Misconduct risks, legal enforcement and venture capital networks

• Published date: 01 June 2022
• Author: Douglas J. Cumming,Ali Mohammadi,Simona Zambelli
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/eufm.12346

DOI: 10.1111/eufm.12346

ORIGINAL ARTICLE

Misconduct risks, legal enforcement and

venture capital networks

Douglas J. Cumming

1,2

|Ali Mohammadi

3

|Simona Zambelli

4

1

Finance Department, College of

Business, Florida Atlantic University,

Boca Raton, Florida, USA

2

Visiting Professor, Birmingham

Business School, University of

Birmingham, UK

3

Department of Strategy and Innovation,

Copenhagen Business School,

Copenhagen, Denmark

4

Department of Economics and Business

Sciences, School of Economics,

University of Florence, Florence, Italy

Correspondence

Douglas Cumming, DeSantis

Distinguished Professor, Florida Atlantic

University, College of Business, 777

Glades Rd., Boca Raton, FL 33431, USA.

Email: cummingd@fau.edu

Abstract

This study investigates the differing role of enforcement

on the formation of venture capital (VC) syndication

networks. We conjecture that public enforcement, with

strong investigative powers against any syndicate mem-

ber, discourages the formation of denser syndication

networks due to misconduct risk by a member. By con-

trast, private enforcement, with strong disclosure and

liability standards, enables denser syndication networks,

through clear liability rules, standardized securities con-

tracts and cost‐sharing amongst syndicate members. Our

VC data from 31 countries show a negative impact of

public enforcement on VC networks and partially sup-

port the positive impact of private enforcement depend-

ing on cultural conditions.

KEYWORDS

culture, legal enforcement, networks, syndication, venture

capital

JEL CLASSIFICATION

G24, G32

Eur Financ Manag. 2022;28:607–650. wileyonlinelibrary.com/journal/eufm © 2021 John Wiley & Sons Ltd.

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We wish to thank the editor (John A. Doukas) and two anonymous referees of European Financial Management for

helpful comments to improve the paper. We also thank the seminar participants at Politecnico Milano, KTH Royal

Institute of Technology and the participants of the Stevens Institute of Technology Conference on Entrepreneurial

Finance, IPAG Paris Financial Management Conference and York University, as well as Ida Ferrara, Martina Weber,

Henry Lahr and Matteo Lippi Bruni for very helpful comments and suggestions. Douglas Cumming owes thanks to the

Social Sciences and Humanities Research Council of Canada for financial support. Ali Mohammadi would like to thank

Scuola Interpolitecnica and Centre of Excellence for Science and Innovation Studies (CESIS) for financial support.

Simona Zambelli owes special thanks to the Government of Canada for financial support as a Winner of the Canada‐

Italy Innovation Award 2018, as well as the Executive Learning Center (Schulich School of Business, York University,

Toronto), Scott Lannan, Ramiro Pinto and Mark Orlan for support.

1|INTRODUCTION

In this study, we empirically analyze whether venture capital (VC) syndication networks

change across countries and over time in relation to changes in the legal enforcement of

securities laws and cultural settings.

Venture capitalists (VCs) are value‐added active investors that typically invest in syndicates

of 2–20 investors into private illiquid firms for 2–7 years (Bertoni & Groh, 2014; Bertoni

et al., 2010; Bianchini & Croce, 2022; D. J. Cumming & Johan, 2013; D. Cumming &

Zambelli, 2017; Dai & Nahata, 2016; Groh & Andrieu, 2012; Groh et al., 2010). Sometimes VC

activities are in violation of securities laws. For example, information gathered and misreported

by a syndicate member may lead to inflated asset values of an investee (D. J. Cumming &

Walz, 2010; Johan & Zhang, 2021; Smith et al., 2022). Some VC syndicate members may engage

in fee‐shifting for co‐mingled vehicles to lower the expenses of preferred clients (Atanasov

et al., 2012). Other VC syndicate members may usurp investment opportunities by entering into

related party transactions at the expense of some investors (Karpati, 2013).

Effective security laws require high‐quality enforcement, with clear accountability rules and

disclosure standards. Around the world, two different types of securities law enforcement exist: (a)

public enforcement, which occurs through public agents or government bodies (such as inspectors,

police or other public prosecutors), who have strong investigative powers and can impose orders,

sanctions and criminal prosecutions in case they detect violations of legal rules; (b) private en-

forcement, which is initiated by private parties seeking compensation through private litigation

(Enriques et al., 2017). Efficient private enforcement involves high standards of disclosure and clear

liability and burden of proof rules (Jackson & Roe, 2009; La Porta et al., 2006).

Often VCs engage in syndication by coinvesting with other VC funds in the same target

company (Lerner, 1994; Wright & Lockett, 2003). Entering a syndicate offers potential rewards

in terms of affiliation with other investors in the network, but also increases possible under-

lying risks and costs if other investors violate securities laws through improper disclosure or

other forms of misconduct.

Syndication implies that more than one separate VC organization jointly invests in the same

target company through binding coinvestment contracts (Bygrave, 1988). Syndication improves

screening before investment and adds value to target firms before exit (Dai & Nahata, 2016;

DeGennaro & Dwyer, 2013;Huangetal.,2015; Manigart & Wright, 2013;Manigartetal.,2000,2006;

Trapido, 2013). Syndication also generates webs of connections (or networks) among VCs coin-

vesting in the same companies (e.g., Bygrave, 1988;Hochbergetal.,2007;Trapido,2013). Given that

syndication involves contractual relationships that bind VCs through financial securities, syndication

networks are particularly affected by securities laws, which matter not only for publicly traded firms

but also for privately held VC‐backed firms (see Section 3formoredetails).Forthepurposeofthis

study, we specifically focus on investment syndication networks and exclude any other types of

informal networks, such as those originated by business connections not involving any formal

coinvestment contract (Sorenson & Stuart, 2001,2008), as investment syndication is pertinent to

securities laws while other types of noninvestment networks are not.

In relation to the specific way in which securities laws are enforced, we develop two

primary hypotheses. First, we expect that high public enforcement, with strong investigative

powers against any member of a syndicate and strong group sanctions, increases the expected

costs of VC syndication and thereby discourages the formation and density of syndication

networks. Second, we conjecture that private enforcement, with strong disclosure and liability

standards, enables VC syndication and the formation of denser networks through clarification

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of liability rules, standardized securities contracts and cost‐sharing amongst VCs in the in-

vestment syndicate.

We further develop two additional hypotheses on the impact of culture, by relating VC

network density to international differences in Hofstede's cultural dimensions (see

Hofstede, 2010,2011). First, we expect a direct effect of a country's degree of uncertainty

avoidance on network density due to risk sharing and a negative effect on density stemming

from a country's level of individualism, masculinity and power distance. Second, we conjecture

that cultural differences moderate the relationship between legal enforcement and syndication

networks. In a similar spirit, prior international evidence shows that cultural settings influence

the development of VC markets in terms of the number of deals and invested amount (Li &

Zahra, 2012). In our study, we extend this evidence by investigating how culture affects the

propensity of VCs to form denser syndicate networks and how it can moderate this impact.

Our empirical evidence is based on a data set of VC transactions carried out in 31 countries

from 1995 to 2014. Our data include 100,018 worldwide investments in 55,621 investee firms and

involves 201,552 relationships, or VC‐investee firm deals. We analyze network density, calculated

as the ratio between the number of existing connections divided by the maximum possible number

of connections (see, e.g., Hochberg et al., 2010). The network density captures both syndication and

the diversity of syndicate partners (Friedkin, 1981) and it is commonly used in the finance literature

to compare different networks among different countries and over time (see e.g., Bygrave, 1988;

Hochberg et al., 2010). For the purpose of our study, we create country‐year level density measures

of ties between VCs through their syndication activity relative to the potential syndicated invest-

ments in a country. Our density measures account for the fact that there may not be significant

syndication opportunities in different parts of the world. Our country‐level measures do not unduly

weigh any one country in respect of more deals being carried out in different parts of the world. We

performed different robustness checks and our results remain robust to excluding different

countries from our sample, among other checks.

VCs often develop specialisms in certain sectors or regions. In deciding to invest, VCs could

refer to already established networks instead of searching for alternative partners. There are

risks of searching for alternative partners that are perhaps less well‐known brand names to

each other due to misconduct risks from others in the network (e.g., see Atanasov et al., 2012).

In this paper, we conjecture that the extent to which VCs search for new alternative partners

will depend on securities law enforcement.

Our results show that public enforcement significantly affects VC syndication behaviour by

discouraging the formation of VC networks, while private enforcement seems, on average, less

pertinent to VC networks and shows a significant impact only within certain cultural settings.

More specifically, countries with higher levels of uncertainty avoidance (see Hofstede,

2010,2011) are associated with higher network density, probably due to the fact that denser

networks help mitigate the risk of operating alone. Also, we show that cultural traits moderate

the expected impact of public and private enforcement on network density. Our data indicate

that public enforcement has a stronger and more significant negative effect on network density

in those countries characterized by lower levels of cultural uncertainty avoidance, higher levels

of masculinity and lower levels of power distance.

The evidence underlying our paper is most closely related to the literature on VC syndi-

cation around the world. Prior studies show that syndication is more common in countries with

stronger legal institutions (D. J. Cumming & Johan, 2013; Tykvová, 2018). However, the prior

literature does not take into account that there are substantially fewer VCs in countries

with weaker legal institutions (Li & Zahra, 2012) due to inefficient exit opportunities

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