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Venture Capital Financing and the

Informativeness of Earnings
a b
Daniel A. Cohen & Nisan S. Langberg
a
New York University , USA
b
University of Houston , USA
Published online: 13 Jan 2012.

To cite this article: Daniel A. Cohen & Nisan S. Langberg (2009) Venture Capital Financing
and the Informativeness of Earnings, Asia-Pacific Journal of Accounting & Economics, 16:2,
171-189, DOI: 10.1080/16081625.2009.9720836

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 Venture Capital Financing and the
Informativeness of Earnings
Daniel A. Cohena* and Nisan S. Langbergb
a
New York University
Downloaded by [Temple University Libraries] at 07:33 22 November 2014

b
University of Houston

Abstract

Are there long-term costs to obtaining venture capital financing? We explore the hypothesis
that venture capital backed firms do not efficiently transform to the corporate structure of public
firms and have difficulties publicly communicating with arm’s length investors. Our results are
three-fold. First, we find that, on average, reported accounting earnings are less informative for
venture capital backed firms. Second, the informativeness of reported earnings is a decreasing
function of venture capitalists’ ownership of firm equity and a decreasing function of venture
capitalists’ board representation. Third, stock prices of venture capital backed firms reflect future
earnings to a lesser extent relative to non-venture capital backed firms. Our findings support
the hypothesis that venture capitalists manage the flow of public information to capital markets
and preserve short-term interests arising from specific investment and ownership horizons. This
evidence suggests that the benefits of receiving venture capital financing are not without costs.

JEL Classifications: M41, G14, G32

Keywords: Venture capital, earnings informativeness, ownership structure, investment horizon

1. Introduction

Efficient allocation of capital to high-growth startup companies is recognized as one

of the most important challenges confronting capital markets, as asymmetric information
between founders and investors often leads to market failure. By unifying ownership
and control, venture capitalists open the flow of funds between arm’s length investors
(e.g. pension funds, insurance companies and other corporations) and entrepreneurs.

*
Corresponding author: Email: [email protected]. Tel: (212) 998-0267.
#
We thank Shirley Daniel and Shu-hsing Li (editors), Boochun Jung (discussant) and participants at
the 2008 APJAE Symposium in Hawaii, Aiyesha Dey, April Klein, Alicia Lofler, director of the Center for
Biotechnology Research at the Kellogg School of Management at Northwestern University for institutional
information, Thomas Lys, participants at the 2006 AAA Annual meeting in Washington DC, especially
Myungsun (Sun) Kim (discussant), and anonymous reviewers for the 2005 Western AAA meeting and the
2005 Midwest AAA meeting.
 172 Daniel A. Cohen and Nisan S. Langberg
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

The greatest impact of venture capital financing on economies around the world is
undoubtedly manifested in the data on Initial Public Offerings (IPOs). Public firms, in
contrast to private firms, operate under a completely different corporate structure.
In this paper we examine whether venture capital backing affects the quality of
financial reporting in the post-IPO period. In particular, we seek to investigate whether
new public firms efficiently make the transition from being a private company to a
public one. In addition, we are interested in analyzing whether there are any long-
term economic consequences associated with the choice of obtaining venture capital
financing.
We address these issues by exploring newly public firms’ ability to credibly
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communicate public financial information to diffused arm’s length investors. Our main
hypothesis predicts that the degrees of control and ownership by venture capitalists
affect public firms’ financial information credibility and thus its quality as manifested
in the informativeness of reported earnings. Most research to date has focused on and
documented the benefits associated with receiving venture capital financing. However,
to the extent that information asymmetries exacerbate agency problems, we interpret our
results as suggesting that these benefits are not without costs.
Throughout the paper, we deploy two methods widely used in the accounting
literature, to measure the informativeness of reported earnings. First, we focus on the
slope coefficients relating annual stock returns to levels of earnings and changes in the
levels of reported earnings. In addition, we also examine investors’ reaction to quarterly
earnings announcements. Viewing the informativeness of earnings as a measure for the
market participants’ confidence in the accounting information is not new (e.g. Teoh and
Wong, 1993).1 Second, we investigate the extent to which stock prices reflect the relative
dependence on current and future earnings, and adopt the approach discussed in Kothari
and Sloan (1992). The underlying premise is that when firms can credibly communicate
with investors (in any form, be it public financial reports or not) then stock prices
reflect future earnings to a greater extent. Consistent with our prediction, we find the
opposite for venture capital backed firms. Our findings throughout the study are robust
to controlling for the endogenous choice of venture capital financing.
We examine venture capitalists’ incentives to manage the flow of public information
to capital market participants. Specifically, in the model presented in the next section,
reported earnings can be manipulated by insiders (e.g. venture capitalists) and thus
may not represent the true underlying economic fundamentals of the firm (Lacker and
Weinberg, 1989). In equilibrium, venture capitalists’ incentives to manipulate earnings
are determined by the equity prices that follow earnings announcements. Anticipating
this behavior, uninformed investors value firm equity while taking into account the
(endogenous) informativeness of earnings (Holthausen and Verrecchia, 1988). Our
model predicts the informativeness of earnings to (i) be higher for non-venture capital
backed firms relative to venture capital backed firms, (ii) be higher when the equity
ownership of the venture capital firm is lower, and (iii) be higher when the board
representation of the venture capital firm is lower.

Teoh and Wong’s (1993) analysis shows a positive relation between the credibility of accounting
1

information and informativeness, interpreted as the coefficient estimate that relates stock returns to reported
earnings.
 Daniel A. Cohen and Nisan S. Langberg 173
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

Two main forces drive the theoretical results. First, venture capitalists play an active
role in the development of the firms they finance. In the process, as a consequence,
probably more than any other investor, venture capitalists acquire private information
regarding the firm’s products, the potential product markets and the expected profits,
among other things. For instance, venture capitalists often offer valuable consulting
services (Gompers and Lerner, 1999; Sahlman, 1990), have board representation and
substantial control rights (Kaplan and Stromberg, 2002), shape and at times replace the
management team (Hellmann and Puri, 2002), and thoroughly screen and monitor the
firms in the pre-funding stage.
Second, like pension funds, insurance companies, corporations and other institutional
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investors, venture capitalists own a substantial fraction of firm equity (Barry, Muscarella,
and Vetsuypens, 1990). However, venture capital funds are unique in that they are (by
law) limited in life span, and exist only for a period of ten to twelve years (Gompers and
Lerner, 1999; Sahlman, 1990). Therefore, among the equity holders and other decision
makers in the newly public firm, venture capitalists may be more interested in advancing
short-term performance at the expense of long-term growth.2 It is this specific conflict
of interests arising from the limited investment and ownership horizon facing venture
capital investors that we view as the potential cost associated with obtaining venture
capital financing, as it might lead to inefficient decisions and reduce the overall firm
value. This is particularly true when venture capitalists benefit the most from a profitable
exit (e.g. when they own a substantial fraction of firm equity) and when they can more
easily affect firm decisions, for instance, when they have substantial voting power or
board representation.
The evidence we document suggests that the reported earnings of venture capital
backed firms are less informative than earnings of non-venture capital backed firms. We
report the results after controlling for other determinants of earnings informativeness,
such as firm size, loss observations, the book-to-market ratio and leverage. We find that
investors react less to a unit of unexpected earnings for venture capital backed firms
and that the reaction depends on the incentives of the venture capitalist to manipulate
earnings. Consistent with the model’s predictions, we find that the more equity the
venture capitalist owns and the more board seats held by the venture capitalist, the less
informative earnings are.
Our study contributes to two streams of research. First, we contribute to the literature
that examines the role of financial intermediaries, and in particular venture capitalists, in
the firms they invest in. Prior research has documented the economic consequences of
venture capital financing, for example, the underpricing of IPOs (Megginson and Weiss,
1991; Lee and Wahal, 2004), product market behavior (Hellmann and Puri, 2000),
corporate governance (Hochberg, 2005), and long-term returns (Brav and Gompers,
1997). We add to this literature by documenting the adverse effects venture capitalists
have on the firm’s informational environment subsequent to its going public. Second,
we extend prior research that examines factors affecting the credibility of reported
accounting earnings, as captured by the coefficient relating stock returns to earnings.
Examples of such studies include Teoh and Wong (1993), Imhoff and Lobo (1992),

2
The compensation of venture capitalists typically depends on the fund’s proceeds upon liquidation, i.e.
the short-term performance of their investments (Gompers and Lerner, 1999).
 174 Daniel A. Cohen and Nisan S. Langberg
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

Warfield et al. (1995), Subramanyam and Wild (1996), Fan and Wong (2002), Gul and
Wah (2002), Yeo et al. (2002), and Francis et al. (2005). In particular, we extend the
findings of studies that focused on the relation between ownership structure and control
and the informativeness of earnings (e.g. Warfield et al., 1995, Fan and Wong, 2002;
and Francis et al., 2005). We show that the ownership structure of newly public firms,
in particular the presence of a venture capitalist, is an important determinant of the
informativeness of earnings.
The remainder of the paper is organized as follows. In section 2 we present a simple
model upon which our empirical analysis builds on. Section 3 describes the data and
the methodology used to estimate the informativeness of earnings, while in section 4
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we discuss our findings. In section 5 we deploy a second methodology to address our

research question. We conclude in section 6.

2. A Simple Model

Consider a public firm that exists for three periods, t = 0, 1, 2, and is endowed
with a risky project. The project yields in period t = 2, Revenues R, where R = U with
probability p and R = D otherwise (U > D). For simplicity, we assume that this project
is the only asset of the firm and that revenues are net of payments to any debt holders. A
venture capitalist (VC) is endowed with equity share α (0, 1) in the firm.
Three properties of venture capitalists are emphasized in this study. First, venture
capitalists are not long-term investors and eventually unwind their equity positions
prior to the pre-specified liquidation date of their fund. Second, venture capitalists
are informed investors. And third, venture capitalists can manage the flow of public
accounting information received by capital markets participants by creating opacity
regarding firm prospects (as discussed and formalized below).
In the model, the venture capitalist (VC) is required to sell his ownership of firm
equity at time t = 2, while having private information regarding the distribution of
future cash flows. The VC’s private information, at this point, is summarized by a signal
(with perfect precision) regarding the state of the firm. In other words, the VC knows if
revenues will be U or D next period. The VC can manipulate the public signal regarding
the true state of the firm s p, by creating “opacity” at level oi [0,1] in states of the world
i = U, D.

Prob (s p = U | R = U, o) = Prob (s p = D | R = D, o) = 1 – o

Thus, if there is no opacity (in other words, full transparency), i.e. o = 0, then there
is no private information and the public is fully informed. However, as we will show,
this is not characterized as an equilibrium. Finally, let β*c(o) denote the cost to the
VC of creating the opacity level o [0,1], where c`(0) = 0, c`(o) ≥ 0, c``(o) > 0,
and lim o 1 c ( o) = ∞. The coefficient β is strictly positive and represents the control
of the VC. Specifically, when the VC has substantial control in the firm, the cost of
manipulation is lower, i.e. β is lower.
 Daniel A. Cohen and Nisan S. Langberg 175
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

2.1 Equilibrium

Consider first the problem of the VC at period t = 1. The optimal level of opacity, o,
maximizes the expected price of firm equity. Therefore, it will not be optimal for the VC
to create opacity when a good signal is received, i.e. R = U. Denote by o* the level of
opacity the VC chooses in equilibrium when a bad signal is received, i.e. R = D.
The publicly observed equity prices are based on public information. Thus, we can
write the price of equity at time t = 1 as a function of public information, P (sp). Also, let
P0 = p*U + (1 – p)*D denote the price of equity at the outset (time t = 0) when there is
symmetric information.
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The equilibrium level of opacity solves:

MAX
o (0,1) ] P(U ) Pr ob ( s p = U | R = D, o) + P (D) Pr ob (s p = D | R = D, o)] c (o)
c (o*) = ( P(U ) P( D )) (1)

The equilibrium equity prices are given by:

P(U ) = U Pr ob (R = U | o*, s = U ) + D Pr ob (R = D | o*, s = U )

p p

p p
=U( ) + D (1 )
p + (1 p )o p + (1 p)o (2)

P( D ) = U Pr ob (R = U | o*, s = D) + D Pr ob (R = D | o*, s p = D) = D
p

The equilibrium is implicitly given by:

p
c (o*) = ]U D] ( )
p + (1 p) o * (3)

We can now define the price reaction to good news, ∆U, as the change in the price of
equity as a result of the release of a good signal:
1
∆U = p ( 1)(U D) (4)
p + (1 p)o *

Proposition 1:
(a) Manipulation takes place in equilibrium at level o*> 0 defined by the
equilibrium in equation (3).
(b) The degree of manipulation increases in VC ownership and in VC control, i.e.
∂o * ∂o *
> 0 and < 0.
∂ ∂
∂ U
(c) The price reaction ∆U is decreasing in VC ownership, i.e. < 0.
∂
 176 Daniel A. Cohen and Nisan S. Langberg
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

∂ U
(d) The price reaction ∆U is decreasing in VC control, i.e. > 0.
∂
Proof: Follows from the above.

3. Empirical Analysis

In this section we compare the informativeness of earnings between venture capital

and non-venture capital backed firms and within the groups of venture capital backed
firms. We define informativeness of earnings as the slope coefficient relating stock
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returns to reported accounting earnings, obtained from regressions of annual stock

returns on annual earnings and changes in earnings, and from short window returns
analysis of quarterly earnings announcements.
Our approach builds on Teoh and Wong’s (1993) analysis, which shows a positive
relation between the credibility of reported accounting information and informativeness,
measured as the coefficient relating stock returns to earnings. Based on Proposition 1,
we test the following hypotheses:
H1: Reported earnings are equally informative for venture capital and non-venture
capital backed firms.
H2: The informativeness of reported earnings does not vary with the venture capitalist’s
ownership of firm equity.
H3: The informativeness of reported earnings does not vary with the venture capitalist’s
representation on the firm’s board of directors.

In order to focus on the implications of venture capital financing for the

informativeness of earnings, we address the endogeneity of ownership structure. The
decision of a firm to receive venture capital funding and the decision of a venture
capitalist to provide such financing are not exogenous. Firm-specific characteristics and
information attributes may determine which firms are eventually venture capital backed.
Therefore, the apparent endogeneity makes the issue of estimating the impact of venture
capital financing on earnings informativeness challenging. To address this problem, we
use a self-selection model, following other studies in the existing literature (e.g. Baker
and Gompers, 2003; Morsfield and Tan, 2006). Throughout the analysis we report
results using both ordinary least squares and after controlling for self-selection.
We estimate the earnings informativeness association for samples that combine both
venture capital and non-venture capital backed firms, and include the following factors
that have been shown by prior research both to differ between venture capital and non-
venture capital backed firms and to be related to earnings informativeness.
Market-to-Book Ratio: This ratio serves as a proxy for investment opportunities.
Collins and Kothari (1989) find that the book-to-market ratio is negatively associated
with earnings informativeness; we include this variable in our regressions to control for
the effect of investment opportunities on earnings informativeness.
 Daniel A. Cohen and Nisan S. Langberg 177
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

Leverage: Dhaliwal et al. (1991) document that the coefficient relating earnings to
stock returns is decreasing in financial leverage. Thus, we need to condition for leverage
in our earnings informativeness tests.
Size: Consistent with prior research (e.g. Jiambalvo et al., 2002, among others) we
control for size when testing the relation between stock returns and earnings. We expect
that the coefficient estimate relating earnings to stock returns is increasing with the
firm’s size.
Loss: We include a dummy variable for loss observations since Hayn (1995)
provides evidence that the coefficient estimates relating stock returns and earnings are
smaller for loss observations.
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High Tech: To address any concerns associated with the unique features of the high
tech industry and their implications for earnings informativeness, we identify firms in
the high tech industry by including a dummy variable.

3.1 Test of Earnings Informativeness

We start our analysis of the differential informativeness of earnings for venture

capital and non-venture capital backed firms by examining the slope coefficients from
regressions of annual stock returns on annual earnings. Following Easton and Harris
(1991), we report tests for both the level of and change in earnings. We include control
variables for the market-to-book ratio, size, leverage, and whether earnings are positive,
since these variables have been shown to influence earnings informativeness. The main
regression we estimate is given in equations (5a) and 5(b):3

EARN i ,t *VC i ,t + ∑ k =1
5
(5a)
k
R i ,t = 0 + 1 EARN i ,t + 2 k EARN i ,t * X j ,t + j ,t

R i ,t = 0 + EARN i ,t + 2 EARN i ,t + 3 EARN i ,t *VC i ,t +

1 4 EARNi ,t *VC i ,t
+∑ k EARN i ,t * X j , t + ∑ k = 1 k
5
(5b)
5 k k
k =1
EARN i ,t * X j ,t + j ,t

where: Ri, t = firm i’s 12-month cumulative abnormal return for fiscal year t. The 12-
month interval starts three months after the end of the fiscal year t – 1 and ends
three months after the end of fiscal year t;4 EARNi, t = firm i’s annual earnings (before
extraordinary items) for fiscal year t, scaled by market value of equity at the end of
fiscal year t-1; ∆EARNi, t = change in EARNi, t between year t – 1 and year t, scaled by
market value of equity at the end of fiscal year t – 1; VCi, t = venture capital backing
dummy variable equal to one if the company is venture capital backed, zero otherwise;
X j , t = vector of control variables, k = 1 to 5, defined as: LOSSi, t = dummy variable equal
k

to one if EARNi,t < 0; HTECHi,t = dummy variable equal to one if SIC code belongs to
2833–2836, 8731–8734, 7371–7379, 3570–3577, 3600–3674, zero otherwise; SIZEi,t =

3
To account for potential dependence among the observations, we calculate the standard errors after
clustering observations at the firm-year level (Petersen, 2008). Thus, all our statistical tests are based on
clustered standard errors.
4
We obtain similar results (not tabulated) if we cumulate stock returns over the 15-month period starting
at the end of year t – 1.
 178 Daniel A. Cohen and Nisan S. Langberg
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

the log of firm’s market value of equity in year t; MBi, t = Market-to-Book ratio, the ratio
of firm i’s market value of equity to their book value of equity at the end of year t; LEVi, t
= firm’s leverage, defined as the ratio of firm i’s long-term debt to total book value of
assets at the end of year t – 1.
For equation (5a), our test of relative earnings informativeness for venture capital
backed firms focuses on the sign of α2. Under the null hypothesis H1, α2 = 0, whereas
α2 < 0 implies less earnings informativeness, while α2 > 0 suggests greater earnings
informativeness. For equation (5b), under the null hypothesis H1, α3 + α4 = 0, whereas
less earnings informativeness implies α3 + α4 < 0 and greater earnings informativeness
implies α3 + α4 > 0.
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Our second test of H1 examines the market reaction of venture capital backed firms
versus non-venture capital backed firms to the earnings news conveyed in quarterly
earnings announcements. Using Compustat quarterly earnings announcement dates and
CRSP stock returns data, we calculate the three-day cumulative abnormal return for all
quarterly earnings announcements during 2001–2006 made by our sample firms. We use
a seasonal random walk model to measure unexpected earnings. We test the differential
sensitivity of returns to unexpected earnings for venture capital backed firms and non-
venture capital backed firms by estimating equation (6), where the null hypothesis
predicts that λ2 = 0:

CARi,q,t = 0 + 1 UEi,q,t + UEi,q,t *VC +

2 i,q,t (6)

Where: CARi,q,t = cumulative abnormal return over the three days (–1, 1) centered on
firm i’s announcement of quarter q earnings for year t; UEi,q,t = unexpected earnings of
quarter q earnings for year t, measured as the difference between reported earnings for
quarter q of year t and reported earnings for quarter q of year t – 1, scaled by the share
price at the end of the prior fiscal quarter.
As previously noted, we acknowledge that venture capital financing is not exogenous
but rather endogenously determined. To control for this problem we estimate a two-stage
model. In the first stage we model the probability of obtaining venture capital financing
and repeat all of our tests by controlling for self-selection. The challenge we face is that
the firm characteristics that determine venture capital backing at the time of the initial
financing are not publicly observable. Using publicly available data following the IPO
event reflects both the selection of venture capital financing as well as the influence
of the venture capital on firm characteristics. To address this concern, studies in the
literature use location and industry indicators in estimating the venture capital backing
selection model since these variables are not influenced by venture capital intervention
in the firm’s operations (see, for example, Morsfield and Tan, 2006). In addition to
the state in which the firm is based we also control for the firm’s age and include an
indicator variable whether the CEO is also the founder of the firm.5 We include the
headquarters state to control for the geographic concentration of venture capital firms,
as it has been shown that venture capital firms are concentrated in several states, such as
California, Massachusetts, Texas and Washington. We use firm age to measure the firm’s

5
We obtain data of firm age from Jay Ritter’s website, http://bear.cba.ufl.edu/ritter/ipodata.htm.
 Daniel A. Cohen and Nisan S. Langberg 179
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

existence prior to the IPO, predicting that more mature firms rely to a less extent on
venture capital compared to younger firms. We include the CEO-founder indicator since
founder firms are less likely to attract venture capital backing since these firms are less
willing to provide significant ownership to venture capital firms. Finally, we control for
the industry in which the firm operates.

3.2 Conditional Tests of Earnings Informativeness

In this subsection we test how venture capital ownership and board of directors’
characteristics affect the informativeness of earnings for a reduced sample of venture
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capital backed firms. We estimate the following two regressions:

Ri ,t = 0 + EARN i ,t + 2 EARN i ,t * OWN i ,t +

1 3 EARN i ,t * SEAT i ,t
+ ∑ k =1 k EARN i ,t * X kj ,t + i ,t
5
(7a)

R i ,t = 0 +
EARN i ,t + 2 EARN i ,t + 3 EARN i ,t * OWN i ,t +
1 4 EARN i ,t * OWN i ,t
+ 5 EARN i ,t * SEAT i ,t + 6 * EARN i ,t * SEAT i ,t + ∑ k =1
5 k
k EARN i ,t * X j ,t

+ ∑ k =1
5
(7b)
k
k EARN i ,t * X j ,t + i ,t

CAR i ,q ,t = 0 + 1 UE i ,q ,t + 2 UE i ,q ,t * OWN i ,t + 3 UE i , q ,t * SEAT i ,t + i ,t (8)

where: OWNi,t = percentage of equity owned by venture capital firms at date of IPO;
SEATi,t = percentage of seats on board of directors occupied by venture capital firms.

3.3 Data and Sample

The empirical analysis is based on data obtained from the following data sources:
the 2006 Compustat annual and quarterly industrial and research files, the 2006 CRSP
files, the Securities Data Corporation (SDC) database for 2001–2006 and the Corporate
Library database available through WRDS. Since the detailed directorship and
ownership data is available in the Corporate Library database beginning with 2001, we
limit our sample to the period 2001–2006. We also hand-collect venture capital backed
related information since Ljungqvist and Wilhelm (2003) suggest that there are some
errors in the SDC database with regards to the definition of venture capital backing.
When specific data on venture capital board representation was not available we read the
IPO prospectus and firms’ proxy statements. Unit offerings and IPOs with an offer price
of less than $5.00 are not included in our sample. In addition, we eliminated IPOs for
which we could not identify valid CUSIP numbers. To be included in the final sample,
IPOs must have financial data available on Compustat both in the year of and the year
prior to the offering as well as stock return data. These criteria result in a main sample
of 509 IPOs for which we have all the data needed to construct our variables of interest.
This sample consists of 228 venture capital backed IPOs versus 281 non-venture capital
backed IPOs.
 180 Daniel A. Cohen and Nisan S. Langberg
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

3.4 Descriptive Statistics

Across all industries (based on two-digit SIC codes), we find that venture capital
backed IPOs represent 44.79% of all IPOs. This figure is very close to the 43.50%
venture capital backed sample used in a recent study by Morsfield and Tan (2006).
There is a significant variation across industries, from 27% in the transportation industry
(SIC codes 37, 39, 40, 42, 44, 45) to a high of 68% in the scientific instruments industry
(SIC code 38). In a finer analysis we find a large concentration of venture capital backed
IPOs in SIC code 7372 – software firms (15%), and in the biotechnology industry (SIC
code 8731, among others – 8%). With regards to the geographical distribution of venture
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capital backed IPOs, we find that the most venture capital backed IPOs are concentrated
in California, Massachusetts and Texas. These three states represent more than 50% of
the overall venture capital backed IPOs. This concentration is not surprising given that
prior research has documented that venture capital backed firms are located closer to
areas where private equity markets are more developed. Usually, the interpretation for
such a finding is that venture capital firms want to closely monitor their investments,
thus increasing the concentration of venture capital backed firms in those specific
geographical areas. In untabulated statistics we find that venture capital backed firms
have higher market values, smaller assets and lower book values, less sales revenues,
and are less leveraged. In addition, venture capital backed firms are more likely to report
negative earnings compared to non-venture capital backed firms.

4. Results

The results of estimating equation (5a) and (5b) are reported in Table 1. Although
we include all the control variables discussed above, we report only the main variable
of interest. Consistent with prior research, the annual regression relating stock returns to
the level and change in earnings provides positive coefficient estimates (both significant
at the 0.001 significance level). In line with the results documented in Collins and
Kothari (1989), we find that the coefficient estimate for the interaction between earnings
and the market-to-book ratio is positive. We also find that earnings informativeness is
decreasing in leverage. This finding is consistent with firms having greater incentives
to manage earnings in the presence of covenant restrictions associated with leverage,
which makes earnings quality, and thus earnings response coefficients, lower for firms
that are more leveraged. Finally, we find that the coefficient estimates are smaller for
loss observations, consistent with the evidence in Hayn (1995).
With respect to our main variables of interest, EARN*VC and ∆EARN*VC, the
estimate of α̂3 in equation (5a), column (1) is -0.465 and α̂3 + α̂4 in column (2) is -0.530,
both significant at the 0.01 level. These results support our hypothesis that the earnings
of venture capital backed firms are less credible and thus provide a lower level of
informativeness. In terms of the magnitude and economic significance of these effects,
the ratio of α̂2 to α̂1 in equation (5a) or the ratio of α̂3 + α̂4 to α̂ 1 + α̂ 2 in equation (5b),
suggests that venture capital backed firms’ earnings are about 35%–48% less informative
(-0.465/0.967, column1 and -0.530/1.53, column 2).
 Daniel A. Cohen and Nisan S. Langberg 181
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

Columns 3 and 4 in Table 1 report the results when we control for the self-selection
model. The findings in columns 3 and 4 are consistent with the previous results
documented in the left two columns of Table 4. With regards to the magnitude and
significance of the effects, columns 3 and 4 suggest that venture capital backed firms’
earnings are about 39%–40% less informative (-0.392/0.974, column 3 and -0.574/1.48,
column 4) even after controlling for the endogenous features inherent in venture capital
backing.

Table 1
Tests of Earnings Informativeness of Venture Capital Backed Firms versus Non-Venture Capital Backed
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Firms

Variable VC DUMMY Controlling for self-selection

-0.008 -0.174 -0.002 -0.157
INTERCEPT
(-2.67) (-3.68) (-2.94) (-3.76)
0.967 0.824 0.974 0.841
EARN
(14.37) (16.27) (13.68) (17.37)
-0.465 -0.341 -0.392 -0.335
EARN*VC
(-10.68) (-11.42) (-11.73) (-12.74)
0.706 0.638
∆EARN
(14.38) (15.37)
-0.189 -0.239
∆EARN*VC
(-12.37) (-11.39)
0.487 0.562
Inverse Mills Ratio
(4.99) (5.07)

Adj. R2 0.142 0.234 0.157 0.264

VC*EARN + VC*∆EARN -0.530 -0.574

Variables definitions: The dependent variable is Ri,t= firm i’s 12-month cumulative abnormal return for fiscal
year t. The 12-month interval starts three months following the end of the fiscal year t-1 and ends three months
after the end of fiscal year t. VC = a dummy variable that equals one for venture capital backed firms and zero
otherwise. EARNi,t = firm i’s annual earnings (before extraordinary items) for fiscal year t, scaled by market
value of equity at the end of fiscal year t-1. ∆EARNi,t = change in EARNi,t between year t-1 and year t, scaled
by market value of equity at the end of fiscal year t-1. VCi,t = venture capital backing dummy variable equal to
1 if the company is venture capital backed, zero otherwise.

Our next test of Hypothesis H1 investigates the capital market’s reaction to the
earnings news conveyed in quarterly earnings announcements of venture capital backed
firms and non-venture capital backed firms. The results estimating equation (6) are
reported in Table 2. Consistent with prior research, we find a positive and significant
value of unexpected earnings (UE). The coefficient estimate λ̂2, which is significantly
negative, suggests that investors respond less to a unit of unexpected earnings for
venture capital backed firms than for non-venture capital backed firms (-0.066,
t-statistic -5.98). Comparing the estimates λ̂1 and λ̂2 suggests that quarterly earnings
announcements are about half as informative for venture capital backed firms relative to
non-venture capital backed firms. Repeating the analysis controlling for self-selection of
venture capital provides the same results.
 182 Daniel A. Cohen and Nisan S. Langberg
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

Table 2
Market Reaction to Quarterly Earnings Announcements of Venture Capital Backed Firms versus Non-
Venture Capital Backed Firms

Variable VC DUMMY Controlling for self-selection

0.004 0.003
Intercept
(7.98) (8.06)
0.129 0.134
UE
(15.47) (14.96)
-0.066 -0.069
UE*VC
(-5.98) (-4.96)
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0.462
Inverse Mills Ratio
(3.87)

Adj. R2 0.021 0.028

Variables definitions: The dependent variable is cumulative abnormal return over the three days (-1,1) centered
on firm i’s announcement of quarter q earnings for year t.
UEi,t = the unexpected earnings in firm i’s quarter q, year t earnings announcement, measured as reported
earnings for quarter q, year t minus reported earnings for quarter q, year t-1, divided by market value of equity
30 days prior to the announcement. VC = a dummy variable that equals one for venture capital backed firms
and zero otherwise.

Overall, the results in Tables 1 and 2 suggest that venture capital backing decreases
the valuation weight investors place on reported earnings of such firms. The results
we document are robust to controlling for self-selection and to the inclusion of control
variables identified by prior research to be related to the returns-earnings relation.

4.1 Venture Capital Ownership and Earnings Informativeness

We test Hypotheses H2 and H3 and report the results in Table 3, Panels A and B. The
evidence in Table 3, Panel A suggests that while EARN and ∆EARN are still positive and
significant (as in the previous analysis), venture capital ownership (OWN) decreases the
informativeness of earnings. In addition, we find that the larger the influence and control
of venture capital firms on the boards of directors, as evidenced in the percentage of the
seats they have on the board (SEAT), the lower the informativeness of earnings. Overall,
we find that both variables significantly decrease the informativeness of earnings, after
controlling for factors known to influence the returns-earnings relation.
Table 3, Panel B presents the results of testing how board characteristics and venture
capital ownership affects the market’s reaction to quarterly earnings announcements. In
line with the results we report in Table 3, Panel A, we find that the higher the ownership
stake of venture capital funds and the more influence these funds have on the board
of directors, the less the market reacts to the earnings news signal as conveyed in the
quarterly earnings announcement. As in Panel A, both SEAT and OWN once interacted
with UE (unexpected earnings) have a statistically significant negative coefficient.
 Daniel A. Cohen and Nisan S. Langberg 183
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

Table 3
The Effect of Venture Capital Ownership and Board of Directors Characteristics on Earnings Informa-
tiveness for Venture Capital Backed Firms

Panel A: Annual Returns-Earnings Regressions

Variable VC DUMMY Controlling for self-selection

-0.005 -0.179 -0.001 -0.143
INTERCEPT
(-2.73) (-3.54) (-2.74) (-3.25)
0.978 0.835 0.986 0.854
EARN
(13.04) (15.09) (12.78) (16.34)
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0.684 0.652
∆EARN
(13.43) (13.41)
-0.254 -0.246 -0.248 -0.239
EARN*SEAT
(-3.68) (-3.79) (-3.71) (-3.92)
-0.187 -0.183
∆EARN*SEAT
(-2.94) (-2.85)
-0.182 -0.196 -0.189 -0.187
EARN*OWN
(-4.69) (-4.83) (-4.52) (-4.51)
-0.171 -0.149
∆EARN*OWN
(-5.06) (-5.12)
0.479 0.559
Inverse Mills Ratio
(4.84) (5.12)

Adj. R2 0.167 0.259 0.173 0.291

Panel B: Market Reaction to Earnings Announcements Conditional on Board and Venture Capital
Ownership

Variable VC DUMMY Controlling for self-selection

0.003 0.002
Intercept
(6.51) (5.74)
0.124 0.131
UE
(14.36) (13.64)
-0.041 -0.039
UE*OWN
(-2.98) (-2.89)
-0.037 -0.043
UE*SEAT
(-4.67) (-4.61)
0.075
Inverse Mills Ratio
(4.37)

Adj. R2 0.027 0.031

Variables definitions for Panel A: The dependent variable is Ri,t = firm i’s 12-month cumulative abnormal
return for fiscal year t. The 12-month interval starts three months following the end of the fiscal year t-1 and
ends three months after the end of fiscal year t. VC = a dummy variable that equals one for venture capital
backed firms and zero otherwise. EARNi,t = firm i’s annual earnings (before extraordinary items) for fiscal year
t, scaled by market value of equity at the end of fiscal year t-1. ∆EARNi,t = change in EARNi,t between year t-1
and year t, scaled by market value of equity at the end of fiscal year t-1. OWN = percentage of equity owned
by venture capital firms at date of IPO. SEAT = percentage of seats on board of directors occupied by venture
capital firms.
 184 Daniel A. Cohen and Nisan S. Langberg
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

Variable definitions for Panel B: The dependent variable is cumulative abnormal return over the three days (-1,1)
centered on firm i’s announcement of quarter q earnings for year t. UEi,t = the unexpected earnings in firm i’s
quarter q, year t earnings announcement, measured as reported earnings for quarter q, year t minus reported
earnings for quarter q, year t-1, divided by market value of equity 30 days prior to the announcement.

Overall, the results in Table 3 suggest that as the ownership and influence of
venture capitalists increases, capital markets investors decrease the valuation weight
on reported earnings. While some of the control variables account for the variation in
earnings informativeness, a significant portion is still unexplained by these variables.
We conclude that the unexplained portion in earnings informativeness is attributed to
investors’ perceptions that venture capitalists influence the public financial reporting
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process in ways that reduce the credibility of earnings and thus its informativeness.
The empirical evidence to date is mixed regarding the association between
ownership structure and earnings informativeness. On one hand, Warfield et al. (1995)
find a positive relation between managerial ownership and earnings informativeness,
whereas Fan and Wong (2002) find a negative relation between ownership and earnings
informativeness for their sample of East Asian firms with concentrated ownership.6
Taken as a whole, the results we document so far indicate that there is a long-term
adverse effect associated with being backed by venture capital financing. In particular,
one implication of these results is that venture capital backed firms have information-
related problems that might affect their ability to raise capital in the future. The specific
test of this assertion is left for future research.

5. An Alternative Test of Communication Efficiency

As in Jiambalvo et al. (2002), who examine the influence of institutional investors

on the informativeness of earnings, we assess the extent to which stock prices lead
accounting earnings conditional on venture capital backing. Specifically, we examine
whether the stock prices of venture capital backed firms impound more or less
information about current earnings relative to future earnings. If venture capitalists are
characterized as transient investors (short-horizon) who are more concerned with current
short-term profitability, they will lack any incentives to become informed regarding the
future prospects of the firm they invest in. Stated differently, venture capitalists will
focus only on current earnings as a measure of profitability. If venture capitalists are
over-focusing and emphasize short-term profitability as reflected in current reported
earnings instead of future profitability, we might expect that stock prices of venture
capital backed firms will reflect more information contained in current reported earnings
relative to the information contained in future earnings. The main motivation for
investigating these empirical predictions is due to the limited investment and ownership
horizon faced by venture capitalists. As we stated earlier, venture capitalists are required
by law to liquidate their equity holdings and exit the newly public firms they have
invested in during a specific time frame.

6
In particular, Fan and Wong (2002) find that concentrated ownership, created by cross-holdings and
pyramid structures that separate cash flow rights from voting rights, decreases the informativeness of earnings.
 Daniel A. Cohen and Nisan S. Langberg 185
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

In order to examine the extent to which stock prices reflect the relative dependence
on current and future earnings, we adopt the approach discussed in Kothari and Sloan
(1992). It is well known that stock prices lead earnings, since not all the economic
actions undertaken by the firm are reflected in current earnings but such actions are
available and known to investors. These economic actions, although known to investors
and not reflected in current reported earnings, will be reflected in future earnings. Under
this scenario, if investors impound value relevant information that is not reflected
in current earnings, current stock prices will reflect the information regarding future
earnings, after controlling for current earnings.
Kothari and Sloan (1992) use the premise that stock prices lead accounting earnings
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and suggest the following association:

E it
R it ,t = 0 + 1( ) + it (9)
P it
where: Rit, t–τ = the buy-and-hold return for firm i over the period t – τ to t; Eit = income
before extraordinary items for the accounting period ended at time t; Pit–τ = the stock
price at the end of period t – τ. The capital market’s response during the period t – τ to t
to accounting earnings information for the period ended at time t is represented by θ1(r).
The discussion in Kothari and Sloan (1992) suggests that as the interval τ increases,
more information contained in reported earnings at time t would be reflected in the
return cumulated over the period t – τ to t. This is the case since the capital market’s
expectation about future profitability will be reflected earlier in stock prices but only
later in reported accounting earnings. If the information contained in current reported
earnings has already been reflected in stock prices in the previous period, the coefficient
θ1(τ) will get smaller (larger) as the interval τ gets smaller (larger). This implies that θ1(τ)
when τ = 2 is larger than for τ = 1. The ratio of θ1(r) obtained for a longer time interval
to the one obtained for a shorter interval (i.e. 1( = 2)
) will provide a measure of the firm’s
1( =1)
information environment. The higher the ratio, the more information in current reported
earnings has already been reflected in previous stock returns.
If venture capitalists can be classified as transient investors who myopically focus on
short-term reported accounting earnings given their limited investment and ownership
horizon, one would expect the ratio 1( = 2)
to be smaller for venture capital backed
1( =1)
firms than for non-venture capital backed firms. In other words, stock prices of venture
capital backed firms would be more sensitive to current reported earnings relative to
future earnings than stock prices of non-venture capital backed firms. To investigate this
prediction, we estimate the coefficient θ1(r) separately for venture capital backed firms
and non-venture capital backed firms for τ = 1 and for τ = 2. Next, we calculate the ratio
1( = 2)
for each group and test whether the ratio is lower for the venture capital backed
1( =1)
firms. A smaller ratio for venture capital backed firms compared to the non-venture
capital backed firms is consistent with the assertion that venture capital investors can be
classified as transient investors with a short-term investing horizon.
The results of estimating equation (9) for venture capital backed versus non-venture
capital backed firms and for the two time periods (τ = 1 and τ = 2) are reported in Table 4.
 186 Daniel A. Cohen and Nisan S. Langberg
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

Table 4
Regression Analysis of Stock Returns on Current Earnings with Different Time Intervals, Venture
Capital Backed Firms and Non-Venture Capital Backed Firms

E it
R it ,t = 0 + 1( ) + it
P it

(1) (2) (3) (4) (5) (6)

θ1(τ = 1) θ1(τ = 2) θ1(τ = 1) θ1(τ = 2)

1( = 2) 1( = 2)

1 ( = 1) 1 ( = 1)

Venture Capital
1.076 1.543 1.094 1.764 1.612
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1.434
Backed Firms
Non-Venture Capital
1.309 2.341 1.788 1.186 2.204 1.858
backed Firms

The robust t-statistics (Petersen, 2008) are based on standard errors that are clustered by both firm and year
(Panel A) and quarter (Panel B) and are shown in parentheses.
Rit, t – τ is the buy-and-hold return for firm i over the period t – τ to t, Eit is income before extraordinary items
for the accounting period ended at time t, Pit – τ is the stock price at the end of period t – τ. θ1(τ) is the capital
market’s response to reported earnings. Columns (1) to (3) report the results of estimating equation (9) for
venture capital backed firms and non-venture capital backed firms. Columns (4) to (6) report the results after
controlling for different factors affecting the earnings-returns relationship: LOSS, HTECH, SIZE, MB, and
LEV.

Columns (1) to (3) report the results of a univariate estimation while the multivariate
analysis after controlling for the interaction of reported earnings with other determinants
of the earnings-returns relationship (SIZE, LEV, MB, LOSS and HTECH) is reported
in columns (4) to (6). Consistent with the findings in Kothari and Sloan (1992), the
estimated coefficients θ1(τ) for both the venture capital backed and non-venture capital
backed firms increase with the time interval over which stock returns are computed. This
finding is consistent with the claim that stock prices lead accounting earnings. Our main
focus is on the ratio 1( = 2)
that captures the extent to which stock prices lead earnings
1( =1)
across venture capital and non-venture capital backed firms. The results suggest that
the ratio 1( = 2)
is significantly lower for the venture capital backed firms (1.434 for
1( =1)
venture capital backed firms versus 1.788 for non-venture capital backed firms, and 1.612
versus 1.858 once the control variables are included (columns 3 and 6)). This finding is
consistent with the view that venture capital investors can be characterized as transient
owners who are myopically focused on short-term earnings.

6. Summary and Conclusions

The extant literature has documented by far the benefits of venture capital financing
for the newly public firm. These benefits range from the valuable strategic advice,
business plans and industry connections provided by venture capitalists to newly public
firms, high quality of underwriters, and the low underpricing of IPOs enjoyed by venture
capital backed firms. We hypothesize that these benefits do not come without costs. For
 Daniel A. Cohen and Nisan S. Langberg 187
Asia-Pacific Journal of Accounting & Economics 16 (2009) 171–190

example, some offsetting effects of obtaining venture capital financing might be due
to the different investment time horizon and specific objectives venture capital firms
face. We seek to investigate whether the unique ownership structure of the newly public
firm, specifically, the degree of control and ownership by venture capitalists, affects its
financial information credibility and thus its quality as manifested in the informativeness
of reported earnings. For a sample of 509 IPOs which consist of 228 venture capital
backed firms we examine what the long-term economic consequences of venture capital
financing are, as evidenced in the informativeness of reported earnings of newly public
firms.
Controlling for other known factors to affect earnings informativeness, we find that
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the informativeness of earnings depends on whether the newly public firm was venture
capital backed or not. In particular, the results suggest that venture capital backed firms
have earnings that are less informative compared to a group of non-venture capital
backed firms. These findings are robust to attempts to control for firms’ decision to
obtain venture capital in the first place. For a sub-sample of venture capital backed firms
we also document that earnings are less informative if venture capitalists retain more
ownership and control of the board.
Taken as a whole the evidence we present suggests that there is a cost associated
with being backed by a venture capitalist. Our theory suggests that the conflict of
interest between long-term equity investors and venture capitalists who seek to promote
short-term performance leads to less informative earnings as one of its attributes.
This by itself might introduce information asymmetry problems affecting the firm’s
ability to raise future capital, which might increase its cost of capital and reduce firm
value. However, the underlying conflict of interest we emphasize may bring about the
inefficiency of other firm decisions. The specific test of this assertion is left for future
research.

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