Recent empirical research in capital structure has focused on regularities in the cross section of leverage to distinguish between various theories of financing policy. Both book and market leverage are related to profitability, book-to-market, and firm size. Changes in market leverage are largely explained by changes in equity value. Past book-to-market ratios have been shown to predict current capital structure. Firms appear to use external debt financing too conservatively, with the leverage of stable, profitable firms being particularly low. Even if firms have a target level of leverage, they move towards it slowly, at a “snail’s pace” (Fama and French (2002)). Firms with low and high leverage react differently to external economic shocks. Existing explanations for these findings are related to various versions of the pecking order, trade-off or market timing theories. Each of these theories is supported by some evidence and challenged by other evidence. This paper attempts to reconcile these apparently conflicting results by providing a quantitative, as well as qualitative, connection between empirical cross-sectional studies of capital structure and dynamic models of optimal financing behavior.
The starting point is a simple but, I believe, powerful observation: in a dynamic economy with frictions the leverage of most firms, most of the time, is likely to deviate from “optimal leverage” prescribed by a model of optimal financial policy. With transaction costs optimizing shareholders will prefer to adjust leverage by issuing or retiring securities infrequently, at “refinancing points”. One simple consequence of this observation is that, even if firms follow a certain model of financing behavior, a static model may nonetheless fail to explain differences between firms in a cross-section since, between refinancing points, the actual and “optimal” leverage differ. It has been long recognized that deviations from optimal leverage may create problems for interpreting the results of empirical research. For example, Myers (1984, p. 578) emphasizes that “any cross-sectional test of financing behavior should specify whether firms’ debt ratios differ because they have different optimal ratios or because their actual ratios diverge from optimal ones”.
Exit and entry of firms are fundamental elements behind the structural changes in different industries. To investigate forces underlying the establishment of new firms and closing down firms is very important, both for understanding industrial change, and from an economic policy point of view. The importance of industrial dynamics and firm entry and exit has been recognised since the early 20th century. Perhaps the most influential contributions in this area are made by Schumpeter (1942) who discussed the concept of creative destruction“. According to Schumpeter the most important form of competition comes from the new commodity, new technology, the new source of supply, the new form of organisation.“ (Schumpeter, 1942 p. 84-85).
Previous research in venture capital finance has documented the relation between the duration of staged investment rounds and the degree to which monitoring is facilitated and informational asymmetry is mitigated between venture capitalists and entrepreneurial firms (Gompers, 1995). Gompers found evidence that investment rounds are shorter, and therefore monitoring is more frequent, when the entrepreneurial firm's assets are intangible, R&D is more intensive, and market-to-book ratios are higher. Moreover, the duration of investment rounds also depended on the stage of firm development, which is consistent with the idea that moral hazard and adverse selection costs are more pronounced at different stages of development (Sahlman, 1990; Macintosh, 1994; Gompers and Lerner, 1999a; Cumming, 1999a). Gompers' (1995) evidence from the duration of staged investment rounds has both supported and given rise to the majority of venture capital research indicating that the structure of venture capital investments is designed to mitigate agency costs between the venture capitalist(s) and the entrepreneurial firm (e.g., Gompers and Lerner, 1994, 1999a; Sahlman, 1990; Trester, 1998, Kaplan and Stromberg, 2000).
A second type of venture capital research has considered venture capitalists' role in mitigating agency costs between entrepreneurial firms and their new owner(s) (Gompers and Lerner, 1999a,b; Megginson and Weiss, 1990; Barry et al., 1990). This second area of venture capital research has received a comparative dearth of attention in the literature. In contrast to analyzing the duration of staged investment rounds and agency costs between venture capitalists and entrepreneurial firms (Gompers, 1995), this paper considers the role of total venture capital investment duration in mitigating agency costs between entrepreneurial firms and their new owner(s). In addition, in the spirit of Black and Gilson (1998), a comparison of evidence across Canada and the United States is provided to highlight the impact of legal and institutional features on the relation between private and public equity markets.
