void setup()

The phenomenon of syndication and syndicated venture capital investments has attracted growing interest in scientific studies mainly within the past two decades.130 The general question is why venture capitalists syndicate investments at all. When deciding whether to co-invest with other investors, VCs have to trade off the potential benefits from syndicating with the costs incurred through the syndication.131 Costs incurred are two- fold, i.e., on the one hand, profits gained from the investment have to be shared among

126 _{In this context, Weitnauer (2001) indicates the lead investor to be playing two roles. On the one hand} side, she invested a significant amount in the portfolio company, on the other hand she has to report to the public funds provider about the economic status of the portfolio company. See Weitnauer (2001), p. 251.

127 _{The lead investor usually provides a larger share of equity capital compared to co-investors. See} Wright/Lockett (2003), p. 2090. Furthermore, the lead investor spends more time supporting the portfolio company than the co-investors. for a further discussion, also see Gorman/Sahlman (1989); Freear/Sohl/Wetzel (1990); Elango et al. (1995).

128 _{See Weitnauer (2001), p. 251.} 129 _{See Weitnauer (2001), pp. 254-257.}

130 _{Authors drawing on the concept of syndication include Wilson (1968), Bygrave (1987), Bygrave} (1988), Lerner (1994), Admati/Pfleiderer (1994), Lockett/Wright (1999), Lockett/Wright (2001), Sorenson/Stuart (2001), Seppä/Jääskeläinen (2002), Brander/Amit/Antweiler (2002), Wright/Lockett (2002), Wright/Lockett (2003), Jungwirth/Moog (2004).

the investors involved. On the other hand, syndication also implies costs for coordinating the investment effort with other venture capitalists. Consequently, VCs only enter a co- investment in the case that the expected benefits outweigh the expected costs.

In literature, there is no generally accepted classification for the rationales of syndication. Categorizations include linking the motives to financial theory and the resource exchange theory,132 or, whether the positive aspects of syndication occur on the level of the single investment or of the entire portfolio.133 Since within this study, not the syndicated investments themselves but the potential connection between deal flow and the network structure of venture capitalists is analyzed based on syndicated investments, a more intuitive and simple categorization of the motives for syndication is helpful. Based on this, the rationales for syndication are distinguished based on whether they primarily stem from gaining a benefit or from mitigating a risk or hazard. This systematic is illustrated in figure 2.9.

Rationales for syndication

Gaining benefits Mitigating hazards

Management support Window- dressing Investment evaluation Reciprocation of deal flow Capital constraints Portfolio diversification Prevention of competition

Figure 2.9: Rationales for syndication134

Rationales for syndication stemming from the primary objective to mitigate risks or hazards are the following:

Portfolio diversification: According to the traditional explanation based on finance

theory, VCs might syndicate investments to share financial risk and thereby diversify their investment portfolio.135 The risk of an investment in a portfolio company is comprised of a market component (systematic risk) and a firm-specific component (non-

132 _{For a detailed discussion of this categorization, see Lockett/Wright (2001), pp. 376 ff.} 133 _{See Nathusius (2005), pp. 75 ff.}

134 _{Own illustration.}

Venture Capital 38

systematic risk). Since the systematic risk cannot be reduced by the venture capitalist, the rationale might be to hold a well-diversified portfolio of investments and thereby reduce the non-systematic risk.136

Prevention of competition: Another rationale for syndication is prevention of

competition, also named collusion. On the one hand, VCs are competitors on the market, searching for attractive investment opportunities. On the other hand, they also act as providers of information and capital to each other.137 Especially in times, when potential investment opportunities are scarce,138 banding together instead of competing represents a feasible strategy. By banding together, VCs prevent the situation of competition and may also significantly enhance their bargaining power vis-à-vis business founders.139 Rationales for syndication that are primarily based on the objective to gain benefits are the following:

Capital constraints: Syndication might also arise due to capital constraints. There are two

basic explanations why a VC might offer an (attractive) investment opportunity to other VCs. Firstly, in case that the venture capitalist does not have sufficient financial resources at hand to exclusively finance the venture business, syndication might be the only way how the VC can participate in that deal.140 Secondly, investors of VCs such as institutional investors often prescribe that the VC may only invest a certain percentage, for example up to 10% or 15%, of the entire investment volume in a single portfolio company in order to ensure portfolio diversification. If the capital requirements of the venture business exceed this given limit, syndication might again be the only way that the VC can invest.141

136 _{A precondition for reducing non-systematic risk by diversification is that the investments do not co-} vary. See Brealey/Myers (2000), pp. 166-169.

137 _{See Bygrave (1988), p. 137.}

138 _{See also Lockett/Wright (2001), pp. 378 f.}

139 _{See Brander/Amit/Antweiler (2002), p. 427; Casamatta/Haritchabalet (2003), p. 2.} 140 _{See Brander/Amit/Antweiler (2002), pp. 426 f.}

Reciprocation of deal flow: Deal flow, i.e., the list of potentially promising investment

opportunities is a highly valued intangible resource for VCs.142 Although also the quality of these opportunities is of significant importance,143 a venture capitalist aims to be in a position, in which he has access to and competes for a wide supply of potential deals. Deal flow becomes even more important to a VC in times when "…'too much money is chasing too few deals'",144 i.e., when the availability of funds is high and there is strong competition for deals among VCs. Reciprocity generally refers to the mutual exchange of resources between at least two parties, i.e., if A offers resources to B, A expects to be offered the same or similar resources from B at a later point in time. If B does not reciprocate A's offer, a further resource exchange between A and B in future is unlikely.145 By syndicating in and out deals with one another, venture capitalists share the pool of available investment opportunities. Therefore, the relationship between venture capitalists is two-way. When syndicating out a deal, the lead investor creates the expectation that this behavior will be reciprocated by the invited VC in the future. Reciprocating deals may result in the fact that "…deal flow can be maintained even when an individual VC may not be the originator of the deal."146

Investment evaluation (selection hypothesis): Without referring to venture capital

investments or any other finance-related topics, Sah and Stiglitz (1986) propose a general model of organizational design. They argue that in a hierarchical organization, investments only proceed if several independent observers agree. Furthermore, decisions that are made by many observers are superior to ones made by only one party.147 _Lerner

(1994) applies this selection hypothesis to the decision making process of VCs.148

142 _{See Lockett/Wright (2001), p. 378.}

143 _{For a detailed discussion on the quantity and quality of deal flow, see section 2.2.2.}

144 _{Gompers/Lerner (2000), p. 282. See also Kaplan/Stein (1993), pp. 313 f. For a further discussion, see} also section 2.2.3.

145 _{See Piskorski (2000), p. 4. In this context, Bygrave explained that, in the US market, reciprocity is a} mechanism that is expected to be existent. See Bygrave (1987), p. 141.

146 _{Lockett/Wright (2001), p. 379. On the reciprocation of deal flow, see also the studies of Piskorski} (2000) and Seppä/Jääskeläinen (2002).

147 _{See Sah/Stiglitz (1986), p. 717.} 148 _{See Lerner (1994), p. 16.}

Venture Capital 40

According to the selection hypothesis, multiple VCs may evaluate investment opportunities more effectively than a single VC would do. This is due to the fact that "…each learns something from the other's evaluation"149 and that "Venture capitalists prefer syndicating most deals for a simple reason – it means that they have a chance to check out their thinking against other knowledgeable sources".150

Management support (value-added hypothesis): In contrast to the selection hypothesis

that applies to the pre-investment stage or ex-ante decision making, the value-added hypothesis refers to the post-investment stage or ex-post decision making.151 Deviating from the function as a financial intermediary, a VC can also be regarded as a collection of resources.152 Resources are "…anything which could be thought of as a strength or weakness of a given firm",153 i.e., tangible and intangible assets such as machines or specific technological know-how or management skills. Since different VCs have different resources and therefore different skills, one venture capitalist might not be able to provide all specific skills that are needed for the portfolio company. One possibility to solve this problem is to engage external industry experts, another one is to invite other VCs to syndicate and bring their skills to the table.154

Window-dressing: One possibility to improve the return at the end of an investment

period is to 'window dress'. Lakonishok et al. (1991) suggest that pension fund managers behave in that way in order to adjust their portfolios at the end of a period, i.e., they buy firms whose shares have appreciated and sell the underperforming stocks. The underlying objective of this strategy is to impress sponsors to be in a better position for raising funds in the future.155 Lerner (1994) claims that venture capital funds act in the same way.156 In

149 _{Brander/Amit/Antweiler (2002), p. 424.} 150 _{Lerner (1994), p. 17.}

151 _{See Lockett/Wright (2001), p. 378.}

152 _{See Manigart et al. (2002), p. 4. The value-added perspective is there also named as resource-based} perspective.

153 _{Wernerfelt (1984), p. 172.}

154 _{See Lockett/Wright (2001), p. 378.} 155 _{See Lakonishok et al. (1991), p. 227.} 156 _{See Lerner (1994), p. 17.}

order to earn publicity, VCs may make investments in late financing rounds of attractive firms, although much of the value appreciation might already have occurred and therefore, financial returns are comparably low. Still, this behavior "…allows them to represent themselves in marketing documents as investors in these firms".157 Along the same lines, young VCs might have incentives to 'grandstand'. That is, they aim to signal their ability to potential investors, either by taking a portfolio firm public prematurely, or by syndicating with well-known venture capitalists in later financing rounds.158

In this chapter 2.1, a common understanding was established as to the development and current state of the German venture capital market. Also, venture capital as method of financing has been explained as well as the types of VC and the characteristics of portfolio companies. In addition, syndicated investments have been defined and the various rationales of VCs to syndicate have been laid out.

Since the deal flow of VCs is an integral part of the analysis within the present study, the some basic thoughts on this topic are provided in the following sections. These include the definition of the term, explanations regarding the quantity and quality of deal flow, a short literature review, as well as aspects regarding the generation of deal flow.

2.2 Deal Flow