firm level to address serial correlation in the error term
Significance: ∗ p < 0.10, ∗∗ p < 0.05

(1) (2) (3)

After debt -1.371∗∗
(0.595)

Round after debt 0.0397 -0.284

(0.434) (0.465)

2nd round after debt -1.155∗∗

(0.436)

Profitable 1.683 1.686 1.710

(2.020) (2.005) (2.004)

Positive revenue -3.140∗∗ -3.181∗∗ -3.151∗∗

(0.582) (0.587) (0.585)

Firm age (years) -1.072∗∗ -1.229∗∗ -1.185∗∗

(0.0928) (0.0665) (0.0689)

1 year Wilshire ret. 2.855∗∗ 2.833∗∗ 2.809∗∗

(0.633) (0.637) (0.637)
Observations 6756 6756 6756
R2 0.094 0.092 0.093
Firms 2175 2175 2175

47
 Table XI: Valuation Regressions: Post-Debt Valuation

Notes: Fixed effect regressions of entrepreneurial firm pre- and post-money valuations on a series of controls. Sample includes all eq-
uity financings (excluding exits) for venture capital-backed firms founded after 1990. The dependent variable is the entrepreneurial
firm’s pre- or post-money valuation . If unavailable, the valuation is imputed using the model of Hall and Woodward (2010). Columns
“Pre$, Debt” and “Post$ Debt” only include firms that had at least one debt financing. Variable definitions as in Table VIII. Standard
errors in parentheses, clustered at the firm level to address serial correlation in the error term Significance: ∗ p < 0.10, ∗∗ p < 0.05

Post$, All Post$, Debt Post$, All Post$, Debt Pre$, All Pre$, Debt Pre$, All Pre$, Debt
(1) (2) (3) (4) (5) (6) (7) (8)
Round after debt -0.394∗∗ -0.474∗∗ -0.567∗∗ -0.391∗∗ -0.361∗∗ -0.428∗∗ -0.494∗∗ -0.335∗∗
(0.0435) (0.0465) (0.0607) (0.0649) (0.0426) (0.0457) (0.0596) (0.0631)

48
2nd round after debt -0.575∗∗ -0.757∗∗ -0.872∗∗ -0.715∗∗ -0.515∗∗ -0.673∗∗ -0.764∗∗ -0.620∗∗
(0.0609) (0.0646) (0.0684) (0.0727) (0.0592) (0.0625) (0.0660) (0.0697)

Profitable 0.624∗∗ 0.281∗∗ 0.686∗∗ 0.321∗∗ 0.592∗∗ 0.237∗∗ 0.657∗∗ 0.310∗∗

(0.0544) (0.101) (0.0569) (0.117) (0.0531) (0.101) (0.0555) (0.118)

Positive revenue 0.209∗∗ 0.118∗∗ 0.237∗∗ 0.211∗∗ 0.216∗∗ 0.111∗∗ 0.243∗∗ 0.202∗∗
(0.0212) (0.0490) (0.0214) (0.0514) (0.0215) (0.0511) (0.0215) (0.0530)

Firm age (years) -0.463∗∗ -0.250∗∗ -0.496∗∗ -0.288∗∗ -0.413∗∗ -0.219∗∗ -0.442∗∗ -0.253∗∗
(0.00870) (0.0147) (0.00947) (0.0210) (0.00800) (0.0139) (0.00868) (0.0198)
Observations 52658 8653 52658 8653 52552 8638 52552 8638
R2 0.461 0.454 0.468 0.463 0.482 0.474 0.488 0.481
Firms 20301 2485 20301 2485 20301 2485 20301 2485
Interactions? N N Y Y N N Y Y
 Table XII: Market to Book Regressions with Initial Capital Stock

Notes: This table reports the results of the same regression as in Table VIII but with the initial cap-
ital stock of the firm (prior to the first VC investment) set to one quarter of the minimum capital
raised. This allows the sample to include all first financings. Standard errors in parentheses, clustered
at the firm level to address serial correlation in the error term Significance: ∗ p < 0.10, ∗∗ p < 0.05

OLS All OLS Debt FE All FE Debt FE All FE Debt FE > 2001
(1) (2) (3) (4) (5) (6) (7)
After debt -3.622∗∗ -5.779∗∗ 0.355 -2.011∗∗ -7.391∗∗ -7.330∗∗ -4.297∗∗
(0.666) (0.722) (0.500) (0.574) (0.895) (0.895) (1.453)

Profitable 5.857∗∗ 1.183 2.143∗∗ 0.551 2.071∗∗ -1.850 1.438

(0.464) (0.912) (0.836) (1.817) (0.845) (1.435) (1.253)

Positive revenue -0.0778 -0.905∗∗ -1.546∗∗ -3.171∗∗ -1.263∗∗ -1.798∗∗ 0.287

(0.121) (0.349) (0.237) (0.500) (0.244) (0.599) (0.439)

Firm age (years) -1.435∗∗ -1.956∗∗ -2.111∗∗ -1.456∗∗ -2.236∗∗ -2.270∗∗ -3.073∗∗
(0.0367) (0.0840) (0.0578) (0.0822) (0.0614) (0.100) (0.0859)

1 year Wilshire ret. 4.329∗∗ 5.743∗∗ 3.006∗∗ 4.442∗∗ 2.938∗∗ 4.746∗∗ 0.152
(0.288) (0.860) (0.376) (0.721) (0.404) (1.064) (0.582)

Debt x Age 0.616∗∗ 1.137∗∗ 1.423∗∗ 1.450∗∗ 1.238∗∗

(0.0939) (0.115) (0.118) (0.137) (0.266)

Debt x Profitable 0.227 4.901∗∗ 2.411 5.490∗∗ -1.628

(1.964) (2.104) (2.471) (2.242) (3.468)

Debt x Positive Rev. -0.218 0.609 -0.0904 0.181 -0.807

(0.487) (0.591) (0.672) (0.782) (1.218)

DebtxWilshire return -0.590 -2.004 0.184 -1.640 2.782∗

(0.970) (1.267) (0.971) (1.405) (1.574)
Observations 56123 9048 56123 9048 56123 9048 16222
R2 0.072 0.119 0.129 0.139 0.134 0.160 0.202
Firms 15924 2175 15924 2175 15924 2175 4636

49
 Table XIII: Market to Book Regressions: Exited Firms

Notes: This table reports the results of the same regression as in Table VIII but with the sample
of firms that exited via IPO, acquisition or liquidation as of 2010. Standard errors in parentheses.
Significance: ∗ p < 0.10, ∗∗ p < 0.05

OLS All OLS Debt FE All FE Debt FE All FE Debt FE > 2001
(1) (2) (3) (4) (5) (6) (7)
After debt -1.668∗∗ -6.089∗∗ -0.0730 -2.080∗∗ -8.524∗∗ -9.546∗∗ -2.388
(0.512) (0.744) (0.519) (0.610) (1.141) (1.162) (2.255)

Profitable 1.714∗∗ -0.375 3.048∗∗ -0.116 2.671∗∗ -2.985 0.725

(0.353) (1.200) (0.633) (1.428) (0.687) (2.262) (1.976)

Positive revenue -0.256∗ -3.058∗∗ 0.336 -2.048∗∗ 0.207 -3.290∗∗ -1.663∗∗

(0.151) (0.521) (0.281) (0.694) (0.287) (0.834) (0.577)

Firm age (years) -0.905∗∗ -1.376∗∗ -1.774∗∗ -1.185∗∗ -1.912∗∗ -1.757∗∗ -2.182∗∗
(0.0339) (0.0989) (0.0487) (0.102) (0.0523) (0.148) (0.100)

1 year Wilshire ret. 1.346∗∗ 5.041∗∗ 1.642∗∗ 2.311∗∗ 1.726∗∗ 3.561∗∗ 0.850
(0.325) (1.025) (0.364) (0.694) (0.406) (1.209) (0.560)

Debt x Age 0.263∗∗ 0.733∗∗ 1.206∗∗ 1.124∗∗ 0.106

(0.0667) (0.113) (0.121) (0.158) (0.303)

Debt x Profitable 0.375 2.464∗ 2.080 5.512∗∗ 3.848

(0.935) (1.460) (1.606) (2.420) (5.370)

Debt x Positive Rev. 0.111 2.913∗∗ 1.998∗∗ 4.109∗∗ 3.312∗

(0.380) (0.626) (0.786) (0.925) (1.920)

DebtxWilshire return -0.736 -4.431∗∗ -0.745 -2.786∗ 0.0344

(0.730) (1.226) (0.901) (1.521) (1.317)
Observations 18769 3806 18769 3806 18769 3806 6880
R2 0.058 0.141 0.181 0.180 0.192 0.216 0.201
Firms 15924 2175 15924 2175 15924 2175 4636

50