0 - VC - Advers Selection and Capital Structure++++

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Douglas 1. Cumming

School oI Business
University oI Alberta
Edmonton, Alberta
Canada T6G 2R6
Tel: (780) 492-0678
Fax: (780) 492-3325
E-mail: Douglas.Cummingualberta.ca
Http://www.bus.ualberta.ca/dcumming

This DraIt: July 2002
Eirst DraIt: March 2001

* I owe special thanks to Mary Macdonald Ior helpIul comments and insights into venture capital in Canada. I owe
thanks to seminar participants at the University oI Alberta School oI Business (March 2001) and the Schulich School oI Business
(April 2001). I have also greatly beneIited Irom with Varouj Aivazian, Paul Halpern, Thomas Hellmann, Mark Huson, Aditya
Kaul, Ted Liu, Erank Mathewson, Mary Macdonald, JeII MacIntosh, Vikas Mehrotra, Randall Morck, Tom Ross, Barry
Scholnick, Corrine Sellars and especially Ralph Winter. I am grateIul Ior Iinancial support Irom the University oI Alberta SAS
Eellowship, University oI Alberta Pearson Eellowship, and University oI British Columbia Entrepreneurship Research Alliance
Scholarship. Macdonald & Associates, Limited (Toronto) generously provided the data.

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Theoretical models on adverse selection and capital structure necessarily impose restrictions on the
contract space, at least in some dimensions, Ior analytical tractability. Recent evidence indicates that the
context observed in practice, at least among some types oI Iinancial intermediaries in some countries, is
somewhat broader. For example, in some non-segmented venture capital markets entrepreneurs receive a
variety oI Iorms oI Iinance: debt, convertible debt, preIerred equity, convertible preIerred equity, common
equity, warrants, and combinations oI these instruments. The types oI entrepreneurial Iirms receiving
Iinancing may be deIined by a variety oI characteristics: stage oI development, type oI industry, and number
oI employees, among other things. Given this broad context observed in practice, previous research has not
considered the extent to which diIIerent Iinancial contracts, among the complete class oI Iorms oI Iinance,
attract diIIerent types oI entrepreneurial Iirms. In this paper we investigate the empirical tractability oI
adverse selection in capital structure Irom 5323 venture capital investments. The evidence provides insight
into the nature oI the uncertainty Iacing investors Ior diIIerent types oI Iinancing transactions.

Kev words. Financial Contracting; Capital Structure; Adverse Selection; Entrepreneurship; Venture Capital
JEL classification. G24, G28, G32, G38

1. Introduction

Important seminal research on selection eIIects and capital structure Iocused on debt and common
equity (Stiglitz and Weiss, 1981, 1986, and 1987; Greenwald et al., 1984; Myers and MjluI, 1984; DeMeza
and Webb, 1987, 1992). Hellmann and Stiglitz (2000) generalize this earlier work and make compatible
models oI adverse selection Ior debt and equity markets. Consistent with the lemons principle (AkerloI,
1970), this work shows equity attracts Iirms with low expected returns, whereas debt Iinance attracts Iirms
with high variability in returns. Related research on adverse selection and capital structure has considered
convertible securities. For example, in the context oI a signalling model, Brennan and Kraus (1987)
investigate the role oI non-linear instruments in revealing inIormation about a Iirm`s characteristics: Iirms
with low variability in returns are attracted to convertible securities.

A common Ieature oI theoretical models oI adverse selection and capital structure is the need to
impose limits on the contracting space Ior reasons oI analytical tractability. Such limits may include the
Iorm(s) oI Iinance available to entrepreneurs, the deIining characteristics oI the entrepreneurs receiving
Iinancing, and/or segmentations in the capital markets among Iinancial intermediaries oIIering diIIerent
Iorms oI Iinance (i.e., one type oI Iinancial intermediary oIIers debt and another type oIIers equity).
Moreover, while adverse selection models necessarily impose limits on the nature oI asymmetric
inIormation between entrepreneurs and investors, in practice private inIormation held by entrepreneurial
Iirms may encompass a multitude oI parameters that cannot be modelled. In this paper we investigate the
extent to which these boundaries are signiIicant by empirically examining adverse selection in a non-
segmented capital market in which Iinancial intermediaries Iinance a wide range oI diIIerent types oI
entrepreneurial Iirms with private inIormation along many parameters, and choose Iorm(s) oI Iinance Irom
among the complete class oI Iorms oI Iinance (debt, convertible debt, preIerred equity, convertible
preIerred equity, common equity, warrants, and combinations thereoI).

The venture capital market oIIers an interesting Iorum Ior empirically examining the relation
between adverse selection and Iorms oI Iinance. Venture capitalists have enhanced screening and
monitoring abilities, and are active value-added investors (Sahlman, 1990; MacIntosh, 1994; Gompers and
Lerner, 1999; Kaplan and Strmberg, 2000a,b; Hellmann and Puri, 2002; Garmaise, 2000; Kanniainen and
Keuschnigg, 2000, 2001; Kirilenko, 2001). Because they Iinance early-stage Iirms Ior which there is a
comparative dearth oI inIormation, venture capitalists take signiIicant steps to try to avoid Iinancing low
quality Iirms (Kaplan and Strmberg, 2000b). Research in venture capital is consistent with the proposition
2

that venture capitalists are among the most sophisticated Iinancial intermediaries with abilities to mitigate
agency problems.
1
ThereIore, in considering the venture capital market, we study not only pronounced
problems oI adverse selection, but also specialized investors that take active steps to mitigate such problems.

To investigate problems oI adverse selection in capital structure decisions, it is useIul to consider a
market in which investors Iinance a wide variety oI diIIerent types oI entrepreneurial Iirms, and use a
heterogeneous mix oI Iorms oI Iinance. Research on the United States venture capital industry is consistent
with the proposition that venture capitalists rarely use Iorms oI Iinance other than convertible preIerred
equity (Admati and PIleiderer, 1994; Bascha and Walz, 2001a; BerglI, 1994; Bergmann and Hege, 1998;
Cornelli and Yosha, 1997; Gompers, 1997; Hellmann, 2000; Kaplan and Strmberg, 2000a; Marx, 1998;
Sahlman, 1990; Trester, 1998); thereIore, the U.S. venture capital market does not oIIer a useIul Iorum to
address problems oI adverse selection in capital structure. Nevertheless, there may be reasons Ior the use oI
Iorms oI Iinance other than convertible preIerred equity (Garmaise, 2000; Bonini and Zullo, 2000;
Cumming, 2000), and data indicates a variety oI Iorms oI Iinance are employed by venture capitalists in
European countries (e.g., Parhankangas and Smith, 2000; Bonini and Zullo, 2000; Bascha and Walz,
2001b; Cumming, 2002; see also www.evca.com).

Extensive data collected by Macdonald and Associates, Ltd. (Toronto) Ior the Canadian Venture
Capital Association (CVCA) indicates that a variety oI Iorms oI Iinance are used by venture capitalists in
Canada (see Figure 1 and Tables I VI below).
2
The diIIerences in the use oI Iorms oI Iinance by
venture capitalists across Canada and the U.S. are probably not attributable to diIIerences in the
deIinition oI venture capital, as the results hold irrespective oI the deIinition oI venture capital and in
every single sub-sample in the data (see Tables I VI below). Not even one oI the private independent
Iunds (the category most similar to U.S. limited partnerships, discussed below) use convertible preIerred
equity more than 50 oI the time, and the average Irequency oI use oI convertible preIerred is less than
10 across all private independent Iunds (Cumming, 2000). DiIIerences in Iorms oI venture capital
Iinance across countries may be explained by diIIerent restrictive covenants placed upon venture capitalists
(Gompers and Lerner, 1996; Cumming, 2000), diIIerences in investment duration, stock markets, and exit
strategies across countries (Black and Gilson, 1998; Jeng and Wells, 2000; Cumming and MacIntosh, 2001,
2002), and/or other legal and institutional Iactors that may impact private equity markets (MacIntosh, 1994;
Gilson and Schizer, 2001; Sandler, 2001). For example, U.S. venture capital limited partnerships typically
Iace restrictions on the use oI debt (Gompers and Lerner, 1996). Because there is heterogeneity in the
3

types oI Iirms Iinanced (Figure 2) and changes in the intensity oI use oI diIIerent Iorms oI Iinance over
time (Figure 1), the Canadian venture capital market oIIers a unique Iorum in which to study adverse
selection in capital structure decisions.

This paper makes three main contributions. First, we introduce a new data set indicating that,
consistent with European venture capitalists, venture capitalists in Canada use a variety oI Iorms oI
Iinance. Second, we introduce evidence that certain types oI investors have a preIerence Ior Iinancing
certain types oI entrepreneurial Iirms. Third, and most importantly, in the spirit oI measuring agency
problems associated with Iorms oI Iinance (e.g., Mello and Parsons, 1992), we empirically assess the
relation between capital structure and adverse selection across a wide array oI entrepreneurial Iirms with
diIIerent characteristics Ior the complete class oI Iorms oI Iinance (debt, convertible debt, preIerred
equity, convertible preIerred equity, common equity, warrants, and combinations thereoI). Regardless oI
the selected Iorm(s) oI venture capital Iinance in the U.S., Canada, Europe, or elsewhere, we present
evidence herein to address Iollowing question that may be considered in any entrepreneurial Iinancing
context: Ior the given Iorm(s) oI Iinance employed by an investor(s), what are the selection eIIects
associated with the use oI that Iinancial instrument? For example, what are the selection eIIects
associated with the use oI convertible preIerred equity relative to the use oI straight preIerred equity?
How do selection eIIects diIIer across Iirms at diIIerent stages oI development and across Iirms in
diIIerent industries? Are start-ups characterized by uncertainty in the variance in expected returns, or in
the mean return? What about expansion stage investments, or turnaround and buyout transactions? In
considering the evidence we gain insight into the nature oI the uncertainty Iacing investors Ior diIIerent
types oI entrepreneurial Iinancing transactions.

This paper is organized as Iollows. In section 2 we develop hypotheses pertaining to adverse
selection in entrepreneurial Iinance. Section 3 describes the Canadian Venture Capital Association data.
Empirical evidence is presented in section 4. The last section concludes.

2. Adverse Selection, Capital Structure, and Entrepreneurial Firm Characteristics

We begin within the standard ex ante contracting setting in which entrepreneurs have a richer
inIormation set relative to investors (Myers and MjluI, 1984). Restrictions on the parameters oI
entrepreneurial private inIormation are not employed. Rather, the analysis is based on the premise that the
4

nature oI private inIormation held by the entrepreneur varies by the type oI entrepreneurial Iirm Iinanced.
Garmaise (2001) considers the case when venture capitalists are better at evaluating the project than the
entrepreneur. This is not inconsistent with the context herein in which there exists inIormation that only
the entrepreneur knows, including leisure preIerence and technical competence. Investors use observable
inIormation about the entrepreneur (including technology, stage oI Iirm development, capital
requirements, among other things) to inIer the extent oI entrepreneurial private inIormation and the
likelihood oI success oI the entrepreneurial project. To this end, we develop hypotheses relating problems
oI adverse selection among alternative Iorms oI Iinance to entrepreneurial Iirms at diIIerent stages oI
development, in diIIerent industries, among other characteristics, and to the investor(s) and the nature oI the
Iinancing transaction. We test the hypotheses against their alternatives in the subsequent sections, and gain
insight into the nature oI the uncertainty Iaced by investors in the diIIerent Iinancing contexts.

The well known lemons principle (AkerloI, 1970) in the context oI capital structure theory is based
on the idea that the Iorm oI Iinance oIIered by an investor attracts the worst possible type oI Iirm Ior that
Iorm oI Iinance. Theoretical research has well established the propositions that common equity attracts
Iirms with low expected returns |'adverse selection costs of common equitv| (DeMeza and Webb, 1987,
1992), straight debt and straight preIerred equity attract Iirms with high variability in returns |'adverse
selection costs of straight debt and straight preferred equitv| (Stiglitz and Weiss, 1981, 1986, 1987;
Hellmann and Stiglitz, 2000) and convertible securities attract Iirms with low variability oI returns
|'adverse selection costs of convertible securities| (Brennan and Kraus, 1987). Investors anticipate these
problems and structure contracts accordingly (see, e.g., Brennan and Kraus, 1987).
3,4

While Iinancial contracts may be designed to mitigate agency problems (adverse selection and
moral hazard), contracts cannot completely eliminate agency problems (Farmer and Winter, 1986). Venture
capitalists take steps to alleviate inIormational asymmetries in entrepreneurial investments; but a large menu
oI entrepreneurial characteristics remains unknown to the venture capitalist at the time oI contracting. Such
characteristics may include non-pecuniary entrepreneurial preIerences (such as leisure), entrepreneurial
intelligence and technical and managerial competence, the likelihood oI developing a successIul technology,
the product market and consumer risk, among a variety oI other Iactors that may aIIect the moments oI the
distribution oI expected returns to the venture. The degree to which inIormational asymmetries may be
mitigated depends on the Iinancing arrangement, Iirm characteristics and institutional Iactors (Sahlman,
1990; MacIntosh, 1994; Gompers and Lerner, 1999; Cumming, 2000; Kaplan and Strmberg, 2000a,b).
5

In order to understand the extent to which entrepreneurs may have inIormation that investors do not
have, it is necessary to identiIy the entrepreneurial Iirm characteristics that are in Iact known to investors.
In practice, entrepreneurial Iirms are characterized by one oI Iour mutually exclusive stages oI development
(as consistently deIined in the Annual Reports oI Venture Economics, 1996, in the U.S. and the Canadian
Venture Capital Association, 1996):

Start-up: The entrepreneurial Iirm may be based on a concept without a product or
any marketing, or it may have a product being developed, but not yet sold
commercially.

Expansion: The entrepreneurial Iirm requires signiIicant capital Ior plant expansion
and marketing to initiate Iull commercial production and sales.

Buyout: The operating management oI the entrepreneurial Iirm wants to acquire a
product line, a division, or a company.

Turnaround: The entrepreneurial Iirm was once proIitable but now is earning less than
its cost oI capital.

The greatest degree oI inIormational asymmetry between entrepreneurs and investors exists among Iirms in
their earlier stage oI development (start-up and expansion stages). Buyout and turnaround Iirms are much
more established, and the entrepreneurs have a much longer track record Irom which venture capitalists can
inIer the technical competence, managerial expertise, intelligence, and pecuniary and non-pecuniary
preIerences oI the entrepreneurial Iirm.

We conjecture that the worst possible Iirm`s expected distribution oI returns Ior the given Iorm(s)
oI Iinance (the lemons principle) is not uniIorm Ior all entrepreneurial Iinancing transactions; rather, it will
vary among diIIerent classes oI entrepreneurial Iirms, and such classes are observable by both the
entrepreneur and the investors. To this end, as inIormational asymmetries are greatest among younger start-
up stage Iirms (and, to a lesser degree, expansion stage Iirms) without a signiIicant track record, and more
established turnaround stage Iirms with a poor track record, we hypothesize that adverse selection costs oI
Iinancing such Iirms with the use oI non-convertible instruments will be the most pronounced: straight debt
and straight preIerred equity will attract riskier Iirms, and common equity will attract Iirms with low
expected average returns. Convertible securities will mitigate problems oI adverse selection to the greatest
degree among early stage and turnaround investments. We Iurther hypothesize that the adverse selection
6

costs associated with straight debt, straight preIerred equity and common equity are relatively less
signiIicant among more established Iirms seeking Iinancing Ior buyout transactions.

Entrepreneurial Iirms may also be characterized by a variety oI non-mutually exclusive
characteristics (that is, not only by one oI the Iour stages oI development, but also by any number oI the
Iollowing characteristics):

Capital Requirements: The amount oI Iinancing needed by the entrepreneurial Iirm.

Employees: The number oI employees working Ior the entrepreneurial Iirm.

Technology: Firms in technology industries (e.g., biotechnology, communications,
electronics, energy, environmental, medical) have characteristics that are
distinct Irom traditional industries (e.g., manuIacturing, industrial).

The amount invested may be used as a screening device (Bester, 1985; Middle and Riley, 1988) subject to
the relation between the amount invested and the uncertainty regarding investment risk and expected
returns. Firms with signiIicant capital requirements generally have more growth opportunities, and
thereIore there exists greater potential Ior agency problems associated with the investment (MacIntosh,
1994; Gompers and Lerner, 1999). An increase in the amount invested may thereIore be expected to
increase the likelihood oI attracting the worst possible Iirm Ior the given Iorm oI Iinance. On the other
hand, it is easier Ior investors to obtain more inIormation with larger Iirms with more employees; thereIore,
problems oI asymmetric inIormation and adverse selection should be less pronounced among Iirms with
more employees. Finally, because high-technology Iirms are characterized by intangible assets that are
more diIIicult to value, problems oI asymmetric inIormation and adverse selection are more pronounced
among technology Iirms relative to Iirms in traditional industries (see, e.g., Noe and Rebello, 1996).

In addition to entrepreneurial Iirm characteristics, it is also necessary to account Ior characteristics
oI the investment to empirically assess the extent oI inIormational asymmetries and adverse selection
associated with alternative Iorms oI Iinance.

New Investment: The entrepreneurial Iirm has not previously received venture Iinancing
(i.e., not 'Iollow-on Iinancing in subsequent rounds oI staged Iinancing).

Syndicated Investment: More than one venture capital Iirm Iinances the entrepreneurial Iirm.

7

Staged investments Iacilitate reduction in inIormational problems between venture capitalists and
entrepreneurial Iirms; problems oI adverse selection are most pronounced Ior Iirst round or new investments
(Gompers, 1995). Syndication reduces inIormational asymmetries and adverse selection costs (Leland and
Pyle, 1977; Lerner, 1994).

In the Iollowing section we describe the data. Empirical tests oI the hypotheses developed herein
Iollow in section 4. We control Ior the diIIerent types oI investors, and make use oI artiIicial regressions to
explore problems oI adverse selection Ior the complete class oI Iorms oI Iinance among diIIerent types oI
entrepreneurial Iirms.

3. Data

The data comprise 5323 Canadian venture capital Iinancing transactions Irom 1991-1998 (source:
Macdonald and Associates, Ltd., Ior the Canadian Venture Capital Association). All venture capital
investors in Canada Iinance a wide variety oI entrepreneurial Iirms and use a wide variety oI Iinancial
instruments (see Tables I VI). The use oI a variety oI Iorms oI Iinance by venture capitalists in Canada is
probably not due to the deIinition oI venture capital in Canada. Cumming (2000) considers reasons Ior this
use oI a variety oI Iorms oI Iinance in Canada.

There exists Iive types oI venture capital investors in Canada (see also MacIntosh, 1994; Halpern,
1997): private independent, corporate, government, hybrid, and labour-sponsored. Private independent
Iunds are similar to U.S. venture capital limited partnerships, but Canadian private independent venture
capital Iunds generally have Iewer and less restrictive covenants placed on the investment managers
(MacIntosh, 1994; Halpern, 1997) and invest in a wider variety oI diIIerent Iirms (see Table I below)
relative to their U.S. counterparts (Gompers and Lerner, 1996, 1999). Canadian corporate VCs are
analogous to U.S. Corporate VCs (Gompers and Lerner, 1999), but tend to Iinance a somewhat more
heterogeneous group oI entrepreneurial Iirms (Table II). Government venture capital Iunds in Canada
(Table V) are managed by independent proIessional venture capital managers and Iinance a wide variety oI
diIIerent entrepreneurial Iirms. Canadian hybrid venture capital Iunds (Table IV) receive both government
and private support and invest in all types oI entrepreneurial Iirms. Private independent, corporate,
government, and hybrid venture capital Iunds in Canada are not restricted, and do not have direct incentives,
to employ any particular Iorm oI Iinance. Nevertheless, it is possible that these diIIerent types oI Iunds may
8

preIer to Iinance diIIerent types oI entrepreneurial Iirms, and diIIerent Iorms oI Iinance may more be
appropriate Ior diIIerent types oI entrepreneurial Iirms in Canada (Cumming, 2000).

As a result oI tax incentives Ior investors contributing to Labour-sponsored Venture Capital
Corporations (LSVCCs) in Canada, LSVCCs have been able to raise the most capital in recent years (see
Figure 4 below). LSVCCs are signiIicantly diIIerent than the other Canadian venture capital Iunds. These
diIIerences arise through statutory restrictive covenants placed upon LSVCC managers (see MacIntosh,
1994; Halpern, 1997). The constraints in which LSVCCs operate may inIluence not only their choice oI
types oI Iirms in which they invest (MacIntosh, 1994), but also the types oI securities they employ
irrespective oI the characteristics oI their investees (Cumming, 2000).

Aggregate industry statistics Irom Macdonald and Associates, Ltd. (Toronto) and the CVCA are
presented in Figures 1-4 Ior the years in which there exists data. Macdonald (1992) Iirst provided a
thorough analysis oI the Canadian venture capital industry; additional details are Iound in MacIntosh
(1994), Halpern (1997) and Cumming and MacIntosh (2002). Figure 1 reports the aggregate number oI
Iorms oI Iinance used by Canadian venture capitalists Irom 1977 1998. Figure 2 indicates the types oI
Iirms being Iinanced by stage oI development. Figure 3 presents statistics Ior the total number oI venture
capital Iirms in Canada and total number oI venture capital investments Irom 1977 1998. Figure 4 reports
the total capital under management by investor type Irom 1992 1998 (the only years Ior which this
inIormation has been recorded).

|Tables I VI and Figures 1, 2, 3 and 4 About Here|

Figure 1 and Tables I VI clearly show that convertible preIerred equity has not been the most
commonly used Iorm oI Iinance by Canadian venture capitalists. This result is not due to the type oI VC
Iund, or the type oI Iirms being Iinanced, as documented in Table I VI. It is also not due to the deIinition
oI venture capital, as the results in Canada hold Ior the Iunds most similar to U.S. limited partnerships (the
transactions Ior Canadian private independent Iunds are presented in Table I). The 5323 transactions in
Tables I VI will be used in the Iollowing section to test the hypotheses developed in section 2.

The empirical analysis below Iocuses on the standard Iinancial instruments: debt, convertible debt,
preIerred equity, convertible preIerred equity, common equity, warrants, and combinations oI debt and
9

common equity. A broader contract space does exist in practice. For example, convertible debt is a hybrid
bond that allows its bearer to exchange it Ior a given number oI shares oI common stock anytime up to and
including the maturity date oI the bond. A convertible bond is equivalent to a portIolio oI 2 securities: (1)
straight debt with the same coupon rate and maturity as the convertible bond, and (2) a warrant written on
the value oI the Iirm. A broader contract space, however, is not considered herein Ior a number oI reasons.
Papers that do consider a broader contract space (e.g., Aghion and Bolton, 1992) yield optimal contracts that
resemble the standard Iinancial instruments. The Iact that the standard instruments in corporate Iinance are
used most Irequently suggests that considerable gains arise Irom standardization, and greater transaction
costs arise Irom designing contracts to mimic the standard Iorms oI Iinance (BerglI, 1994; Macdonald,
1992). Regardless, the data used to test the hypotheses developed herein has been recorded such that iI a
contract was designed to mimic one oI the standard Iorms oI Iinance then the standard Iorm was recorded.
5

The data on the Iorms oI venture capital Iinance is used to test Ior the presence oI adverse selection
in the Iollowing section. The econometric analysis considers the entire sample oI 5323 investments without
segmenting the sample. For example, diIIerent estimates using subsamples by the type oI venture capital
Iund are not presented as the Canadian venture capital market is integrated; diIIerent venture capital Iunds
syndicate more than 45 oI their investments (Tables I VI). Failure to account Ior syndication across
venture capital Iirms would ignore the Iact that Iinancial contracts may diIIer across 'lead or 'inside
investors and 'Iollow-on or 'outside investors (Rajan, 1992; Admati and PIleiderer, 1994; Cumming,
2000) in Canada. Separating the data by sectors would Iail to account Ior venture capital syndicates and
diIIerences among inside and outside investors, and thereIore would signiIicantly bias the results. The use
oI the Iull data set enables the richest array oI results by accounting Ior interactions among diIIerent VC
Iirms in Canada, while recognizing that the Canadian venture capital market is not segmented by sectors.

4. Empirical Evidence

4.1. The Determinants of Forms of Venture Capital Finance in Canada

Since the seminal work oI Jensen and Meckling (1976), a large literature on capital structure has
related agency costs to the selection oI diIIerent Iorms oI Iinance. In venture capital, at least in certain
countries, a variety oI Iorms oI Iinance are employed (Parhankangas and Smith, 2000; Bonini and Zullo,
2000; Cumming, 2000). DiIIerences across countries are likely due to a combination oI legal and
10

institutional Iactors and the particular agency costs associated with the characteristics oI the transacting
parties (Rajan and Zingales, 1995). Moreover, restrictive covenants imposed upon the venture capital
managers (Gompers and Lerner, 1996, 1999) may aIIect the Iinancial contract. The Iundamental premise is
that certain agency problems are more pronounced among Iirms with diIIerent characteristics; because
diIIerent Iorm(s) oI Iinance mitigate agency problems to diIIerent degrees, predictions arise as to the
optimal Iorm oI Iinance depending on the particular agency problems in the given institutional context (e.g.,
Noe and Rebello, 1996).

In the Canadian context, Cumming (2000) estimates instrumental variable multinomial logit
regressions oI the Iollowing Iorm. The dependent variables indicate the likelihood oI selecting one Iorm oI
Iinance over the other; Ior example, Ln(P
Common
/ P
Preferred
) is the likelihood oI selecting common equity over
preIerred equity. A complete set oI 21 equations Ior tradeoIIs among the other Iorms oI Iinance are
estimated (Cumming, 2000), including Ln(P
Common
/ P
Debt
), Ln(P
Preferred
/ P
Debt
), Ln(P
Common
/ P
ConvertiblePreferred
),
Ln(P
/ P
Debt
), etc. The equations test the proposition that the choice oI Iorm(s) oI Iinance
depend on the pronounced agency problems associated with Iirm characteristics.

() Ln(P
Common
/ P
Preferred
)
1
Start-up
2
Expansion
3
Turnaround
4
Buyout
5

Deal$1m
6
Deal~$5m
7
New Investee
8
Syndication
9

Employees50
10
Technology
11
LSVCC

The right-hand-side variables in () are described above in section 2. These variables are also used herein
in the subsequent sections.

Instrumental variables were used to estimate equation () to account Ior endogeneity resulting Irom
adverse selection associated with oIIers oI diIIerent Iorms oI Iinance (Cumming, 2000). In the Iollowing
subsections we consider in more detail the nature oI this adverse selection problem associated with diIIerent
Iorms oI Iinance and the presence oI certain types oI entrepreneurial Iirms in the market Ior venture capital.
We proceed in two steps. In the Iirst step (subsection 4.2), we consider instrumental variables that impact
the types oI Iirms that may exist in the market Ior venture capital. In the second step (subsection 4.3), we
use the residuals Irom the Iirst step regressions to test the eIIect oI endogeneity on the estimated coeIIicients
in equation (). This artiIicial regression in the second step, a modiIied version oI the Durbin-Wu-Hausman
(DWH) test,
6
is not a direct test Ior exogeneity, but does indicate the eIIect oI endogeneity on the coeIIicient
estimates in (), and thereIore provides insight into the nature oI adverse selection associated with diIIerent
Iorms oI Iinance and diIIerent types oI entrepreneurial Iirms.
11

4.2. Do Different Types of Investors Select Different Types of Entrepreneurial Firms?

Each year VCs receive around 1000 requests Ior Iinancing (Sahlman, 1990). This may create noise
in the allocation oI an entrepreneurial Iirm to a VC Iirm. But venture capital Iirms tend to have a preIerence
Ior Iinancing certain types oI entrepreneurial Iirms according to their stage oI development, required capital,
and/or type oI technology, among other things (Gompers and Lerner, 1999).
7
Herein, we relate the presence
oI diIIerent types oI Iirms in the venture capital market (as per the characteristics outlined in section 2
above), to geographic location oI investees
8
and to the type oI venture capital Iirm (see section 3). We
estimate the basic logit regression equations (1) (10) oI the Iollowing Iorm:

(1) Start-up
1
Private Independent
2
Corporate
3
Government
4
Hybrid
5
LSVCC
6
British Columbia
7
Alberta
8
Saskatchewan
9

Manitoba
10
Ontario
11
Quebec
12
Interest Rate Start-up

Start-up
is the vector oI residuals Ior equation (1), and is used in the endogeneity tests below. Equations (2)
(10) are analogous Ior the other entrepreneurial Iirm characteristics outlined in section 2, and similar vectors
oI residuals (Expansion
Irom equation (2), Buyout
Irom equation (3), etc.) are employed in subsection 4.3 below.
Diagnostic tests suggested in the main that the right-hand-side variables Ior equations (1) (10) were
orthogonal to the diIIerent Iorms oI Iinance and are thereIore suitable instruments Ior the DWH tests (see
Table VII).
9
The main results are not sensitive to the choice oI instrument (alternative regressions are on
Iile with the author). The variables Ior the type oI venture capital Iund are separated into the Iive types
indicated in section 3: private independent, corporate, government, hybrid, and labour-sponsored. A sixth
category ('unknown type) exists in the data. The dummy variable Ior this category is suppressed to avoid
estimation problems resulting Irom collinearity; similarly, variables Ior other geographic regions are
suppressed to avoid collinearity. The estimates Ior equations (1) (10) are presented in Table VIII.

|Tables VII and VIII About Here|

There are three main results in Table VIII. First, certain types oI entrepreneurial Iirms are more
likely to come Irom diIIerent geographic regions in Canada. Second, interest rates appear to aIIect the
likelihood that certain entrepreneurial Iirms will seek venture capital Iinancing relative to bank Iinancing.
10

Third, there is support Ior the proposition that diIIerent types oI venture capital Iirms are more likely to
12

Iinance diIIerent types oI entrepreneurial Iirms in Canada. Below, we elaborate on this third result.

DiIIerences across types oI venture capital Iunds are noticed with respect to their Iocus on stage oI
development (see equations 1 4). Private independent venture capital Iirms in Canada do not appear to
Iocus on any single stage oI development. Corporate venture capitalists Iocus on expansion stage and
buyout investments (equations 2 and 3), while government Iunded venture capitalists and hybrid venture
capitalists (that receive both private and government Iunding) are more likely to Iocus on start-up
investments (equation 1). In contrast, the data suggest LSVCCs do not Iocus on start-up investments, but do
tend to invest in turnaround Iirms.

All types oI venture capital Iirms generally appear to make smaller investments (equations 5 and 6)
and stage their investments (equation 7) (i.e., new investments are less likely than Iollow-on investments).
Note that while the coeIIicient estimates Ior equation (8) suggest that Iunds are less likely to syndicate, these
coeIIicients are sensitive to the type oI venture capital Iund dummy variable that is suppressed. While more
than 40 oI venture investments are syndicated Ior all types oI venture capital Iunds (Tables I VI), more
than 60 oI venture capital Iirms in the 'unknown category (Ior which the dummy variable was
suppressed to avoid perIect collinearity) syndicate investments.

Government and hybrid venture capital Iirms appear more likely to make investments in technology
Iirms (equation 9), which contrasts to corporate venture capitalists and LSVCCs in Canada. Finally,
corporate venture capitalists tend to Iinance larger Iirms with more employees than government venture
capitalists (equation 10) in Canada.

In the Iollowing subsection we make use oI the vectors oI residuals in equations (1) (10) to
construct artiIicial regressions and test Ior the eIIect oI endogeneity associated with estimating equation ()
(see Cumming, 2000). That is, while the choice oI Iorm(s) oI Iinance depends on the type oI Iirm and the
particular agency problems associated with the investment, are diIIerent types oI Iirms more attracted to
diIIerent Iorms oI Iinance?

13

4.3. Adverse Selection, Forms of Finance and Firm Characteristics: Empirical Evidence

We test Ior the eIIect oI adverse selection associated with the choice oI Iorm(s) oI Iinance by
estimating a system oI artiIicial regressions oI the Iollowing Iorm:

(11) Ln(P
Common
/ P
Preferred
)
1
Start-up
2
Expansion
3
Turnaround
4
Buyout
5

Deal$1m
6
Deal~$5m
7
New Investee
8
Syndication
9

Employees50
10
Technology
11
LSVCC
12
Start-up

13
Expansion

14
Buyout

15
Turnaround

16
Deal$1m

17
Deal~$5m

18
NewInvestee

19

Syndication

20
Employees50

21
Technology

Equations (12) (31) are similar, with diIIerent leIt-hand-side variables Ior the other Iorms oI Iinance (see
Table IX; see also note 6 regarding robustness to alternative speciIications). Only the coeIIicients and t-
statistics Ior
12
-
21
are reported in Table IX Ior equations (11) to (31), as these coeIIicients are pertinent to
the issue oI adverse selection by virtue oI the eIIect oI endogeneity on the coeIIicient estimates oI equation
(). The estimates in Table IX provide strong support Ior the general proposition that adverse selection in
capital structure is signiIicant. DiIIerent Iorms oI Iinance may be more appropriate Ior diIIerent
entrepreneurial Iirms (equation (); see also Cumming, 2000); but the causal relation between type oI Iirm
and Iorm oI Iinance is not unidirectional. Where the residual vectors () are not orthogonal in (11) (31),
diIIerent types oI Iirms are attracted to diIIerent Iorms oI Iinance.

Table IX provides evidence relating selection eIIects to Iorms oI Iinance Ior the diIIerent types oI
Iirms Iinanced by Canadian venture capitalists. Generalizing across all Iorms oI Iinance (equations 11
31), selection eIIects appear to be most problematic among expansion stage Iirms, and appear to be
signiIicantly related to deal size. There is mixed evidence across all Iorms oI Iinance that selection eIIects
are problematic among turnaround Iirms, technology Iirms and new investees. There is less evidence oI
selection eIIects among start-up Iirms and buyout Iirms, and no evidence oI selection eIIects among Iirms
with Iew employees. Finally, there is evidence that syndication mitigates problems oI adverse selection (see
also Lerner, 1994). The particulars in Table IX are summarized in Table X and described below.

|Tables IX and X About Here|

The coeIIicients on Table IX viewed in the context oI the lemons principle enable an understanding
oI the nature oI the uncertainty Iaced by investors Ior the diIIerent types oI Iinancing transactions. Common
14

equity provides the greatest ownership percentage; relative to common equity, convertible debt and
convertible preIerred equity provide a smaller equity stake to the investors aIter conversion; straight debt
provides no equity ownership. From the perspective oI an entrepreneur with expectations oI high variability
in returns, the best Iorm oI Iinance is straight debt and straight preIerred equity, then convertible securities,
then straight common equity. From the perspective oI an entrepreneur with expectations oI a low average
return, the best Iorm oI Iinance is common equity, then convertible securities, then straight debt and straight
preIerred equity. Even though the exact opposite ranking Iollow Ior the investor`s perspective, based on the
lemons principle, the Iorm oI Iinance oIIered by an investor attracts the worst possible type oI Iirm Ior that
Iorm oI Iinance. The impact oI adverse selection indicated by the coeIIicient estimates provide insight into
the type oI uncertainty Iacing investors and their ability to screen the worst quality entrepreneurs among
Iirms at diIIerent stages oI development, in diIIerent industries, among other things.

The evidence is consistent with the view that start-up Iirms do not like to like to 'give up common
equity to their investors when compared with convertible preIerred equity (equation 12), straight debt
(equation 13), convertible debt (equation 14), and mixes oI debt and common equity (equation 15; but this
coeIIicient is only marginally signiIicant). II the Iorm oI Iinance oIIered by an investor attracts the worst
possible type oI Iirm Ior that Iorm oI Iinance ('lemons principle), then start-up investments in Canada must
be characterized by uncertainty regarding second-order stochastic dominant expected returns. The evidence
in equations (12) (15) suggests entrepreneurial Iirms are more attracted to Iorms oI Iinance other than
common equity. The evidence in the main suggests start-ups are most attracted to convertible securities (see
equations 12, 14, 17 and 19). One explanation is the Iact that convertible securities tend to have more
Iavourable conversion rates Ior the entrepreneur (and thereIore less Iavourable Ior the venture capitalist) the
better the perIormance oI the Iirm (Sahlman, 1990).

In contrast to start-up Iirms, expansion stage Iirms appear to be attracted to warrants and common
equity relative to other Iorms oI Iinance (equations 13 16, 21, 25, 28, 30 and 31). The worst types oI Iirms
Ior these Iorms oI Iinance are those with the lowest expected returns. The evidence that expansion stage
Iirms are attracted to convertible preIerred equity relative to debt (equation 22), convertible debt (equation
23), and mixes oI debt and equity (equation 24) is supportive oI the view that investors Iace relatively less
uncertainty regarding the second moments oI the returns to expansion stage investments. It may be that
entrepreneurs have a better understanding about the expected average returns to their venture when they are
in the expansion stage oI development. It may also be the case that investors Iace relatively less uncertainty
15

regarding the variability oI such returns Ior expansion stage Iirms, possibly due to the Iact that expansion
stage Iirms have a longer track record than start-ups. Investors may also have previously Iinanced an
expansion stage investment pursuant to staged Iinancing. Poorer quality investments that should be
abandoned may continue to receive staged Iinancing where the entrepreneur engages in short term signal
manipulation (Cornelli and Yosha, 1997).

It is noteworthy that expansion Iirms are attracted to straight preIerred equity relative to debt
(equation 18), convertible debt (equation 19), and mixes oI debt and common equity (equation 20). This
suggests the type oI uncertainty Iaced by investors using straight preIerred equity Ior expansion stage Iirms
is diIIerent than the type oI uncertainty Iaced by investors using other Iorms oI Iinance Ior expansion stage
Iirms. Related research suggests only speciIic types oI investors will consider straight preIerred equity Ior
start-up Iirms: investors that are uncertain about the upside prospects oI the Iirm, and interested in attracting
outside syndicated partners Ior later investment rounds in staged Iinancing (see Cumming, 2000).

There is similarity in the evidence Ior buyout and turnaround stage Iirms. The evidence Irom the
equations Ior common equity relative to the other Iorms oI Iinance suggests buyout and turnaround stage
Iirms are least likely to selI-select to common equity (see equations 13 15 Ior the buyout stage, and
equations 11 15 Ior the turnaround stage). There is weak evidence that turnaround Iirms select Iurther
towards warrants (equation 16). The majority oI the evidence suggests Canadian venture capital investors
are less able to screen the riskier buyout and turnaround Iirms and avoid adverse selection problems
associated with common equity. Buyout and Turnaround entrepreneurs are more likely to selI-select to
straight debt, mixes oI debt and common equity, convertible debt and convertible preIerred equity (see
equations 19, 20 and 23 Ior the buyout stage, and equations 19, 26 and 29 Ior the turnaround stage).

Selection eIIects are most prevalent towards straight warrants among Iirms with low capital
requirements oI less than $1 million and Iirms with signiIicant capital requirements oI more than $5 million
(equations 16, 21, 25, 28, 30 and 31).
11
The worst type oI Iirm Ior warrants are those in which investors
Iace the least uncertainty regarding risk. Smaller deals oI less than $1 million tend to be staged in order to
mitigate risks and associated agency costs (Gompers, 1995). Larger investments tend to be among more
established Iirms with a signiIicant track record.

16

New investees are least attracted to common equity (equations 11 16). This is strong evidence
that venture capitalists are least able to resolve uncertainty regarding the riskiness oI the entrepreneurial
Iirms in which they have not previously invested. The evidence does not signiIicantly distinguish between
selection eIIects towards convertible debt (equations 14, 29 and 30) and warrants (equations 16, 30 and 31)
Ior new investees. The selection eIIects are most signiIicant towards straight debt (equations 13, 18 and
22), which is consistent with the equations (11), (12) and (14) (16) and the idea that new investments are
best characterized by their risk.

Selection eIIects are generally insigniIicant among entrepreneurial Iinancing transactions where
there exists more than one investor (see also Lerner, 1994). There is evidence oI selection towards warrants
(equations 25, 28 and 30) and away Irom debt (equations 18 and 27), which suggests investor syndicates
most oIten screen riskier Iirms with greater uncertainty in the second moment oI their returns.

Selection eIIects are pronounced among entrepreneurial Iirms in technology industries. High-tech
Iirms most Irequently select towards straight preIerred equity (equations 11, 17, 18, 19, and 21).
12
PayoIIs
to high-tech Iirms tend to be more uncertain relative to Iirms in traditional industries; riskier Iirms are the
worst type oI Iirm Ior non-convertible preIerred equity. In support oI theoretical research on adverse
selection and capital structure (e.g., Brennan and Kraus, 1987), the evidence also indicates that high-tech
Iirms most oIten select away Irom convertible debt (equations 14, 19, 26 and 29).

4.4. Limitations and Future Research

This is a Iirst attempt at providing empirical tractability in adverse selection in a non-segmented
market in which Iinancial intermediaries use any number oI diIIerent Iorms oI Iinance, and Iinance a variety
oI types oI entrepreneurial Iirms. The approach taken here may have limitations Ior other contexts. First,
we employed artiIicial regressions to test Ior the eIIect oI endogeneity on the coeIIicient estimates in ().
To the extent that () is not appropriate Ior other contexts, the implied adverse selection evidence may not
be generally applicable. Second, we do not consider relative price changes across diIIerent securities and
other Iactors (see notes 3 and 4); this may limit the extent to which the results are generalizable. Third, our
analysis is based on the premise that certain venture capital Iirms may preIer to Iinance particular types oI
entrepreneurial Iirms, and certain Iorms oI Iinance are more appropriate Ior diIIerent types oI
entrepreneurial Iirms. We present the results Ior the complete sample in light oI the widespread syndication
17

oI investments. We do not segregate the sample by type oI Iirm, as this would ignore the interdependence
among venture capital Iirms in the syndication and screening oI investments, and thereIore bias the results.
Diagnostic tests did not suggest certain venture capitalists in Canada are better at screening than others.
Nevertheless, diIIerences may exist among other Iinancial intermediaries and across countries.

Given the Iact that the evidence may not be generalizable, we suggest avenues Ior Iuture research.
Empirical research in diIIerent countries and/or among diIIerent Iinancial intermediaries would be IruitIul in
providing empirical tractability in adverse selection and capital structure among entrepreneurial Iirms.
Additional theoretical research could also incorporate diIIerent and/or broader contract spaces Ior
alternative Iorms oI Iinance, diIIerent types oI entrepreneurial Iirms, and diIIerent Iinancial intermediaries.

5. Conclusions

The Canadian venture capital market is a unique setting in which one may study non-segmented
Iinancial intermediaries that are not restricted by the type oI security they may employ. Within this setting
we build on previous research (e.g., Stiglitz and Weiss, 1981; DeMeza and Webb, 1987; Brennan and
Kraus, 1987; Hellmann and Stiglitz, 2000) by relating and tracking the presence oI selection eIIects in
capital structure to a variety oI types oI entrepreneurial Iirms and Ior the complete class oI Iorms oI Iinance.

The evidence provides insight into the type oI uncertainty Iaced by investors in diIIerent types oI
entrepreneurial Iinancing transactions. Canadian venture capital investors appear to Iace the greatest
uncertainty among Iirms with high expected variability in returns in most Iinancing transactions, including
start-up, buyout and turnaround stage Iirms, as well as Ior new investments (as opposed to Iollow-on
Iinancing). However, diIIerences exist across the alternative types oI transactions in the data. For example,
expansion stage investments appear to be characterized by greater adverse selection problems associated
with the Iirst moments oI expected returns, and not the second moments. This diIIerence may be explained
by the Iact that relative to start-ups, expansion stage investments have a longer track record. In addition,
staged Iinancing oI expansion stage investments may result in window dressing (Cornelli and Yosha, 1997)
and uncertainty about the quality and expected mean return oI the investment.

We also observe other diIIerences. There is support Ior the proposition that adverse selection is not
independent oI capital requirements (see also Noe and Rebello, 1996). High-tech Iirms tend to select away
18

Irom convertible securities and towards straight preIerred equity and straight debt (see also Brennan and
Kraus, 1987). The number oI employees in an entrepreneurial Iirm, on the other hand, is unrelated to
problems oI adverse selection in capital structure. Finally, the evidence adds to research on the syndication
oI venture capital (Lerner, 1994), indicating syndication mitigates problems oI adverse selection.

That there are diIIerences across the variety oI entrepreneurial Iinancing transactions is signiIicant.
Further theoretical and empirical research could explore the robustness oI the relation between adverse
selection and capital structure to alternative contexts.

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23

Figure 1. Forms of Venture CapitaI Finance in Canada: 1977-1998
0
50
100
150
200
250
300
350
400
77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98
<HDU
#

I
n
v
e
s
t
m
e
n
t
s
Common Equity Preferred Equity Convertible Preferred Equity Common & Preferred Equity
Debt Convertible Debt Debt and Common Equity Other Combinations
Figure 2. Distribution of Venture CapitaI Finance in Canada, 1977-1998
0
100
200
300
400
500
600
700
800
77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98
<HDU
N
u
m
b
e
r

o
f

V
C

I
n
v
e
s
t
m
e
n
t
s
Start-up Expansion Turnaround Buyout
24

Figure 3. Venture CapitaI Firms in Canada: 1977-1998
0
500
1000
1500
2000
2500
3000
77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98
Year
T
o
t
a
I

#

I
n
v
e
s
t
m
e
n
t
s
0
20
40
60
80
100
120
T
o
t
a
I

#

F
i
r
m
s
Total # Investments Total # VC Firms

0
1
2
3
4
5
6
7
8
9
10
$Can (biIIions of 1997 doIIars)
92 93 94 95 96 97 98
Year
Figure 4. Venture CapitaI Under Management by Investor Type in Canada: 1992-1998
Private
Labour Sponsored
Hybrid
Government
Corporate

TotaI # # Inv. # Inv. # Inv. # Inv. # Inv. #Inv. # Inv. # Inv. # Inv. # Inv. # Inv. < 50
Forms of Finance Investments Start-up Expansion Buyout Turnaround DeaI<$1m $1m<DeaI<$5m DeaI>$5m New Syndication TechnoIogy EmpIoyees
Common 572 273 222 26 12 321 181 70 220 219 418 280
Preferred 59 47 8 0 1 14 34 11 21 48 51 37
ConvertibIe Preferred 75 36 31 1 5 23 38 14 18 48 71 47
Preferred and Warrants 2 2 0 0 0 0 2 0 2 2 2 0
ConvertibIe Debt 171 66 87 5 8 102 61 8 48 63 124 93
Straight Debt and Warrants 2 0 1 0 1 1 1 0 2 1 2 0
Straight Debt 204 53 74 18 21 160 41 3 65 45 87 104
Warrants 36 5 27 2 1 14 8 14 15 21 26 14
Common and Straight Debt 72 22 28 14 3 40 26 6 52 22 36 39
Common and Preferred and Debt 51 14 31 4 1 19 25 7 34 20 36 23
Preferred and Debt 15 3 4 2 2 4 10 1 5 5 9 7
Preferred and Common 32 16 11 3 1 22 7 3 21 15 17 22
Common and Warrants 16 8 8 0 0 4 7 5 7 12 14 5
Other Combinations 35 16 12 4 3 18 13 4 22 10 17 17
TotaI 1342 561 544 79 59 742 454 146 532 531 910 688
TabIe I. Number of Investments with AIternative Forms of Finance used by Canadian Private Independent Venture CapitaIists from 1991 - 1998.
Common 238 87 132 8 5 76 102 60 124 123 188 79
Preferred 19 10 6 2 0 4 9 6 11 10 15 9
Straight Debt 182 45 96 20 9 129 40 13 89 41 75 41
Warrants 13 4 8 0 1 4 4 5 5 5 7 7
TotaI 767 222 432 61 29 317 314 136 383 331 485 225
TabIe II. Number of Investments with AIternative Forms of Finance used by Canadian Corporate Venture CapitaIists from 1991 - 1998.
26

Common 581 203 267 21 35 283 230 68 309 309 332 264
Preferred 89 58 19 2 7 27 39 23 28 51 63 56
Straight Debt 234 68 79 13 41 166 54 14 63 0 89 119
Warrants 69 10 55 2 2 12 34 23 32 5 57 23
TotaI 1558 554 653 72 150 757 604 197 768 713 882 783
TabIe III. Number of Investments with AIternative Forms of Finance used by Canadian Labour Sponsored Venture CapitaIists from 1991 - 1998.
Common 218 114 90 6 2 130 68 20 74 104 185 103
Preferred 26 17 7 0 1 16 6 4 7 9 23 9
Straight Debt 36 20 11 2 3 33 3 0 3 10 27 15
Warrants 6 2 4 0 0 5 1 0 4 1 5 3
TotaI 408 214 155 13 14 255 122 31 147 182 313 215
TabIe IV. Number of Investments with AIternative Forms of Finance used by Canadian Hybrid Venture CapitaIists from 1991 - 1998.
27

Common 393 287 90 6 7 258 103 32 237 160 332 297
Preferred 34 21 10 0 3 14 16 4 15 20 29 26
Straight Debt 69 22 31 5 7 59 10 0 24 22 40 36
Warrants 14 5 5 0 2 10 2 2 6 4 6 9
TotaI 736 451 220 15 37 468 209 59 385 342 586 533
TabIe V. Number of Investments with AIternative Forms of Finance used by Canadian Government Venture CapitaIists from 1991 - 1998.
Forms of Finance Investments Start-up Expansion Buyout Turnaround DeaI<$1m $1m<DeaI<$5m DeaI>$5m New Syndication TechnoIogy Em pIoyees
Common 226 120 88 6 4 67 93 66 443 123 219 118
Preferred 25 18 7 0 0 6 12 7 10 25 25 19
Preferred and W arrants 0 0 0 0 0 0 0 0 0 0 0 0
Straight Debt and W arrants 14 2 9 3 0 4 9 1 0 1 14 0
Straight Debt 51 17 24 6 4 27 18 6 27 0 44 15
W arrants 27 6 20 1 0 2 11 14 10 1 27 19
Common and W arrants 2 0 2 0 0 1 0 1 0 0 2 2
TotaI 512 239 217 24 20 157 219 136 514 311 496 263
TabI e VI. Num ber of I nvestments with AIternative Forms of Finance used by Canadian Venture CapitaIists (Unknown Type) from 1991 - 1998.
28

Preferred Common ConvertibIe Preferred Debt ConvertibIe Debt Warrants Mixed Debt-Equity
Private Independent -0.0092 0.0142 0.0176 0.0141 0.0033 -0.0140 -0.0324
Corporate -0.0436 -0.0939 -0.0144 0.1045 0.0363 -0.0333 0.0436
Government -0.0022 0.0896 -0.0157 -0.0582 -0.0286 -0.0277 -0.0351
Hybrid 0.0222 0.0745 -0.0055 -0.0450 -0.0335 -0.0271 -0.0205
LSVCC 0.0296 -0.0608 -0.0283 0.0039 -0.0135 0.0493 0.0768
British CoIumbia 0.0211 -0.0579 0.0520 0.0110 0.0706 0.0489 -0.0445
AIberta 0.0154 -0.0633 0.0231 0.0372 0.0554 0.0997 -0.0534
Saskatchewan 0.0053 -0.0154 0.0358 -0.0352 0.0486 0.0682 -0.0203
Manitoba 0.0165 -0.0433 0.0419 -0.0104 0.0650 0.0745 -0.0391
Ontario 0.0233 -0.0885 0.0589 0.0480 0.0915 0.0543 -0.0655
Quebec 0.0247 -0.1000 0.0572 0.0591 0.1021 0.0239 -0.0651
Interest 0.0020 0.0174 -0.0304 -0.0030 -0.0453 -0.0698 0.0462
TabIe VII. CorreIations Across Financing Choices, Canadian Provinces, and Type of Venture CapitaI Fund
29

Dependent Private British Saskat- Interest
Eqn (Endogenous) VariabIes Constant Independent Corporate Govenrment Hybrid LSVCC Columbia Alberta chewan Manitoba Ontario Quebec Rate
1 Seed -13.764 -0.0783402 -0.805637 0.77366 0.305453 -0.487299 -0.53626 -0.189904 -0.182835 1.61937 0.197799 -0.034453 1.0323
(-2.1165)** (-0.7374) (-6.7058)*** (6.4398)*** (2.2751)** (-4.6887)*** (-1.8871)* (-1.8431)* (-1.8005)* (1.8701)* (1.9062)* (-1.8519)* (2.0346)*
2 Expansion 27.6057 -0.02949 0.561703 -0.49367 -0.174073 -0.0380069 1.24851 0.451604 0.468839 -3.79789 -0.465375 0.0854782 -2.15952
(3.8408)*** (-0.2754) (4.8317)*** (-4.0099)*** (-1.2722) (-0.3664) (3.9520)*** (3.9385)*** (4.1267)*** (-3.9447)*** (-4.0258)*** (4.1125)*** (-3.859)***
3 Buyout -13.4435 -0.0190802 0.702748 -1.20834 -0.542521 0.0833116 -0.488561 -0.179783 -0.182585 1.48437 0.184147 -0.0368873 0.905203
(-1.1945) (-0.0783) (2.7913)*** (-3.5478)*** (-1.5331) (0.3417) (-1.0011) (-1.0193) (-1.0542) (0.9982) (1.0368) (-1.1623) (1.0253)
4 Turnaround -11.4596 -0.186276 0.0309186 -0.14156 -0.320591 1.02401 -0.472681 -0.176787 -0.221753 1.54179 0.181697 -0.0395303 0.612876
(-1.0875) (-0.6922) (0.1032) (-0.4872) (-0.8940) (4.1490)*** (-1.0363) (-1.0705) (-1.3754) (1.1107) (1.0933) (-1.3314) (0.7420)
5 Deal <$1m -7.45564 1.00868 0.4546 1.34496 1.32606 0.770268 -0.340357 -0.124502 -0.133641 1.02121 0.126778 -0.0228851 0.491484
(-1.1542) (9.0225)*** (3.7483)*** (10.768)*** (9.4159)*** (7.0772)*** (-1.2046) (-1.2152) (-1.3218) (1.1861) (1.2282) (-1.2358) (0.9755)
6 Deal >$5m 9.09027 -1.01658 -0.535416 -1.32021 -1.44932 -0.952647 0.484086 0.178145 0.180645 -1.48515 -0.17146 0.0300009 -0.850583
(0.8117) (-7.5248)*** (-3.8567)*** (-7.6872)*** (-6.8119)*** (-7.5239)*** (0.9850) (0.9984) (1.0236) (-0.9909) (-0.9544) (0.9298) (-0.9752)
7 New Investee 15.0824 -0.50326 0.146508 -0.013586 -0.605731 0.067715 0.618882 0.218324 0.228624 -1.88867 -0.226332 0.0385616 -1.14939
(2.4072)** (-4.6876)*** (1.2625) (-0.1144) (-4.3860)*** (0.6547) (2.2585)*** (2.1973)** (2.3341)*** (-2.2622)*** (-2.2616)** (2.1487)** (-2.3516)**
8 Syndication -22.0177 -3.76334 -3.79997 -3.4025 -3.62138 -4.10063 -1.02795 -0.368548 -0.355924 3.13394 0.377712 -0.0667948 1.94366
(-3.1909)*** (-14.422)*** (-14.310)*** (-12.795)*** (-13.220)*** (-15.739)*** (-3.418)*** (-3.380)*** (-3.313)*** (3.418)*** (3.4340)*** (-3.394)*** (3.610)***
9 Technology -6.54996 0.0814756 -0.387708 0.837929 0.441327 -0.675934 -0.290777 -0.106583 -0.080487 0.863613 0.104529 -0.0166194 0.471245
(-1.0172) (0.6987) (-3.1085)*** (5.9955)*** (2.8430)*** (-6.0700)*** (-1.0333) (-1.0451) (-0.8013) (1.0075) (1.0176) (-0.9028) (0.9373)
10 Employees <50 -6.61709 -0.0154158 -0.933767 0.89889 0.055856 -0.0347398 -0.298602 -0.106294 -0.111428 0.89187 0.112924 -0.0208608 0.515631
(-1.0194) (-0.1464) (-7.8277)*** (7.3027)*** (0.4187) (-0.3399) (-1.0507) (-1.0312) (-1.0963) (1.0301) (1.0877) (-1.1201) (1.0190)
Note: t-statistics in parentheses. The variable for entreprenrueial firms in Maratime provinces was suppressed to avoid estimation problems due to collinearity.
*Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level.
TabIe VIII. Logit Regressions on the ProbabiIity of Different EntrepreneuriaI Firms in the Venture CapitaI Market / First Stage DWH Regressions
Independent VariabIes (Instruments used for DWH Tests)
30

Eqn Dependent Variable Start-up Expansion Buyout Turnaround Deal<1m Deal>5m New lnvestee Syndication Technology Emp<50
11 Log
e
(P
Common
/ P
Preferred
) -0.0668 -0.2676 0.168878 -0.9978 0.2297 -0.0855 -0.4272 0.1851 -0.7866 -0.2012
(-0.2980) (-0.8675) (0.2648) (-2.0336)** (1.2241) (-0.4682) (-2.3822)** (0.7492) (-2.8436)*** (-0.9397)
12 Log
e
(P
Common
/ P
) -0.5667 -0.2560 0.5849 -1.3264 -0.1359 -0.1506 -0.3964 0.3848 0.3800 -0.1401
(-2.6419)*** (-0.8972) (0.6802) (-2.3076)** (-0.7032) (-0.9138) (-2.2803)** (1.5553) (0.9179) (-0.6751)
13 Log
e
(P
Common
/ P
Debt
) -0.4658 0.7991 -0.614185 -0.6695 -0.1814 0.6744 -0.8378 0.8341 -0.1248 -0.0071
(-2.8547)*** (4.3832)*** (-2.5962)** (-2.9428)*** (-1.4536) (3.4734)*** (-7.2025)*** (4.6095)*** (-0.6887) (-0.0466)
14 Log
e
(P
Common
/ P
ConvertibleDebt
) -0.5153 0.7371 -1.1073 -2.1618 -0.1132 0.8766 -0.7164 0.5904 1.0135 0.2033
(-3.2180)*** (3.7677)*** (-2.7800)*** (-6.1862)*** (-0.8887) (5.1509)*** (-5.9940)*** (3.3411) (3.3023)*** (1.2766)
15 Log
e
(P
Common
/ P
Debt+Equity
) -0.2813 0.7999 -0.9452 -0.7418 0.2808 0.4018 -0.3312 0.1922 -0.3859 -0.0540
(-1.7303)* (4.5319)*** (-3.7473)*** (-2.7376)*** (2.2207)** (2.6801)*** (-2.9633)*** (1.0684) (-2.3015)** (-0.3638)
16 Log
e
(P
Common
/ P
Warrants
) -0.2041 -1.5838 -0.77689 -1.2794 -1.2286 -0.8070 -0.7932 -0.3482 0.3490 -0.1141
(-0.6892) (-3.7149)*** (-1.0279) (-1.7435)* (-4.4126)*** (-3.9004)*** (-3.3885)*** (-0.9230) (0.7131) (-0.4368)
17 Log
e
(P
Preferred
/ P
) -0.4998 0.0115 0.4160 -0.3286 -0.3656 -0.0650 0.0308 0.1997 1.1666 0.0610
(-1.7136)* (0.0291) (0.3980) (-0.4568) (-1.4608) (-0.2909) (0.1301) (0.6079) (2.4650)** (0.2192)
18 Log
e
(P
Preferred
/ P
Debt
) -0.3989 1.0667 -0.783064 0.3284 -0.4111 0.7599 -0.4106 0.6491 0.6617 0.1941
(-1.5154) (3.1581)*** (-1.2096) (0.6609) (-1.9599)** (3.0305)*** (-2.0206)** (2.2371)** (2.1686)** (0.7866)
19 Log
e
(P
Preferred
/ P
ConvertibleDebt
) -0.4484 1.0047 -1.27619 -1.1639 -0.3429 0.9621 -0.2892 0.4053 1.8001 0.4044
(-1.7279)* (2.9284)*** (-1.7715)* (-2.0736)** (-1.6399)* (4.1662)*** (-1.4200) (1.4208) (4.6154)*** (1.6203)
20 Log
e
(P
Preferred
/ P
Debt+Equity
) -0.2145 1.0674 -1.11407 0.2561 0.0511 0.4874 0.0960 0.0072 0.4007 0.1472
(-0.8175) (3.2009)*** (-1.7076)* (0.4954) (0.2434) (2.2258)*** (0.4801) (0.0248) (1.3537) (0.6029)
21 Log
e
(P
Preferred
/ P
Warrants
) -0.1372 -1.3162 -0.945768 -0.2816 -1.4583 -0.7215 -0.3660 -0.5333 1.1356 0.0871
(-0.3812) (-2.5741)** (-0.9812) (-0.3296) (-4.5034)*** (-2.7677)*** (-1.2776) (-1.2157) (2.0790)** (0.2682)
TabIe IX. Durbin-Wu-Hausman Tests of the Effect of Endogeneity on the Estimated Forms of Venture CapitaI Finance
t-statistics in parentheses. *Significant at the 10% level. **Significant at the 5% level. ***Significant at the 1% level. Continued.
lndependent Variables: Residuals from the Regressions Reported in Table Vlll. Other lndependent Variables not Reported.
31

Eqn Dependent Variable Start-up Expansion Buyout Turnaround Deal<1m Deal>5m New lnvestee Syndication Technology Emp<50
22 Log
e
(P
/ P
Debt
) 0.1009 1.0551 -1.1991 0.6570 -0.0455 0.8250 -0.4413 0.4494 -0.5049 0.1331
(0.3945) (3.3137)*** (-1.3801) (1.12735) (-0.2108) (3.4598)*** (-2.2193)** (1.5438) (-1.1602) (0.5498)
23 Log
e
(P
/ P
ConvertibleDebt
) 0.0514 0.9932 -1.69222 -0.8353 0.0227 1.0272 -0.3199 0.2056 0.6334 0.3434
(0.2061) (3.1024)*** (-1.8385)* (-1.3196) (0.1065) (4.7761)*** (-1.6209) (0.7249) (1.2782) (1.4167)
24 Log
e
(P
/ P
Debt+Equity
) 0.2854 1.0559 -1.5301 0.5846 0.4167 0.5524 0.0653 -0.1926 -0.7659 0.0861
(1.1196) (3.3560)*** (-1.7520)* (0.9724) (1.9249) (2.6858)*** (0.3336) (-0.6645) (-1.7846)* (0.3600)
25 Log
e
(P
/ P
Warrants
) 0.3626 -1.3277 -1.36179 0.0470 -1.0928 -0.6564 -0.3967 -0.7330 -0.0311 0.0261
(1.0341) (-2.6822)*** (-1.2143) (0.0520) (-3.3574)*** (-2.6620)*** (-1.4104) (-1.6807)* (-0.0498) (0.0820)
26 Log
e
(P
Debt
/ P
ConvertibleDebt
) -0.0495 -0.0620 -0.493128 -1.4923 0.0682 0.2022 0.1214 -0.2437 1.1383 0.2103
(-0.2405) (-0.2675) (-1.2154) (-4.2543)*** (0.4464) (0.8461) (0.8200) (-1.0778) (3.4883)*** (1.0800)
27 Log
e
(P
Debt
/ P
Debt+Equity
) 0.1845 0.0008 -0.331009 -0.0723 0.4622 -0.2725 0.5066 -0.6419 -0.2610 -0.0469
(0.8832) (0.0036) (-1.2311) (-0.2625) (3.0438)*** (-1.2265) (3.5730) (-2.7776)*** (-1.2770) (-0.2510)
28 Log
e
(P
Debt
/ P
Warrants
) 0.2617 -2.3828 -0.162704 -0.6100 -1.0473 -1.4814 0.0446 -1.1824 0.4738 -0.1070
(0.8030) (-5.3302)*** (-0.2129) (-0.8274) (-3.5767)*** (-5.5435)*** (0.1768) (-2.9138)*** (0.9369) (-0.3722)
29 Log
e
(P
ConvertibleDebt
/ P
Debt+Equity
) 0.2340 0.0627 0.1621 1.4200 0.3940 -0.4747 0.3852 -0.3982 -1.3993 -0.2573
(1.1194) (0.2695) (0.3849) (3.6819)*** (2.5056)*** (-2.2883)** (2.6203)*** (-1.7321)* (-4.3365)*** (-1.3096)
30 Log
e
(P
ConvertibleDebt
/ P
Warrants
) 0.3112 -2.3209 0.3304 0.8823 -1.1154 -1.6836 -0.0768 -0.9386 -0.6645 -0.3173
(0.9647) (-5.1474)*** (0.3996) (1.1284) (-3.8158)*** (-6.7795)*** (-0.3042) (-2.3340)** (-1.1844) (-1.0944)
31 Log
e
(P
Debt-Equity
/ P
Warrants
) 0.0772 -2.3836 0.168305 -0.5376 -1.5094 -1.2089 -0.4620 -0.5404 0.7348 -0.0601
(0.2375) (-5.3684)*** (0.2190) (-0.7160) (-5.1494)*** (-5.0892)*** (-1.8553)* (-1.3363) (1.4694) (-0.2113)
TabIe IX (Continued). Durbin-Wu-Hausman Tests of the Effect of Endogeneity on the Estimated Forms of Venture CapitaI Finance
t-statistics in parentheses. *Significant at the 10% level. **Significant at the 5% level. ***Significant at the 1% level.
lndependent Variables: Residuals from the Regressions Reported in Table Vlll. Other lndependent Variables not Reported.
32

Form of Finance Start-up Expansion Buyout Turnaround Deal<$1m Deal>$5m New lnvestee Syndication Technology Emp<50
Warrants N/A 1 N/A 7 1 1 2 1 5 N/A
Common Equity 6 2 6 6 4 2 7 2 3 N/A
Straight Preferred Equity 5 3 3 2 5 2 4 2 1 N/A
Convertible Preferred Equity 1 4 3 5 N/A 2 4 5 5 N/A
Convertible Debt 1 7 1 1 2 7 2 5 7 N/A
Debt and Common Equity 3 5 1 2 5 5 4 2 2 N/A
Straight Debt 3 5 3 2 2 5 1 7 3 N/A
TabIe X. Rankings of the LikeIihood of SeIf SeIection to AIternative forms of Finance
Rankings based on the empirical evidence presented in Table lX.
N/A: Not applicable for cases in which the evidence does not indicate any selection effects relative to other forms of finance.
A rank of "1" means that type of firm is most likely to self-select towards that particular form of finance.
Note: the same rankings are given where the data does not indicate significant differences across forms of finance.
Type of Firm / Transaction
Endnotes

The presence oI agency costs (both moral hazard and adverse selection) in venture capital has been
used as a primary explanation Ior the very existence oI specialized venture capital investors that mitigate
such problems in entrepreneurial Iinance; see Sahlman (1990), MacIntosh (1994), Amit et al. (1990, 1993,
1997). The existence oI venture capitalists can also be explained by a risk-sharing argument (Amit et al.,
1990) or a 'skills learning story (Chan et al., 1990); see also Garmaise (2000). Agency problems,
however, can only be mitigated and not eliminated (Farmer and Winter, 1986). Because venture capitalists
Iinance early-stage Iirms, it is not surprising that around 20 oI venture capital investments are written oII
(Cumming and MacIntosh, 2001, 2002; Cochrane, 2001).

2
At the time this paper was prepared, the Canadian Venture Capital Association was the only
venture capital association in the world that has collected industry-wide data on Iorms oI Iinance used by
venture capitalists. See Sahlman (1990), Gompers (1997), Bergmann and Hege (1998), Kaplan and
Strmberg (2000a) Ior U.S. evidence. Various links Irom www.vIinance.com (see the Iirm web pages)
also indicate Iorms oI Iinance used by certain venture capital and other private equity Iirms in the U.S.

3
Increasing the price oI one security relative to another may lead some entrepreneurs to switch to
an alternative source oI Iinance (e.g., Irom the type oI Iinancial intermediary providing debt to the type oI
Iinancial intermediary providing equity); see e.g., Stiglitz and Weiss (1981), DeMeza and Webb (1987,
1992), Hellmann and Stiglitz (2000). Given the limitation that our data (see section 3 below) does not
indicate relative security prices Ior Iorms oI Iinance in Canadian venture capital, we hold constant
relative security prices and Iocus on adverse selection associated with the use oI alternative Iorms oI
Iinance. But this may not be a signiIicant limitation Ior two reasons. First, our empirics include interest
rates as a control variable (subsection 4.2 below). Second, since all types oI venture capitalists in
Canada employ all Iorms oI Iinance (see Figure 1 and Tables I VI below), relative security prices Ior
entrepreneurs seeking venture Iinancing in Canada are likely quite stable, especially compared to
situations in which diIIerent Iorms oI Iinance are only available Irom diIIerent types oI Iinancial
intermediaries.

4
Our data does not indicate inIormation pertaining to control and cash Ilow rights (Sahlman,
1990; Gompers, 1997; and Kaplan and Strmberg, 2000a). To the extent that selection eIIects are
associated with the allocation oI control and cash Ilow rights, there may be 'noise in our empirical

34

evidence. Nevertheless, Iollowing Stiglitz and Weiss (1981, 1986, and 1987), Greenwald et al. (1984),
Myers and MjluI (1984), DeMeza and Webb (1987, 1992), MacIntosh (1994), Hellmann and Stiglitz
(2000), among others, we suspect that selection eIIects are more broadly associated with Iorm(s) oI
Iinance at the outset, and not the particular underlying terms oI the Iinancial contract determined
pursuant to contractual negotiations and Iine-tuning.

5
The data does make all possible distinctions between, Ior example, convertible debt and mixes oI
straight debt with warrants (mixes were much less Irequent). However, such contracts were grouped
together in the empirical analysis where the theoretical predictions were similar; distinct contracts did not
materially change the results. Some oI the other combinations oI Iorms oI Iinance recorded in the data
are presented in Tables I VI; but such Iorms were used inIrequently and were generally insigniIicant in
the empirical analysis.

6
Davidson and MacKinnon (1993) discuss DWH tests Ior continuous variables. These
speciIication tests have also been reIerred to as simply Hausman speciIication tests` in various texts.
Angrist (2000), Rivers and Vuong (1988) and Wooldridge (2000, 2002) and others consider various ways to
deal with endogeneity in limited dependent variable models. The problem oI causal inIerence is not
Iundamentally diIIerent, but limited dependent variables do present additional challenges in certain
contexts, particularly Ior censored regression models. The DWH artiIicial regressions with (potentially
endogenous) standard binary dummy variables in the context oI this paper are quite robust to alternative
methods and speciIications. The tests are also quite robust to various possible adjustments Ior multiple
potential endogenous variables as described in, Ior example, Maddala (2001, chapter 12). Alternative
speciIications are available upon request.

7
See also mission statements Irom venture capital Iirms; links are available Irom
www.vIinance.com and www.cvca.ca.

8
DiIIerent types oI entrepreneurial Iirms may be more prevalent in diIIerent provinces in Canada.
For example, Ontario and Quebec may have relatively more high-technology Iirms than other regions
due to diIIerences in regional development.

35

9
Geographic location is not related to the use oI diIIerent Iorms oI Iinance. Bank interest rates
appear to aIIect whether or not a Iirm will be in the VC market, but not the type oI Iinancing employed.
DiIIerent types oI venture capital Iirms in Canada are not restricted Irom using diIIerent Iorms oI
Iinance. DiIIerent types oI Iunds may preIer to Iinance certain types oI entrepreneurial Iirms, and
diIIerent Iorms oI Iinance may be more appropriate Ior diIIerent types oI entrepreneurial Iirms, but there
is generally no direct incentive Ior diIIerent types oI Iunds to use diIIerent Iorms oI Iinance. The one
possible exception is the case oI LSVCCs (see Cumming, 2000, Ior details); thereIore, we include the
LSVCC variable in equations (11) (31).

10
The results are robust to alternative interest rates. The results in Table VII and VIII are
presented Ior 90-day bank rates. Theoretical work also indicates other Iactors such as intellectual
property protection may also aIIect the choice between banks versus venture capital (Ueda, 2000);
however, we do not have proxies Ior other Iactors in the Canadian data.

11
There are nevertheless diIIerences in the Iorms oI Iinance to which Iirms with diIIerent capital
requirements are least attracted. Firms with low capital requirements appear to select away Irom straight
preIerred equity and mixes oI debt and common equity (equations 15, 18, 19, 21, 29 and 31). Firms with
signiIicant capital requirements tend to select away Irom convertible debt (equations 14, 19, 20, 23 and 29)
and straight debt and mixes oI debt and common equity (equations 15, 28, 22, 24 and 31).

12
High-tech Iirms are less likely to select towards straight debt. High-tech Iirms, especially high
tech entrepreneurial Iirms, are less likely to have revenues Ior an extended period oI time to pay Iixed
interest payments on debt (see, e.g., MacIntosh, 1994; Rajan and Zingales, 1995; Noe and Rebello, 1996;
Cumming and MacIntosh, 2000).

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