Innovation and Venture Capital Exits

Abstract

This paper analyzes how startups financed by venture capital choose their innovation strategy based on the investor's exit preferences, and thereby form different outcomes in the product market. It considers innovation choices and venture capital exits (IPO vs trade sale) in a setting in which entrepreneurs derive private benefits from staying independent, which is better guaranteed under an IPO. Since the venture capitalist typically does not take such benefits into account when choosing the exit route, the entrepreneur has incentives to distort the innovation strategy in order to induce the venture capitalist to bring the company public. This protects the entrepreneur's private benefits but comes at the expense of eroding expected monetary value. Our analysis generates a number of empirical implications for the link between innovation, valuation, venture capital exit routes and market structure.