Capital Market Imperfections and Entrepreneurial Finance

Bruce Petersen
Seigle Hall 385
Phone: 314-935-5643

Office Hours: T, Th, 4:05pm – 5:30pm

Teaching Assistants:
Seigle Hall 373
Office Hours: W, 4:00pm – 5:30pm

Description: Capital market imperfections arise for many reasons, including asymmetric information between firms and potential investors. Information asymmetries can lead to adverse selection and moral hazard problems. These problems can cause external financing to be substantially more costly than internal financing, reducing the number of startups and constraining the investment and growth of existing firms. In addition to examining theoretical aspects of capital market imperfections, we will also consider empirical tests of the presence of financing constraints, particularly as they pertain to R&D investment. Approximately forty percent of the course will explore the role played by venture capital in dealing with capital market imperfections in high-tech industries. Venture capital financing is an important reason for the U.S.’s success in commercializing new science.

Required Materials: The required text for the course is: The Venture Capital Cycle, second edition, by Paul Gompers and Josh Lerner, MIT Press, 2004. In addition, there are required journal articles that will be available as a packet that you can purchase in the economics department office (Seigle 307). The cost is approximately $10.00.

Grading: There will be a midterm exam and a final exam. If you miss the midterm exam, there will not be a makeup exam, but you can be excused from the exam because of illness or a family emergency. Tentatively, the midterm exam is scheduled for Wednesday, October 10th (6:30-8:00), Seigle 304. On October 10, you can take the exam as early as 5:00 P.M. or as late as 9:00 P.M. if need be. I am assuming that most students want to have the exam before fall break, hence the choice of dates. If I am on track, there will be no class on October 11. The final exam will occur December 17, 1:00-3:00 (but you can take the exam later in the day if need be). Please contact me well in advance concerning possible conflicts.

Schedule of Readings: (The starred readings are required.)

I. Introduction:

*Gompers, Paul and Josh Lerner, The Money of Invention, Harvard Business School Press, 2001: Chapter 1 (pp.1-12); Chapter 2 (all pages).

Sahlman, William A., “The Structure and Governance of Venture-Capital Organizations,” Journal of Financial Economics, 27, 1990, pp. 473-521.

Jeng, Leslie A. and Philippe C. Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries,” Journal of Corporate Finance, 6, 2000, pp. 241-289.

Stiglitz, Joseph E., “The Contributions of the Economics of Information to Twentieth Century Economics,” The Quarterly Journal of Economics, November, 2000.

II. Capital Market Problems Arising from Asymmetric Information Between the Firm and Potential Investors:

Ackerloff, George, “The Market for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism,” Quarterly Journal of Economics, 84, 1970, pp. 488-500.

*Myers, Stewart C. and Nicholas S. Majluf, “Corporate Financing and Investment Decisions When Firms Have Information that Investors do not Have,” Journal of Financial Economics, 13, 1984, 187-221. (**pp. 187- 200 required.)

*Asquith, Paul and David W. Mullins, “Equity Issues and Offering Dilution,” Journal of Financial Economics, 15, 1986, pp. 61-89. (**pp. 61-76 required).

*Stiglitz, Joseph E. and Andrew Weiss, “Credit Rationing in Markets with Imperfect Information,” American Economic Review, 71, 1981, 393 – 410. (**pp. 393-398, *401-402 required.)

D’Mello, Ranjan and Stephen Ferris. “The Information Effects of Analyst Activity at the Announcement of New Equity Issues,” Financial Management, 29, 2000, pp 78-95.

Cornett, M. M. and H. Tehranian, “An Examination of Voluntary versus Involuntary Issuances by Commercial Banks,” Journal of Financial Economics, 35, 1994, pp. 99-122.

Berger, Allen and Greg Udell, “The Economics of Small Business Finance: Roles of Private Equity and Debt Markets in the Financial Growth Cycle,” Journal of Banking and Finance, 22, 1998, pp. 613-673.

III. Other Capital Market Considerations:

Brealey, Richard and Stuart Myers, “Costs of Financial Distress,” in Principles of Corporate Finance, 2000, pp. 510-524.

Lee, Inmoo, Scott Lochhead, Jay Ritter, and Quanshui Zhao, “The Costs of Raising Capital,” Journal of Financial Research, 19, 1996, pp. 59-74.

Altinkilic, Oya and Robert S. Hansen, 2000, “Are there Economies of Scale in Underwriting Fees? Evidence of Rising External Financing Cost,” Review of Financial Studies, 13, pp. 191-218.

IV. Testing for Imperfections in Capital Markets:

*“Capital Market Imperfections, Financing Constraints, and Empirical Tests” (this is a set of background notes in your course packet).

*Brown, James R., Steven M. Fazzari, and Bruce C. Petersen, “Financing Innovation and Growth: Cash Flow, External Equity and the 1990s R&D Boom,” The Journal of Finance, 2009, pp. 151-185 (**pp. 151-173 required).

*Brown, James R. and Bruce C. Petersen, “Which Investments Do Firms Protect? Liquidity Management and Real Adjustments When Access to Finance Falls Sharply,” Journal of Financial Intermediation, 2015, pp. 441-465 (**441-457 required.)

Brown, James R., Gustav Martinsson, and Bruce C. Petersen, “Law, Stock Markets, and Innovation,” The Journal of Finance, 2013.

Brown, James R. and Bruce C. Petersen, “Cash Holdings and R&D Smoothing,” Journal of Corporate Finance, 2011.

Fazzari, Steven M., R. Glenn Hubbard, and Bruce C. Petersen, “Financing Constraints and Corporate Investment,” Brookings Papers on Economic Activity,
1988, pp. 141-205.

Hubbard, R. Glenn, “Capital-Market Imperfections and Investment,” Journal of Economic Literature, 36, 1998, pp. 193-225.

V. Venture Capital Investing:

*Gompers, Paul and Josh Lerner, The Money of Invention, Harvard Business School Press, 2001: Chapter 4 (pp. 61-74).

*Textbook, Chapter #1, Introduction.

*Textbook, Chapter #8, Why Are Investments Staged?

*Textbook, Chapter #10, How Do Venture Capitalists Oversee Firms?

*Textbook, Chapter #11, Why Do Venture Capitalists Syndicate Investments? (**pp. 255-260 required.) (Note: We cover only the overview of this chapter).

Gompers, Paul, William Gornall, Steven Kaplan, Ilya Strebulaev. 2016. “How Do Venture Capitalists Make Decisions?”, NBER Working Paper Series, #22587.

Kaplan, Steven N., and Per Stromberg, “Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts,” Review of Economic Studies, 2002.

Da Rin, Marco, Thomas Hellmann and Manju Puri, “A Survey of Venture Capital Research,” Working Paper. National Bureau of Economic Research.

Admati, Anat R. and Paul Pfheiderer, “Robust Financial Contracting and the Role of Venture Capitalists,” Journal of Finance, 49, 1994, pp. 371-402.

Sahlman, William A. “Aspects of Financial Contracting in Venture Capital,” Journal of Applied Corporate Finance, pp. 23-36.

VI. Exiting Venture Capital Investments:

*Textbook, Chapter #14, An Overview of Exiting Venture Capital Investments.

*Textbook, Chapter #15, Do Market Conditions Affect the Decision to Go Public?
(pp. 355-367 required.)

*Textbook, Chapter #16, Does Reputation Affect the Decision to Go Public?

Megginson, William L., and Kathleen A. Weiss, “Venture Capital Certification in Initial Public Offerings,” Journal of Finance, 46, 1991, pp. 879-903.

VII. Case Study on Venture Capital Financing:

*ImmuLogic Pharmaceutical

VIII. Final Topics: More on the Role of Public Equity Markets for Innovation:

(Note: No Articles Required: All Covered in Class)

La Porta, Rafael, Florencio LoPez-De-Silanes, Andrei Shleifer and Robert Vishny, “Legal Determinants of External Finance,” The Journal of Finance, 1997, pp. 1131-1150.

Kahle, Kathleen M. and Rene Stulz. 2017. “Is the US Public Corporation in Trouble?” The Journal of Economic Perspectives,” 31, 67-88.

Acharya, Viral and Zhaoxia Xu. 2017. “Financial Dependence and Innovation: The Case of Public Versus Private Firms,” Journal of Financial Economics, 124, 223-343.

Brown, James R., Gustav Martinsson, and Bruce C. Petersen, “Law, Stock Markets, and Innovation,” The Journal of Finance, 2013, 1493-1524.

Brown, James R. and Bruce C. Petersen, “New Public Firms, Public Equity Finance, and Creative Destruction,” Journal of Banking and Finance, 2010.