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Journal of Corporate Law Studies Volume 3, 2003 - Issue 2
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Original Articles

The Structure, Governance and Performance of UK Venture Capital Trusts

Douglas J CummingUniversity of New South Wales School of Banking and Finance, and University of Alberta School of Business.
Pages 401-427 | Published online: 27 Apr 2015

  • A start-up entrepreneurial firm may be based on a concept without a product or any marketing, or it may have a product being developed, but not yet sold commercially. An expansion entrepreneurial firm requires significant capital for plant expansion and marketing to initiate full commercial production and sales. For definitions of firm development stages, see eg <http://www.evca.com>, accessed 31 October 2002.
  • In a buy-out transaction, the capital is provided to enable the operating management of the entrepreneurial firm to acquire a product line, a division, or an entire company; see eg M Wright, RE Hoskisson, LW Busenitz and J Dial, “Finance and Management Buyouts: Agency versus Entrepreneurship Perspectives” (2001) 3 Venture Capital: An International Journal of Entrepreneurial Finance 239. Turnaround investments are in firms that were once profitable but are now earning less than their cost of capital.
  • PA Gompers and J Lerner, The Venture Capital Cycle (Cambridge: MIT Press, 1999), and PA Gompers and J Lerner, The Money of Invention: How Venture Capital Creates New Wealth (Cambridge, Mass.: Harvard Business School Press, 2001).
  • For a discussion see, eg R Cressy, “Funding Gaps: A Symposium” (2002) 112 Economic Journal F1.
  • Gompers and Lerner (1999, 2001), supra n 3. For a supportive industry report that looks at the impact of venture capital in the UK, see British Venture Capital Association, The Economic Impact of Private Equity in the UK (2001) <http://www.bvca.co.uk>, accessed on 31 October 2002.
  • Gompers and Lerner (1999, 2001), supra n 3. See also S Kortum and J Lerner, “Assessing the Contribution of Venture Capital to Innovation” (2000) 31 RAND Journal of Economics 647.
  • JM Poterba, “Capital Gains Tax Policy Toward Entrepreneurship” (1989a) 42 National Tax Journal 375; JM Poterba, “Venture Capital and Capital Gains Taxation” in: LH Summers (ed), 3 Tax Policy and the Economy (Cambridge, Mass.: MIT Press, 1989b), pp 47–67; PA Gompers and J Lerner, “What Drives Venture Fundraising?” (1998) Brookings Proceedings on Economic Activity—Microeconomics 149; LA Jeng and PC Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries” (2000) 6 Journal of Corporate Finance 241; Gompers and Lerner (1999, 2001), supra n 3.
  • J Lerner, “The Government as Venture Capitalist: The Long-Run Effects of the SBIR Program” (1999) 72 Journal of Business 285.
  • D Osbourne and D Sandler, “A Tax Expenditure Analysis of Labour-Sponsored Venture Capital Corporations” (1998) 46 Canadian Tax Journal 499; DJ Cumming and JG MacIntosh, “Crowding Out Private Equity: Canadian Evidence”, Working Paper, University of Alberta and University of Toronto (2002).
  • Lerner, supra n 8. See also J Lerner, “When Bureaucrats Meet Entrepreneurs: The Design of Effective ‘Public Venture Capital’ Programmes” (2002) 112 Economic Journal F73.
  • Lerner (2002), ibid.
  • B Leleux and B Surlemont, “Public Versus Private Venture Capital: Seeding or Crowding Out? A Pan-European Analysis” (2003) 18 Journal of Business Venturing 81. Armour and Cumming, however, find crowding out of private investment by government programmes in a sample of 13 western European countries, Canada and the US over the 1990–2002 period; see J Armour and D Cumming, “The Legal Road to Replicating Silicon Valley”, Working Paper, University of Cambridge and University of Alberta (2003).
  • VCTs were introduced by legislation in the Finance Act 1995, ss 70–73 and schedules 14–16.
  • See, eg <http://www.trustnet.com/vct/>, accessed on 31 October 2002.
  • The statutes are summarised online at <http://www.inlandrevenue.gov.uk/manuals/vcmanual/index.htm>, accessed on 31 October 2002.
  • Osbourne and Sandler, supra n 9; Cumming and MacIntosh, supra n 9; DJ Cumming and JG MacIntosh, “Comparative Venture Capital Governance: Private versus Labour Sponsored Venture Capital Funds”, CESifo Working Paper Series No 853 (2003), forthcoming in V Kanniainen and C Keuschnigg, eds, Venture Capital, Entrepreneurship and Public Policy (MIT Press, 2004). See also DJ Cumming and JG MacIntosh, “Canadian Labour Sponsored Venture Capital Corporations: Bane or Boon?” in A Ginsberg and J Hasan, eds, New Venture Financing (Elsevier Science Academic Press, (2004) forthcoming.
  • PA Gompers and J Lerner, “The Use of Covenants: An Empirical Analysis of Venture Capital Partnership Agreements” (1996) 39 Journal of Law & Economics 463; see also Gompers and Lerner (1999, 2001), supra n 3.
  • To simply review the legislation by itself, see the statute available online, supra n 15.
  • There is one exception: prior work has considered corporate venture capital funds. For empirical work on corporate VC funds, see Gompers and Lerner (1999), supra n 3; for theoretical work on corporate funds, see T Hellmann, “A Theory of Strategic Venture Investing” (2002) 64 Journal of Financial Economics 285.
  • Ideally, we would like to be able to compare the VCT structure with the structure and governance of private venture capital funds in the UK. To date, unfortunately no data directly on point (in the spirit of Gompers and Lerner (1996), supra n 17) are available. Further research is warranted. For related work that offers some insight along these lines through international comparisons, see S Maginart, K De Waele, M Wright, K Robbie, P Desbrières, H Sapienza, and A Beekman, “Venture Capital, Investment Appraisal, and Accounting Information: A Comparative Study of the US, UK, France, Belgium and Holland” (2000) 6 European Financial Management 380; J Armour, “Financing Innovation: The Role of Insolvency Law”, Working Paper, University of Cambridge (2002); C Mayer, K Schoors, and Y Yafeh, “Sources of Funds and Investment Activities of Venture Capital Funds: Evidence from Germany, Israel, Japan and the UK”, Working Paper, Oxford University, University of Ghent and Hebrew University of Jerusalem (2002). Similarly, in the spirit of Vermeulen (2001) and McCahery and Vermeulen (2001), it would be useful to study the corporate structure of the entrepreneurial firms in which VCTs invest; see EPM Vermeulen, “Towards a New Company Structure for High-Tech and Start-ups in Europe”, Working Paper, Tilburg University (2001); J McCahery and EPM Vermeulen, “Regulatory Competition and the Evolution of Closely Held Business Forms in Europe”, Working Paper, Tilburg University (2001). Again, further research is warranted.
  • See, eg Hellmann, supra n 19.
  • Gompers and Lerner (1999), supra n 3; Lerner, supra n 8.
  • Gompers and Lerner (1996), supra n 17.
  • Gompers and Lerner (1996), supra n 17, (1999, 2001), supra n 3. See also WA Sahlman, “The Structure and Governance of Venture Capital Organizations” (1990) 27 Journal of Financial Economics 473.
  • For the complete statute, see <http://www.inlandrevenue.gov.uk/manuals/vcmanual/index.htm>, accessed on 31 October 2002; see also the various VCT Annual Reports. Table 1 is largely based on the VCT legislative summary in the Aberdeen Growth VCT 1 PLC Annual Report 31 January 2002.
  • <http://www.trustnet.com/vct/>, accessed on 31 October 2002.
  • Gompers and Lerner (1996), supra n 17, (1999, 2001), supra n 3.
  • Added flexibility was provided in the 2001 budget; see <http://www.inlandrevenue.gov.uk/budget2001/revbn11.htm>, accessed on 31 October 2002.
  • Cumming and MacIntosh (2002) note a similar problem with Canadian LSVCC statutory governance. The restriction in Canada varies between 1–3 years depending on the particular province in which the LSVCC is incorporated.
  • Convertible securities are often used by venture capitalists, at least in the United States (see Sahlman, supra n 24; PA Gompers, “Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities in Venture Capital Investments”, Working paper. Harvard University (1999); SN Kaplan and P Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts” (2002) Review of Economic Studies, forthcoming), and therefore many academics believe that convertible securities are “optimal”. Recently, however, Gilson and Schizer have shown that there is a significant tax bias in favour of the use of convertibles securities in the US, and this tax bias is not present in other countries such as Canada (Sandler); see RJ Gilson and DM Schizer, “Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock” (2003) 116 Harvard Law Review 874; D Sandler, “The Tax Treatment of Employee Stock Options: Generous to a Fault” (2001) 49 Canadian Tax Journal 259. Convertibles are not the most frequently used securities in countries outside the US, such as Canada (DJ Cumming, “The Convertible Preferred Equity Puzzle in Canadian Venture Capital Finance”, Working Paper, University of Alberta (2000), and various European countries (A Bascha and U Walz, “Financing Practices in the German Venture Capital Industry: An Empirical Assessment”. Working Paper, University of Tübingen (2001); A Schweinbacher, “An Empirical Analysis of Venture Capital Exits in Europe and the United States”, Working Paper, University of Namur (2002); Cumming (2002)). Nevertheless, convertibles are sometimes used by European VCs (estimates of the frequency of use of convertibles in Europe range from 10–30%; see Bascha and Walz, 2001; Schwienbacher, 2002; DJ Cumming, “Contracts and Exits in Venture Capital Finance”, Working Paper, University of Alberta (2002).
  • Albeit, it is hard to imagine how the VCT tax subsidies could operate without the legislative structure in Table 1, Part I.B.7.
  • It is noteworthy that LSVCCs in Canada have reasons to select securities for reasons unrelated to efficient contract structure; see Cumming (2000), supra n 30, for a discussion and empirical evidence.
  • See, eg Gompers and Lerner (2001), supra n 3; see also JG MacIntosh, “Venture Capital Exits in Canada and the United States” in PJN Halpern (ed), Financing Growth in Canada (Calgary: University of Calgary Press, 1997), pp 279–356; DJ Cumming and JG MacIntosh, “A Cross-Country Comparison of Full and Partial Venture Capital Exits” (2003a) 27 Journal of Banking and Finance, 511; DJ Cumming and JG MacIntosh, “Venture Capital Exits in Canada and the United States” (2003b) 53 University of Toronto Law Journal, 101.
  • Details on the 2002 VCT legislative change affecting exits and rationales for the change are provided at <http://www.nds.coi.gov.uk/coi/coipress.nsf/b1a2a38b9054fb1c80256bf40033dbc2/fbc5b3cbcabbd14580256c5b00596bc4?OpenDocument>, accessed on 31 October 2002.
  • For research on LSVCCs, see MacIntosh, supra n 33; F Vaillancourt, “Labour-Sponsored Venture Capital Funds in Canada: Institutional Aspects, Tax Expenditure and Employment Creation” in PJN Halpern (ed), Financing Growth in Canada (Calgary: University of Calgary Press, 1997), pp 571–592; Osborne and Sandler, supra n 9; DJ Cumming, and JG MacIntosh, “Venture Capital Investment Duration in Canada and the United States” (2001) 11 Journal of Multinational Financial Management 445, op cit. DJ Cumming and JG, “Economic and Institutional Determinants of Venture Capital Investment Duration” in Advances in the Study of Entrepreneurship, Innovation and Economic Growth, vol 14 (Gary Libecap, Editor, JAI Press, 2002), pp 125–159; Cumming and MacIntosh, supra n 9; Cumming and MacIntosh (2003), supra n 16; Cumming and MacIntosh (2003a, b), supra n 33.
  • See http://www.inlandrevenue.gov.uk/budget2002/revbn13.htm, accessed on 31 October 2002.
  • These figures are for the province of Ontario; see Cumming and MacIntosh, supra n 16, for details.
  • See Cumming and MacIntosh, supra n 9, and supra n 16; see also JA Brander, R Amit and W Antweiler, “Venture Capital Syndication: Improved Venture Selection Versus the Value-Added Hypothesis” (2002) 11 Journal of Economics and Management Strategy 423.
  • Cumming and MacIntosh, supra n 9.
  • The amount depends on the income of the individual investor; figures for the province of Ontario; see Cumming and MacIntosh, supra n 16.
  • Cumming and MacIntosh, supra n 9 find evidence of more that 100% crowding out.
  • Leleux and Surlemont, supra n 12, provide a thorough analysis in support of European government programmes seeding, not crowding out, private equity across Europe. Note, however, that their data are from 1990–1996, and the VCT legislation was first introduced in the UK in the autumn of 1995; as such, the effect of VCTs would not appear in the Leleux and Surlemont data. Armour and Cumming, supra n 12, do find crowding out in a sample including the UK and 14 other countries over the 1990–2002 period.
  • Cumming and MacIntosh, supra n 9.
  • Ibid.
  • Cumming and MacIntosh, supra n 9; supra n 16; and supra n 33; see also Brander et al., supra n 38.
  • Cumming and MacIntosh (2001), supra n 35.
  • The under performance of Canadian LSVCCs has been attributed to a similar restriction of one to three years (depending on the particular province); see supra n 29 and accompanying text. The primary reason is that the restriction limits the VCs’ ability to effectively screen low quality (low expected return and/or high risk) projects.
  • See eg C Spink, “Why Invest in Venture Capital Trusts?”, Multex (UK Investment Web Site) (22 November 2002); see also http://ww.trustnet.com/vct/ (accessed on 31 October 2002) for popular press articles entitled “VCTs offering good profit for value” (November 2002) and “Time is ripe for buying improved value in VCTs” (November 2002).
  • Ibid.
  • See also Maginart et al. (2000) supra n 20, Schwienbacher (2002) supra n 30 and Cumming (2002) supra n 30 for academic studies on returns to the VC investment in Europe. See also E Barnes, E Cahill and Y McCarthy “Grandstanding in the UK Venture Capital Industry”, Working Paper, University College Cork (2002).
  • <http://www.trustnet.com> (accessed on 31 October 2002).
  • VCs invest in private companies for at least a few years before exiting; see eg Sahlman, supra n 24; CB Barry, CJ Muscarella, JW Peavy III, and MR Vetsuypens, “The Role of Venture Capitalists in the Creation of Public Companies: Evidence from the Going Public Process” (1990) 27 Journal of Financial Economics 447. WL Megginson and KA Weiss, “Venture Capitalist Certification in Initial Public Offerings” (1991) 46 Journal of Finance 879; Gompers and Lerner (1999, 2001) supra n 3; Cumming and MacIntosh, supra nn 33 and 35; and L Peng, “Building A Venture Capital Index”, Yale Center for International Finance Working Paper (2002).
  • The UK performance statistics in Table 4 are for the year ending 31 December 2001, while the performance statistics in Tables 2 and 3 are for the periods ending 8 November 2002. The reason for this difference is due to the availability of data. The returns are directly comparable across and within Tables 2 and 3; however, when comparing Tables 2 and 3 with Table 4, keep in mind that the year end for the results in Table 4 is December 2001.
  • “Economic returns” do not incorporate the tax benefits for investors contributing funds to VCTs, as outlined in Table 1, Part II.
  • See supra n 34 and accompanying text.
  • Sahlman, supra n 24; Gompers and Lerner (1996), supra n 17 and (1999), supra n 3.
  • In other words, there is excess money chasing too few deals; see PA Gompers, “Venture Capital Growing Pains: Should the Market Diet?” (1998) 22 Journal of Banking and Finance 1089; PA Gompers and J Lerner, “Money Chasing Deals?: The Impact of Fund Inflows on the Valuation of Private Equity Investments” (2000) 55 Journal of Financial Economics 281. A similar problem has been noted among Canadian LSVCCs (Cumming and MacIntosh, 2002).
  • http://www.trustnet.com/vct/, accessed on 31 October 2002.
  • Ibid. 60 See eg Sahlman, supra n 24.
  • Cumming's summary statistics indicate that Canadian LSVCCs have the largest portfolios on average (38 entrepreneurial firms per fund), followed by government VCs (32 firms per fund), institutional investors (31 firms per fund), corporate VCs (17 entrepreneurial firms in the portfolio), and private limited partnerships (with an average of 8 entrepreneurial firms per fund). That LSVCCs have larger portfolios is a statistically and economically significant result in Cumming's multivariate regression analysis based on OLS as well as various Box-Cox specifications. This evidence is highly suggestive that LSVCCs add less value to their entrepreneurial firms than do other types of venture capitalists. See DJ Cumming, “The Determinants of Venture Capital Portfolio Size: Empirical Evidence”, Working Paper, University of Alberta (2001).
  • For the seminal theoretical work on the issue of portfolio size and venture capital value added activities, see V Kanniainen and C Keuschnigg, “The Optimal Portfolio of Start-up Firms in Venture Capital finance” (2000) CESifo Working Paper No 381, Journal of Corporate Finance, forthcoming; V Kanniainen and C Keuschnigg, “Start-up Investment with Scarce Venture Capital Support” (2001) CESifo Working Paper No 439, (2004) Journal of Banking and Finance, forthcoming; C Keuschnigg, “Taxation of a Venture Capitalist with a Portfolio of Firms”, University of St. Gallen Working Paper (2002), (2004) Oxford Economic Papers, forthcoming. For related work on tax policy towards venture capital, see C Keuschnigg and SB Nielsen, “Public Policy for Venture Capital” (2001) 8 International Tax and Public Finance 557; C Keuschnigg and SB Nielsen, “Tax Policy, Venture Capital and Entrepreneurship” (2003) 87 Journal of Public Economics 175; C Keuschnigg and SB Nielsen, “Start-ups, Venture Capitalists and the Capital Gains Tax” (2003) Journal of Public Economics, forthcoming.
  • According to http://www.trustnet.com/vct/ (accessed on 31 October 2002), VCT performance fees are invariably higher than other UK investment trusts. Further research on the exact management fees (base fees and carried interest performance fees) for VCTs relative to private venture capital funds in the UK is warranted.
  • Specifically, the BVCA indicated: “Over time a number of venture capital managers have moved into the financing of larger MBOs and MBIs and generally larger fund raisings and VCTs (usually by syndication) have become increasingly involved in the second round funding of UK growing entrepreneurial companies that those other venture capital managers had previously focused on…. VCTs are receiving an increasing number of requests to assist with second round funding and funding at the £1 million to £2 million level generally (in addition to a continuing demand for funding at the up to £1 million level.)”
  • See eg AR Admati and P Pfleiderer, “Robust Financial Contracting and the Role for Venture Capitalists” (1994) 49 Journal of Finance 371; J Lerner, “The Syndication of Venture Capital Investments” (1994) 23 Financial Management 16; Gompers and Lerner (1999), supra n 3; M Wright and A Lockett, “The Structure of Management Alliances: Syndication in the Venture Capital Industry” (2004) Journal of Management Studies, forthcoming.
  • See <http://www.inlandrevenue.gov.uk/manuals/vcmanual/index.htm>, accessed on 31 October 2002.
  • Cumming and MacIntosh, supra n 9.
  • Leleux and Surlemont, supra n 12. Armour and Cumming, supra n 12 do find crowding out by government programmes of all types across 15 countries, including the UK, over 1990–2002.
  • Mayer et al., supra n 20, provide seminal work along this line by studying the relation between the source of capital and the types of venture capital investments.
  • Gompers and Lerner, (1999, 2001) supra n 3, and (1996) supra n 17.
  • Cumming and MacIntosh, supra nn 9, 16; Osborne and Sandler, supra n 9; and more generally see PJN Halpern (ed), Financing Growth in Canada (Calgary: University of Calgary Press, 1997).

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