The interplay of venture capital and IPO signals on entrepreneurial ventures ' valuation at acquisitions

Signaling in entrepreneurial ventures’ acquisitions: the combined effect of venture capital backing with the choice to go through IPO before being acquired Name: Benedetta Montanaro Affiliation: Politecnico di Milano Enrollment to PhD program: November 2018 Expected final date: 2021/2022 e-mail: benedetta.montanaro@polimi.it The aim of this work is to understand whether venture capital backing provides signaling effect on the valuation obtained by entrepreneurial ventures when they are acquired by other companies, and to study its combined effect with the choice of the firm to go through an Initial Public Offering (IPO) before the acquisition. Valuing entrepreneurial ventures, i.e. young firms created by one or more entrepreneurs based on an innovative business idea (Carland et al. 1984), is challenging, due to the high uncertainty brought by their newness, the fact that their assets are predominately intangible and their lack of a long track record. As a consequence, these firms are exposed to strong information asymmetry, that can be tackled by sending to the market signals of the companies’ quality, in the form of observable and costly decisions that distinguish high-quality firms from lower-quality ones for which bearing signaling costs is unprofitable (Spence, 1973). Despite signaling theory has been widely employed in works on firms’ valuation at IPO, studies focused on signaling in acquisitions are still few (e.g. see Reuer et al., 2012; Wu et al., 2013). The limited contributions on the topic show that affiliations with prominent Venture Capitalists is a potential signal in acquisition. However, these studies have been performed on a sample of public companies. Going through an IPO before being acquired not only provides disclosed information about the market value of the firm, but it is also a quality signal itself, being the listing process highly costly (Pagano, 1998; Ragozzino and Reuer, 2007). Hence, evidences on drivers of valuation for public companies cannot be extended to private firms. As a result, we address the following research question: how does going through an IPO before being targeted for an acquisition interact with venture capital backing signal in determining the valuation of entrepreneurial ventures at acquisitions? For public companies, the positive impact of venture capital backing could be traced back to its substantive benefits in supporting the business rather than to ? pure? signaling effect (for the distinction between signaling and substantive benefits, see Colombo et al., 2019). We expect that the pure signaling of venture capital backing has impact only on the valuation of private firms, because their quality is opaque and information on their value is not available on the market. On the contrary, substantive benefits are expected to be present in equal measure both for private and public companies. In other words, we expect that the positive effect of venture capital backing on target firm’s valuation at acquisition is higher when the firm did not go previously through an IPO. We use a difference in difference model to disentangle venture capital signaling effect from its substantive benefit. We consider as treated the venture capital backed firms and as control group the non VC-backed ones. Moreover, we distinguish private from public firms. Our model measures the difference between venture capital backing impact in private companies (given both by ? pure? signaling and by substantive benefits) and venture capital backing impact in public firms (given only by substantive benefits), isolating in this way the signaling effect. We based our model on a cross-sectional database derived from VICO 4.0, a proprietary database developed in the context of the RISIS project, funded by the European Commission under FP7, that contains information on investment rounds underwent by entrepreneurial ventures, and that has been complemented with information on IPO or acquisition, using Zephyr by Bureau Van Dijk as main source, and with accounting figures from Orbis, always by Bureau Van Dijk. Our final sample contains 682 acquisitions of VC-backed companies, and 995 of non VC-backed ventures. Among these, 103 VCbacked and 119 non VC-backed companies went through an IPO before the acquisition. All the acquisition deals happened between 2006 and 2017. Results confirm our expectations, showing that the signal provided by venture capital backing is effective and leads to higher valuations if the entrepreneurial ventures did not go through an IPO before.