Innovation and Venture Capital Exits

This paper addresses the choice between different exit routes of venture capitalists for a project yielding a quality-improving product innovation. We explicitly introduce product market characteristics into the analysis with the aim to identify their effects on the optimal exit strategy and on the financial contract. Going public can be more profitable than a trade sale (i.e., selling the venture to an existing company) when the new product is sufficiently innovative. This leads to an agency conflict if the entrepreneur enjoys private benefits from staying an independent manager in the firm after the exit of the venture capitalist. The entrepreneur has incentives to distort the innovation strategy so as to make an IPO the preferred exit. We derive the optimal financing strategy under different allocations of control rights and market power. The use of an optimal mix of debt and equity can partially mitigate such a distortion. We also discuss empirical implications and offer partial empirical evidence. Keywords: venture capital, exit strategy, innovation, link between product market and capital market, divestment, IPO JEL Classification: G24; G32; L15; O32