Entrepreneurship Mar 2, 2011

Not All VCs Are Cre­at­ed Equally

High-qual­i­ty ven­ture cap­i­tal­ists can improve finan­cial man­age­ment and reporting

Based on the research of

Wan Wongsunwai

Listening: Interview with Wan Wongsunwai

download

Your browser doesn’t support HTML5 audio

It is human nature to want to look good to oth­ers. Add to that the finan­cial incen­tives that man­agers of pri­vate com­pa­nies have to make their com­pa­nies look good, and you have a recipe that some­times results in manip­u­la­tion of finan­cial data and some­times out­right cook­ing the books.” Research by Wan Wong­sun­wai, an assis­tant pro­fes­sor of account­ing infor­ma­tion and man­age­ment at the Kel­logg School of Man­age­ment, shows that over­sight by the best ven­ture cap­i­tal­ists (VCs) can sub­stan­tial­ly improve finan­cial report­ing in the cru­cial peri­od sur­round­ing the ini­tial pub­lic offer­ing (IPO) of equi­ty stock. But the pres­ence of a VC alone is not enough to reduce the risk of dis­hon­est finan­cial report­ing — the VC must have the skills need­ed to exer­cise influ­ence over man­age­r­i­al behavior.

Add Insight
to your inbox.

We’ll send you one email a week with content you actually want to read, curated by the Insight team.

Sign up here

There are wide­ly diver­gent views of VCs, Wong­sun­wai notes. Pre­vi­ous aca­d­e­m­ic papers have tend­ed to por­tray them as very use­ful inter­me­di­aries who chan­nel funds from those who have them to those who need them. How­ev­er, some busi­ness­peo­ple refer to VCs as vul­ture cap­i­tal­ists,” believ­ing they seize oppor­tu­ni­ties and exploit weak­ness­es they detect in peo­ple they are deal­ing with. Wongsunwai’s study attempt­ed to rec­on­cile these oppos­ing views of VCs.

Unlike oth­er stud­ies exam­in­ing the rela­tion­ship between VCs and com­pa­ny finan­cial report­ing, Wongsunwai’s work dis­tin­guish­es between VCs who are able to mean­ing­ful­ly influ­ence man­age­ment behav­ior (“high-qual­i­ty VCs”) and those who lack that abil­i­ty. How­ev­er, try­ing to mea­sure the qual­i­ty of VCs is not straight­for­ward, Wong­sun­wai says. For exam­ple, pre­vi­ous research attempt­ed to use finan­cial per­for­mance as a mea­sure of VC qual­i­ty, but that approach was com­pli­cat­ed by the dif­fi­cul­ty researchers faced in obtain­ing accu­rate infor­ma­tion. He says that is because VCs are often required to dis­close this infor­ma­tion only to their investors, not to out­siders. To over­come this prob­lem, he dis­tilled a vari­ety of qual­i­ty mea­sures into two: past invest­ment his­to­ry and syn­di­ca­tion activity.

Peer­ing into the Past

Past invest­ment his­to­ry reflects the suc­cess of past deals — for exam­ple, whether the VC invest­ed in Google. Syn­di­ca­tion activ­i­ty looks at how many times a giv­en VC attracts oth­ers as investors in a project and sug­gests how he or she is per­ceived by peers. The idea is, VCs will know who the bet­ter ones are amongst them­selves,” Wong­sun­wai explains. If we see a suc­cess­ful VC going to syn­di­cate often with anoth­er VC, chances are they think that oth­er VC is a qual­i­ty VC,” he says. On the oth­er hand, if a VC tends to do things on his or her own, it is often because oth­er VCs avoid joint ven­tures because of his or her poor reputation.

The advan­tage these mea­sures have over finan­cial per­for­mance is that the data are read­i­ly avail­able to researchers. We can see which com­pa­nies VCs invest in because they don’t mind telling us,” Wong­sun­wai says. We can also see who they have been work­ing with because if one par­ty doesn’t tell you, anoth­er par­ty is willing.”

Wong­sun­wai focused on how VCs impact two kinds of earn­ings man­age­ment: real earn­ings manip­u­la­tion and accru­al-based manipulation.

Real earn­ings manip­u­la­tion describes activ­i­ties firms under­take to influ­ence the num­bers that they are required to report. For exam­ple, a com­pa­ny near­ing the end of a quar­ter may real­ize that it is going to fall short of what the mar­ket expects. Per­haps investors fore­cast that the com­pa­ny would deliv­er $100 of prof­it in the com­ing quar­ter, with sales of $500 and expens­es of $400. Pri­or to the end of the quar­ter, the com­pa­ny real­izes that although its sales will be $500, its expens­es will be $420, leav­ing it with prof­it of only $80. In this sit­u­a­tion, the com­pa­ny might look for expens­es it could cut or post­pone. It might decide that a mar­ket­ing cam­paign cost­ing $20 and sched­uled to start two weeks before the end of the quar­ter should be post­poned two weeks so that it is not part of the fourth-quar­ter report. Thus, the earn­ings fig­ure will rise to the expect­ed $100.

Accord­ing to Wong­sun­wai, The prob­lem with this type of behav­ior is that it has impli­ca­tions for long-term future per­for­mance. If I cut down on my mar­ket­ing today, I am like­ly to make few­er sales tomor­row.” He went on to explain that com­pa­nies manip­u­late fig­ures in this way, despite the neg­a­tive impact on long-term per­for­mance, because the need to avoid dis­ap­point­ing investors is seen to out­weigh the future loss of prof­its that may derive from those actions.

The oth­er type of earn­ings man­age­ment, accru­al-based manip­u­la­tion, is real­ly cook­ing the books,” Wong­sun­wai says. In our exam­ple, you go ahead and do the mar­ket­ing activ­i­ties as planned, but you mis­re­port it. Instead of say­ing that you spent $20 on mar­ket­ing, you use some account­ing tricks to make it look like it is only $5. There are many ways com­pa­nies can do this kind of thing.”

Wong­sun­wai used Thom­son Financial’s Ven­ture Eco­nom­ics data­base to iden­ti­fy VC-backed com­pa­nies that con­duct­ed IPOs between 1990 and 2004, togeth­er with the names of the VCs who pro­vid­ed first-round financ­ing. For each VC-backed com­pa­ny that went pub­lic, he iden­ti­fied from Secu­ri­ties Data Cor­po­ra­tion a match­ing non-VC-backed com­pa­ny that con­duct­ed an IPO in the Unit­ed States in the same year, was in the same indus­try, and had the clos­est return on assets in the year of the IPO. This yield­ed 1,226 IPO com­pa­nies. He then col­lect­ed finan­cial state­ment data on these com­pa­nies from Com­pu­s­tat, as well as data com­piled by Audit Ana­lyt­ics on finan­cial restate­ments announced between Jan­u­ary 2001 and Decem­ber 2008.

Wongsunwai’s research sug­gests that when high-qual­i­ty VCs are involved in a com­pa­ny, not only is one type not being used as a sub­sti­tute for the oth­er, but nei­ther type is observed.

Wong­sun­wai exam­ined earn­ing man­age­ment activ­i­ties over four peri­ods of time rel­a­tive to the IPOs. Phase 1 was the pre-IPO phase, con­sist­ing of four quar­ters end­ing on the fis­cal quar­ter-end date imme­di­ate­ly pre­ced­ing the IPO date. Phase 2 was the peri­od start­ing with the fis­cal quar­ter-end imme­di­ate­ly pre­ced­ing the IPO date and end­ing on the fis­cal quar­ter-end imme­di­ate­ly pre­ced­ing the lock­up expi­ra­tion date. Phas­es 3 and 4 were two sub­se­quent peri­ods of four quar­ters each.

Qual­i­ty That Shows

Wong­sun­wai found that com­pa­nies backed by high­er-qual­i­ty VCs engaged in less aggres­sive finan­cial report­ing, as reflect­ed in low­er abnor­mal accru­als and low­er real activ­i­ties manip­u­la­tion (Fig­ures 1 and 2), and a low­er rate of sub­se­quent finan­cial restate­ments. The dif­fer­ence in abnor­mal accru­als was dri­ven by the peri­od imme­di­ate­ly pre­ced­ing the expi­ra­tion of IPO lock­ups. (When attract­ing VCs, many entre­pre­neurs com­mit to a lock­up” peri­od, a length of time they will hold their own shares of the stock after the IPO, to assure investors that the com­pa­ny is a legit­i­mate operation.)

Fig­ure 1. Aver­age abnor­mal accru­als for three groups of IPO com­pa­nies in four time peri­ods. The phas­es are defined as fol­lows: (1) the pre-IPO phase con­sist­ing of four quar­ters end­ing on the fis­cal quar­ter-end date imme­di­ate­ly pre­ced­ing the IPO date, (2) the peri­od start­ing with the fis­cal quar­ter-end imme­di­ate­ly pre­ced­ing the IPO date and end­ing on the fis­cal quar­ter-end imme­di­ate­ly pre­ced­ing the lock­up expi­ra­tion date, (3) and (4) two sub­se­quent peri­ods of four quar­ters each.
Fig­ure 2. Aver­age aggre­gate mea­sures of real earn­ings man­age­ment for three groups of IPO com­pa­nies in four time periods

More­over, high­er-qual­i­ty VCs drove the low­er abnor­mal accru­als in VC-backed com­pa­nies. Low­er-qual­i­ty VC-backed and non-VC-backed IPO com­pa­nies had sta­tis­ti­cal­ly indis­tin­guish­able lev­els of abnor­mal accru­als in all peri­ods sur­round­ing the IPO and lock­up expi­ra­tion. These find­ings sug­gest that low­er-tier VCs are unable or unwill­ing to mon­i­tor their com­pa­nies so as to con­strain the aggres­sive report­ing of finan­cial results to poten­tial new investors,” Wong­sun­wai reports in a work­ing paper. Over­all, the evi­dence points to high­er-qual­i­ty VCs mon­i­tor­ing their port­fo­lio com­pa­nies more effectively.”

The exist­ing lit­er­a­ture gen­er­al­ly asserts that real activ­i­ties manip­u­la­tion and accru­al-based manip­u­la­tion tend to be used inter­change­ably (i.e., com­pa­nies try one approach and, if it doesn’t work, try the oth­er). How­ev­er, Wongsunwai’s research sug­gests that when high-qual­i­ty VCs are involved in a com­pa­ny, not only is one type not being used as a sub­sti­tute for the oth­er, but nei­ther type is observed. I ascribe that to the fact that top-tiered VCs with strong skills are able to con­strain the human-nature ten­den­cy to over­state per­for­mance,” he says.

This research is about why peo­ple do the things they do,” Wong­sun­wai explains. In the case of busi­ness man­agers, for exam­ple, the rea­son they manip­u­late earn­ings may be stock options. If peo­ple run­ning a com­pa­ny have their wealth tied to the price of the com­pa­ny stock, they will resort to a lot of ways to keep the stock prices as high as they can,” he says. In the case of VCs, this research looks at a point in time at which VC mon­i­tor­ing incen­tives might be weak­ened. If the com­pa­nies are try­ing to inflate prices, the VCs might be tempt­ed to let their mon­i­tor­ing role lapse a lit­tle bit,” Wong­sun­wai points out, because if as a result stock prices go up, the VC ben­e­fits as well. How­ev­er, the high­est-qual­i­ty VCs have a counter-incen­tive: their rep­u­ta­tion. Wong­sun­wai con­cludes, If VCs don’t have the skills need­ed to influ­ence man­age­r­i­al deci­sions, or if they choose not to apply their skills at the time their com­pa­nies are going pub­lic, then we will see neg­a­tive consequences.”

Relat­ed read­ing on Kel­logg Insight

The Promise, Per­ils, and Per­for­mance of Pri­vate Equi­ty: The returns that insti­tu­tion­al investors real­ize from pri­vate equi­ty dif­fers dra­mat­i­cal­ly across institutions

In with the In” Crowd: In ven­ture cap­i­tal, high school rules prevail

Featured Faculty

Wan Wongsunwai

Member of the Department of Accounting Information & Management from 2007-2016

About the Writer

Beverly A. Caley, JD, is an independent writer based in Corvallis, Ore., who concentrates on business, legal, and science topics.

About the Research

Wongsunwai, Wan. Forthcoming. The Effect of External Monitoring on Accrual-Based and Real Earnings Management: Evidence from Venture-Backed Initial Public Offerings. Contemporary Accounting Research.

Read the original

Editor’s Picks

Careers

Pod­cast: How to Be a Great Mentor

Plus, some valu­able career advice that applies to just about everyone.

Marketing

A New Way to Per­suade Kids to Drink More Water and Less Soda

Get­ting chil­dren to make healthy choic­es is tricky — and the wrong mes­sage can backfire.

Innovation

How Can Social Sci­ence Become More Solutions-Oriented?

A con­ver­sa­tion between researchers at Kel­logg and Microsoft explores how behav­ioral sci­ence can best be applied.

Innovation

Buy­ing a Com­pa­ny for Its Tal­ent? Beware of Hid­den Legal Risks.

Acquir­ing anoth­er firm’s trade secrets — even unin­ten­tion­al­ly — could prove costly.

Careers

Take 5: Tips for Widen­ing — and Improv­ing — Your Can­di­date Pool

Com­mon bias­es can cause com­pa­nies to over­look a wealth of top talent.

Innovation

Every­one Wants Phar­ma­ceu­ti­cal Break­throughs. What Dri­ves Drug Com­pa­nies to Pur­sue Them?

A new study sug­gests that firms are at their most inno­v­a­tive after a finan­cial windfall.

Careers

4 Key Steps to Prepar­ing for a Busi­ness Presentation

Don’t let a lack of prep work sab­o­tage your great ideas.

Healthcare

Video: How Open Lines of Com­mu­ni­ca­tion Can Improve Health­care Outcomes

Train­ing physi­cians to be bet­ter com­mu­ni­ca­tors builds trust with patients and their loved ones.

Operations

Here’s a Bet­ter Way to Sched­ule Surgeries

A new tool could dri­ve sav­ings of 20 per­cent while still keep­ing sur­geons happy.

Politics & Elections

Why Eco­nom­ic Crises Trig­ger Polit­i­cal Turnover in Some Coun­tries but Not Others

The fall­out can hinge on how much a country’s peo­ple trust each other.

Marketing

Build­ing Strong Brands: The Inside Scoop on Brand­ing in the Real World

Tim Calkins’s blog draws lessons from brand mis­steps and triumphs.

Economics

How the Cof­fee Indus­try Is Build­ing a Sus­tain­able Sup­ply Chain in an Unsta­ble Region

Three experts dis­cuss the chal­lenges and rewards of sourc­ing cof­fee from the Demo­c­ra­t­ic Repub­lic of Congo.