Determinants of the round-to-round returns to pre-IPO venture capital investments in U.S. biotechnology companies

• Published in: Journal of business venturing Vol. 22; no. 1; pp. 1 - 28
• Main Author: Hand, John R.M.
• Format: Journal Article
• Language: English
• Published: New York Elsevier Inc 2007; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Business Venturing
• Subjects: Biotechnology industry; Book-to-market; Firm size; Growth options; Initial public offerings; Rates of return; Return on equity; Risk; Round-to-round returns; Studies; Venture capital; United States > US; Risk; Firm size; Round-to-round returns; Book-to-market; Growth options
• ISSN: 0883-9026; 1873-2003
• DOI: 10.1016/j.jbusvent.2005.09.004

I propose that pre-IPO venture-backed biotech companies offer a useful new setting through which to evaluate the relative merits of theories for why firm size and book-to-market explain variation in stock returns. This is because pre-IPO biotech firms have large and rapidly evolving growth options relative to assets-in-place. Such attributes align closely with the key features of the model by Berk et al. [Berk, J.B., Green, R.C., Naik, V., 1999. Optimal investment, growth options, and security returns. Journal of Finance 54 (5), 1553–1607] of the endogenous relations between growth options, optimal investment actions and expected equity returns, where firm size and book-to-market emerge as sufficient statistics for the aggregate risk of a firm's assets-in-place. Using venture capital investments in pre-IPO U.S. biotech companies during 1992–2001, I find that equity returns between financing rounds (‘round-to-round’ returns) are reliably negatively related to firm size and positively related to book-to-market ratios. I interpret these results as being most consistent with the theory of Berk et al., and less consistent with alternative explanations such as financial distress, behaviorally biased investors or data snooping.