Navigating Political Hazard Risks and Legal System Quality

Institutional Conditions and VC Investments

Country-level effects—such as institutional conditions—are an important determinant of business strategy and performance (Busenitz, Gomez, & Spencer, 2000; Khanna, Palepu, & Sinha, 2005; Lyles, Saxton, & Watson, 2004; Murtha & Lenway, 1994). Naturally, country-level conditions also affect the performance of VC firms (Black & Gilson, 1998; Cumming, Fleming, et al., 2010; Cumming, Schmidt, & Walz, 2010; Lerner & Schoar, 2005), which has strategic implications for developing country ventures pursuing resources in order to enhance their chances of survival (Baker, Gedajlovic, & Lubatkin, 2005; Vaaler, 2011). Generally, both ventures and capital providers are able to thrive and benefit from the general level of predictability, transparency, and consistency within the institutional environment.

In weaker institutional environments, the informal norms and relational means to facilitate transactions are integral to business practices (Peng & Khoury, 2009; Webb, Tihanyi, Ireland, & Sirmon, 2009). Although the impact to entrepreneurship varies across developing countries (Baker et al., 2005), accounting for these institutional challenges within investment decisions may reveal additional transaction costs and risks (Ahlstrom & Bruton, 2006; Peng, Lee, & Wang, 2005). Focusing on specific legal and political institutions and the likelihood of investment occurring, Guler and Guillen (2010b) reinforce this assumption in finding that fewer VC entries occur in countries with lacking institutional environments. Thus, given the national differences in how firms interface with unique political and legal institutions (Brewer, 1993; Hillman & Keim, 1995), prospective investors are apt to consider the risks of, and costs to, successfully navigating institutional dimensions, as each presents its own specific challenges.

In this study, we focus on two important institutional factors: the quality of the legal system and political hazards, which have been identified as being universally crucial and salient dimensions within the institutional setting in terms of shaping perception of investment risk and guiding entrepreneurship (i.e., Bottazzi, Da Rin, & Hellmann, 2009; Cumming, Fleming, & Schwienbacher, 2006; Cumming, Schmidt, et al., 2010; Guler & Guillen, 2010b; Henisz, 2000b; La Porta et al., 1998, 1999; La Porta, Lopez-de-Silanes, Pop-Eleches, & Shleifer, 2004; Lerner & Schoar, 2005). Although both factors are drawn from the venture’s country-level institutional environment, each presents particular challenges to investment decisions.

Stage of Development of the Venture, Institutional Conditions, and VC Investments

Traditionally, scholars have proposed that there is a positive relationship between the stage of development of a venture and the size of a VC investment transaction and documented this result for U.S. ventures (Gompers, 1995). ² Looking beyond the United States, this investment strategy might be challenged by developing country institutional environments. Thus, with respect to the next hypotheses, we propose that the quality of the legal system and political hazards, respectively, moderate the relationship between stage of development and the size of the VC investment round.

The process of pairing ventures with capital investment involves the reconciliation of asymmetric information between the entrepreneurs themselves and prospective financiers, giving rise to significant agency problems (Akerlof, 1970; Gompers & Lerner, 1999; Jensen & Meckling, 1976). A fundamental challenge that a VC must overcome is that of adverse selection, where venture founders privately know more about their own ventures than those seeking to invest, such as outside financiers. In this case, entrepreneurs with access to a variety of capital resource outlets will seek to self-finance more proven ventures and seek more outside capital when ventures are less proven. Hence, financiers can be left to choose from “lemons” (Akerlof, 1970; Amit et al., 1990). Further, not only is there asymmetric information regarding the potential of the new venture, but also regarding the entrepreneur’s ability, skill level, or even willingness to work hard (Amit et al., 1990). However, such ventures typically face fewer capital market outlets for financing their ventures (Butler & Fauver, 2006; Lerner & Schoar, 2005), which might allow VCs to participate in deals that provide them with more influence or more favorable investment terms (i.e., in terms of ownership or exit options).

Another challenge posed to VCs by the presence of asymmetric information relates to moral hazard. Once a venture owner has raised capital or divested a portion of his or her stock, the concern is that incentives become less congruent between the new owners (investors) and the controlling managers (e.g., venture founders). Under these circumstances, founders may take actions that are not in line with investor interests (Gompers & Lerner, 1999; Jensen & Meckling, 1976; Junkunc & Eckhardt, 2009). In accounting for the tension in agent and principal incentives that occurs with VC participation, VCs invest incrementally in stages with smaller size transactions for earlier stage firms and larger transaction rounds for firms that have overcome earlier stage risks (Fitza, Matusik, & Mosakowski, 2009; Sahlman, 1990), as seen at least in developed countries.

The moderating role of institutional conditions

For developing country investment decisions, VCs not only face the challenge of overcoming firm-level information asymmetries inherent in the target venture, but also have to address the problem of understanding how the institutional environment may impact an investment targeted for an earlier stage venture versus that targeted for ventures in a more advanced stage of development. Given the unique challenges faced by ventures operating in weaker institutional environments (Fisman, 2001; Lee et al., 2007), the investment difficulties are more complex and further compounded, which leads to an interactive relationship between institutional factors and firm-level sources of uncertainty (Baker et al., 2005). As mentioned earlier, in countries with strong institutional systems, staging of investments in rounds that increase in size according to the venture’s development is a common strategy used by VCs to monitor and compensate for the risks associated with their investments (Gompers, 1995; Sahlman, 1990). However, given the compounded effect of firm-level liabilities with institution-born uncertainties that take place in developing countries, this conventional VC investment strategy must be redressed to account for such interacting challenges.

Developing country ventures that are farther along in their development should experience less impact from risks associated with the institutional environment because: (1) having moved forward into more advanced stages of development may indicate the accumulation and possession of more seasoned capabilities or capacities to deal with institutional deficiencies when compared to earlier stage ventures (Goodstein & Velamuri, 2009) and (2) they may have acquired more resources to focus on institutional challenges than their younger counterparts (Young, Peng, Ahlstrom, Bruton, & Jiang, 2008). In other words, the harsher and potentially devastating effects of a weaker institutional environment exacerbate the investment risk associated with a young venture’s liability of newness (Stinchcombe, 1965). For example, ventures at earlier stages of development are particularly dependent on basic guarantees of property rights and contract enforcement (Kaplan & Stromberg, 2003). These ventures will have to spend significant resources to overcome political and legal challenges inherent in more uncertain institutional environments. Hence, VCs in weak institutional environments can be expected to shy away from, or avoid, investments in early stage ventures, as they are perceived as being exceedingly risky pursuits.

Ventures at an earlier stage of development operating within institutional environments where the legal system lacks sufficient mechanisms for handling contract disputes or judicial impartiality may find greater challenges in attracting sizable VC investments (La Porta et al., 2006). Here, the legal problem may be twofold in that (1) earlier stage ventures face a greater struggle of establishing trust with capital providers when they operate in a domestic legal environment that is not trustworthy and (2) the risk of asset or resource appropriation is higher for ventures that lack the necessary informal ties or resources to manage legal challenges around impartiality, justice, or governance oversight. Compared to more established ventures, earlier stage ventures typically lack access to political actors who hold great power and influence over the release of valuable permits or approvals to operate in specific markets (Coppedge, 1993; Cross, 1998; Fisman, 2001; Goodstein & Velamuri, 2009). Accordingly, earlier stage ventures facing weaker legal and more uncertain political climates present greater risks to VCs and are more apt to not receive venture capital or, when they do, to likely receive substantially smaller investments. VCs may prefer to hold off and wait for ventures to evolve more and demonstrate their ability to weather the uncertainties posed by a weak institutional environment. Rather, sizable investments in early stage ventures are more likely to occur when ventures reside in stronger institutional environments.

The challenges associated with weaker institutional settings, although still present, should be respectively less problematic for middle stage ventures that have overcome these earlier stage liabilities. In addition to being more adroit at mitigating the effects of weak institutions, more established firms have access to greater resources to deal with unfavorable settings for entrepreneurship (Michael & Pearce, 2009). This presents a caveat to more conventional VC strategies (Gompers, 1995) and supports the proposal that amid more uncertain institutional conditions, middle (compared to early) stage ventures present a lower risk proposition for VCs to initiate larger investment rounds.

In such environments, middle stage ventures present a viable investment option that is more on par to that presented by advanced stage investments. Also, VCs investing at middle stages are more likely to invest comparatively more than usual in order to establish greater influence and control to help navigate the uncertainties posed by a weak institutional environment (Lerner & Schoar, 2005). Therefore, the strategy of staging investments in incremental amounts throughout the life of the venture—typically used in more developed economies—should become less apparent in weaker institutional environments because the avoidance of early stage investments translates to proportionally larger investments at more advanced stages of development. In other words, the investment strategy in weaker institutional environments is to focus on middle and later stage ventures rather than investing incrementally at each available stage of the venture’s development. Thus, VCs adapt their investment behavior in accordance with the institutional environment faced by the venture in its home country.

In sum, building on the main effect arguments made in support of Hypotheses 1 and 2, we propose that the pattern of investing incrementally in stages is highly sensitive to the risks posed by the venture’s institutional environment, as characterized by the quality of the legal system and risk of political hazards. More specifically, the strategy of escalating investment amounts throughout the life of a venture, typically found in more developed economies with strong institutional systems (Gompers, 1995), tends to disappear when considering ventures operating amidst weaker institutions.

Hypothesis 3a: As the quality of the legal system weakens, the pattern of increasingly larger amounts of investment within a round occurring at later stages of firm development also weakens.

Hypothesis 3b: As the risk of political hazards increase, the pattern of increasingly larger amounts of investment within a round occurring at later stages of firm development weakens.

The hypothesized relationships are summarized in Figure 1.

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Figure 1

Proposed Theoretical Model

Sample

We test the hypotheses on a data set compiled from VC transaction rounds that occurred in Latin America from 1995 through 2003. ³ We obtain our venture capital transaction data from the Thomson Financial VentureXpert database, formerly known as Venture Economics, and include all transaction rounds from the database for which the dollar amount invested was disclosed. The VentureXpert database is used extensively by management and finance scholars and has long been cited as the leading source for venture capital information (Barry et al., 1990; Gompers, 1995; Gompers & Lerner, 1999; Guler & Guillen, 2010b; Junkunc & Eckhardt, 2009; Sahlman, 1990; Sorenson & Stuart, 2008). Our data set contains 433 venture capital transaction rounds from the following 13 Latin American countries: Argentina, Brazil, Chile, Colombia, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Peru, and Venezuela. We also use annual country level data obtained from various archival sources.

We limit our sample to Latin America specifically to reduce unobservable factors, as there are many similarities in the cultural histories of countries in this region, and, in many cases, similarities exist in terms of the relative pace of economic and societal development and business culture (Bulmer-Thomas, 2003; Grosse, 2001). As a result, the region has been the research subject of various other strategy and entrepreneurship studies that emphasize the influence of the institutional environment (Bengoa & Sanchez-Robles, 2003; Bruton et al., 2009; Cuervo-Cazurra & Dau, 2009; Khoury & Peng, 2011). Based on our theoretical emphasis of institutions and entrepreneurship, Latin America is an ideal region to explore (Nicholls-Nixon, Davila Castilla, Sanchez Garcia, & Rivera Pesquera, 2011), as few other VC investment settings exist among developing country regions that offer sufficient within-country variance for the chosen institutional variables over the sample period. Further, in focusing on this region, we improve on prior research that has (1) emphasized a need to expand work on the role of institutions in shaping venture strategies within less understood developing country regions (Bruton et al., 2010) and (2) highlighted the deficiencies in understanding more about Latin America as an empirical setting (Coppedge, 1993; Cuervo-Cazurra & Dau, 2009; Elahee & Vaidya, 2001; Nicholls-Nixon et al., 2011).

Dependent Variable

Since our unit level of analysis is the venture capital transaction round, our dependent variable measures the total amount invested in a venture by VC firms within a particular investment round (Gompers, 1995). It is well established from prior literature that VCs invest in rounds of participation (Fitza et al., 2009; Gompers, 1995; Guler & Guillen, 2010b; Sahlman, 1990). For example, Agropool, a VC-backed venture in Argentina that received $10 million in a disclosed seed stage of development round of investment in the year 2000, represents one transaction-level observation. Our data are reported in thousands of U.S. dollars, and we adjust the data for purchasing power parity (PPP) and inflation. To account for the wide variation in investment size in our data, we use the natural log of the amount invested as our dependent variable, round investment. Gompers’ (1995) seminal VC finance article leverages this dependent variable and advocates this variable as being critical to understanding VC staging strategies. Elsewhere, it has been used to measure venture quality in other works and found to be a relevant independent predictor of subsequent investments occurring and successful exits (Nahata, 2008; Tian, 2011; Wang & Wang, 2011). This variable enriches previous studies that have investigated the likelihood of occurrence for VC investments, entry, or syndication dyads (e.g., Guler & Guillen, 2010a, 2010b; Sorenson & Stuart, 2008). Beyond its highlighted value to understanding deal structure within VC staging (Gompers, 1995), this variable provides valuable information on how such ventures that are, perhaps, more disadvantaged, compared to developed country ventures seeking VC investment, can overcome growth or launch hurdles through securing more sizable investments that are more impactful to venture survival.

Independent Variables

Control Variables

We control for several variables related to country and institutional-related factors, VC and syndication, and the target venture, and also include eight year-dummies to control for unobserved time trends.

Estimation

The data are structured as transaction-level observations. To test our hypotheses, we adopt ordinary least squares (OLS) regression models. Since observations from the same country are possibly correlated, we cluster the standard errors by country in each model, and, in finding evidence of heteroskedasticity in the data, we correct for this issue, similar to previous work (Cumming et al., 2006; Wang & Wang, 2011), by employing White’s (1980) heteroskedasticity-consistent variances and standard errors as recommended by Gujarati (2003). In testing for the presence of multicollinearity, we find a maximum variance inflation factor (VIF) equal to 7.26 and the average VIF at 3.40, which are within the acceptable range of tolerance (Gujarati, 2003). However, robustness checks are conducted to confirm that no concerns arise from highly correlated variables. With respect to our hypothesized main effects, we center the continuous variables by subtracting the mean to further mitigate any collinearity issues (Aiken & West, 1991; Cohen, Cohen, West, & Aiken, 2003).

Robustness Checks

Considering the character of our data, we conduct two significant robustness tests related to outliers, a set of tests related to selection bias, and subgroup analyses. The first test considers the role of outliers in our model. We adopt STATA’s hadimvo command, which flags significant outliers (at a p < .01 level) within the data. This test yields 15 outlying cases out of 433 observations associated with transactions in Argentina, Brazil, Ecuador, Guatemala, Honduras, and Nicaragua. Removing these observations from our models provides results that are highly consistent with our findings for each model, but the R² values are slightly smaller in comparison to testing our theory with the full data set, and thus, we favor Table 2’s results.

Acknowledging the debate around the use of mean-centered data with interaction relationships to lessen multicollinearity concerns (Echambadi & Hess, 2007), we also tested the relationships with uncentered transformations of the quality of legal system and political hazards variables. In unreported models available from the authors, we find qualitatively similar findings. ¹¹ Further, we also investigated any issues related to highly correlated variables within our model, particularly between military presence within political system and the political hazards and quality of legal system variables and between same country investor and the other VC and syndication round variables. Similar to Guler and Guillen (2010a, 2010b), we find that the removal of the higher correlated variables (other than our focal variables) does not impact our findings and our results remain robust.

We also consider the potential issue of selection bias in our models with a two-stage Heckman (1979) selection model. ¹² Here, we consider selection criteria related to both (1) ex ante and (2) ex post information on the target venture. First, we consider ex ante information related to the target firm, such as whether the venture is manufacturing oriented, and separately whether they are driven by intellectual property strategies by whether or not they have patents prior to receiving investment, since both of these could shape investment outcomes (Gompers, 1995). Possessing patents or a manufacturing orientation are each coded as a 1 and 0 otherwise to, respectively, represent the dependent variables of the first stage probit regressions. The patent-ownership dummy variable is regressed onto GDP per capita (per noted adjustments), international capital market financing availability, North American investor, same country investor, VC host country investment experience (natural log values), the number of years since the venture first started receiving VC funding, whether the venture is manufacturing oriented, and the year dummies. The manufacturing orientation dummy is regressed onto these same variables, except the number of domestic patents issued (natural log values) replaces the manufacturing orientation dummy. We do not find any evidence of a meaningful selection bias in our models from either of these ex ante factors. Second, with respect to ex post determinations of venture quality in looking ahead to the exits (per Gujarati, 2003), we capture the non-random exit outcomes of the VC-backed ventures (Cumming et al., 2006; Wang & Wang, 2011). VentureXpert reports exit outcomes of initial public offering (IPO) or acquisition. All unsuccessful exits and non-exits are not reported (i.e., failures cannot be determined). To account for this, we coded successful exits as a 1 if the portfolio venture achieved an IPO, or was acquired or bought out, and a 0 otherwise. Separately, we also create a similar variable that is based solely on IPO-based exists. In accordance with the Heckman model, we use these respective binary variables in separate first stage probit regression models and regress each of these variables on the following independent variables: GDP per capita (per noted adjustments), international capital market financing availability, North American investor, same country investor, VC host country investment experience (natural log values), the number of years since the venture first started receiving VC funding, the number of domestic patents issued (natural log values), whether the venture is manufacturing oriented, and the year dummies. We find no meaningful evidence of a selection bias in accounting for these ex post outcomes that capture firm quality.

Finally, given our emphasis on investment size within our study, we conduct subgroup analyses to understand how sensitive our relationships are to industry conditions beyond our inclusion of three industry dummy variables in our regressions. We partitioned the sample to those firms that are not affiliated with computer related industries, as classified by VentureXpert, and eliminate the computer related industry dummy (losing 125 transactions, 29% of our sample) from our regressions, since ventures in these industries may be operating differently as suggested by the significance of our computer related industry dummy. In these unreported tests, we find qualitatively similar results to those reported in Table 2 of the full sample, however the significance of our findings are markedly improved when removing the computer industry data.

Navigating Legal System Quality

Contrary to what was hypothesized, we uncover a valuable finding for Hypothesis 1 in that—after controlling for political uncertainty—lower quality legal systems are associated with larger investments. To explain this outcome, we suggest that when VCs invest in developing country ventures residing in low quality legal systems, the investment transactions that take place are larger in order to account for additional contract-based transaction costs that accompany weak legal settings (Lerner & Schoar, 2005; Williamson, 1991). Contracts provide a valuable means to gain access to different forms of organizing around transactions to accomplish firm-level strategic goals (Kaplan & Stromberg, 2003; Young et al., 2008). According to North (1990), the greater the threat to the formal system through the informal means of subjugating contracts, the greater the costs introduced to the firm in having to account for this unpredictable factor in its search for capital. For example, Lerner and Schoar (2005) report a case of investors changing from their favored investment strategy of complex convertible preferred stock to a strategy of holding majority equity through common stock. This change occurred after the investors experienced a costly litigation with a target venture in Peru (Lerner & Schoar, 2005). Higher quality legal systems have a more judicious, credible, and transparent process for resolving disputes (La Porta et al., 2004). Less investment is required to mitigate legal inefficiencies in these environments. On the contrary, in weaker legal environments, higher transaction costs are induced, which may require VCs to make larger investments in order to overcome or mitigate the inadequacy of the legal system.

Regarding the moderating relationship of the legal system quality proposed in Hypothesis 3a, we uncover at least two critical findings. First, when legal systems are weak, the largest investment rounds occur for later stage ventures, but with a relatively small difference between middle and later stages, and early stage ventures find drastically smaller transaction sizes. Second, the relationship between investment amount and early stage ventures is most sensitive to legal system quality, in that as a legal system improves in quality, the realizable investment that can be received by such ventures is increasingly larger. This outcome is most pronounced when a legal system is comparatively stronger than the average developing country setting encountered by VCs. Thus, traditional VC staging (Gompers, 1995; Sahlman, 1990) breaks down in lower quality legal environments such that almost negligible transactions occur in the earliest stages and the distinction between middle and later stages practically disappears. As legal systems improve, VCs may put in even larger amounts for the few outstanding early stage investments. Also, the expected distinction between middle and later stage rounds begin to take shape as a traditional VC staging strategy emerges for the more developed ventures.

Navigating Political Hazard Risks

In the case of political hazards, the evidence shows a negative relationship between the size of an investment transaction and the level of political hazards in the target venture’s home country, as predicted. For the moderating role of this variable, we find that with increasing risks of political hazards, the differences in the investment amount received in a round between middle and later stage ventures tends to disappear. However, as uncertainty in political institutions diminishes, there is an increasingly disproportionate investment amount funneling to later, rather than middle, stage ventures.

Thus, if we assume that the conditions of less risk for political hazards occurring are more akin to that found in advanced economies, then our findings are consistent with that of Gompers’ (1995) seminal study. As the risk of political hazards escalates, investment size drops for later stage as compared to middle stage ventures. Per Gompers (1995), this result may be explained, in part, due to the higher rate of cash utilization that occurs for later stage ventures. This use of cash creates a situation of escalated risk for VCs that have larger investments in ventures operating in environments susceptible to a catastrophic political event. Thus, political hazards may take a more significant toll on later stage ventures and their corresponding investors. With the threat of political hazards occurring, it is conceivable that later stage ventures may appear as more likely targets for hazards relative to middle-stage ventures. This case may occur, as they have more (accumulated) resources, assets, or business to expropriate.

Contributions

In proposing a theory of VC investment strategies in developing countries, this work offers several contributions. Our first contribution, in extending the work of Gompers (1995), relates to how the quality of the legal system and political hazards differentially affect VC investment size. Also, to our knowledge, this study is the first to examine VC investment size at the transaction level in developing countries. We infer that larger investments per round are required when the transaction costs associated with institutional deficiencies are high, while higher uncertainty about future policy changes induces VCs to reduce the average size of the investment. This relationship is an important contribution to the literature studying the linkages between VC strategy and specific institutional factors (Ahlstrom & Bruton, 2006; Bruton et al., 2005, 2009; Guler & Guillen, 2010b; Zacharakis et al., 2007).

Further, while Guler and Guillen (2010b) find that fewer VC transactions occur in country-level legal environments that offer less protection for investor’s rights or pose more challenges to investment exits, our work shows that in lower quality legal systems, the size of each VC transaction that occurs tends to be larger. This finding, complemented by the transaction cost argument, may provide a supportive explanation for Guler and Guillen’s (2010b) result. Our finding with regard to legal quality may also support the notion that private equity investors that have investments in countries with poor legal systems must commit greater amounts of investment to account for more sophisticated (and costly) contractual contingencies and investment security. This is consistent with the notion that VCs, in seeking majority ownership and control to avoid contractual issues (i.e., by holding more common stock per Lerner & Schoar, 2005), will initiate larger investment sizes.

Second, with the exception of a select few studies (Ahlstrom & Bruton, 2006; Bruton et al., 2009; Cumming, Fleming, et al., 2010; Guler & Guillen, 2010b; Vaaler, 2011; Zacharakis et al., 2007), research on VC investment strategies in developing countries is limited. Complementing the richness offered by qualitative studies within the region (Bruton et al., 2009), descriptive single country studies (Charvel & de Yeregui, 2002; Chocce & Ubeda, 2006), and institutional research in South and Central America (Cuervo-Cazurra & Dau, 2009; Fatehi-Sedeh & Safizadeh, 1988; Khoury & Peng, 2011), this work is novel in systematically investigating a sizable data set of VC transactions in a dynamic, yet under-researched, developing region: Latin America (Elahee & Vaidya, 2001; Nicholls-Nixon et al., 2011).

Third, the use of Latin America as a research setting is also an interesting contribution and can motivate new research in the region. The checkered history of policy reform and institutional change within Latin America (Bulmer-Thomas, 2003; Cross, 1998; Cuervo-Cazurra & Dau, 2009; Grosse, 2001) serves as an appropriate setting to study how the conditions of legal systems and political hazards affect the size of VC investment transactions. The shared cultural factors and norms among these nations are particularly important because unobserved factors that are common to all Latin American countries will be less likely to introduce an omitted variable bias. However, despite these similarities, spatial proximities, and common languages between Latin American nations, a wide range of varying institutional quality exists (Nicholls-Nixon et al., 2011).

Finally, our study indicates that a heightened uncertainty in policy change shapes the investment strategies of VCs to produce a relatively unconventional VC market. In attempting to explain this market, we propose that VCs may be investing in a smaller number of deals with greater potential and avoiding earlier stage investment strategies (e.g., “cherry-picking” target ventures after waiting longer for the cherries to ripen). In other words, we infer that a higher likelihood of political hazards or lower legal system quality present meaningful risks that interact with the stage of venture development to change the investment strategies of VCs.

Implications for Entrepreneurs and Entrepreneurship Policy

This study has several implications for VC investors, entrepreneurs, and policymakers. Figure 2 shows the average political hazards and quality of legal system by country for the transactions in our data set. Although these data vary by year, the averages help to make the point that countries like Argentina, Brazil, and Chile have developed relatively higher quality legal systems and established lower political hazards in the time period studied. On the other hand, countries such as Colombia, Ecuador, Guatemala, and Mexico have not achieved these levels. Based on these data, it is not surprising that most of the early and middle stage investments in the data come from Argentina and Brazil. Likewise, though Mexico has a relatively large number of VC investments in the data set, they are much more concentrated on ventures in the later stages of development. This picture helps to reveal the implications for entrepreneurs and policy makers.

VCs and entrepreneurs can act more intelligently by adjusting their expectations and anticipating the nature of the marketplace. For example, early stage firms operating in politically uncertain environments may consider relocating to more stable environments if they require VC funding to succeed. If relocation is not feasible, early stage firms should exert more effort toward meeting some development milestones before focusing on getting VC funds. Relying more heavily on financing from family, the government, business groups, and other strategic partnerships may be wiser during earlier stages of development (Ahlstrom & Bruton, 2006).

VC investment may provide a qualitatively unique inspiration for entrepreneurship within developing countries (von Burg & Kenney, 2000), which can occur through more frequent (Guler & Guillen, 2010b) and sizable investments within such regions (Vaaler, 2011). With this assertion, policymakers may be in a position to influence institutional priorities or changes that favor greater VC interest. In order to foster more robust and functional VC markets, policymakers should seek to nurture the broader quality of political and legal institutions—with specific priorities placed on strengthening the national legal system and averting the risk of political hazards—before constructing more targeted policies to incentivize VC interest.

With a weak institutional environment, specific intervention—such as governments attempting to occupy the role of a private equity investor via state-ownership—may prove to be unsuccessful in furthering economic progress. Using public funds to assist new ventures may not pan out if the basic enforcement mechanisms of contracts and intellectual property laws are deficient (Khoury & Peng, 2011), or the risks in the venture’s home political institutions can lead to unpredictable business environments. Policy changes that favor the repair of institutions to increase a firm’s access to capital may lead to more efficient investment transactions (Michael & Pearce, 2009). Without improvements in these institutional conditions, governments face great challenges and a potentially wasteful effort in seeding entrepreneurship through attracting VC interest and may be indirectly supporting the rise of more informal forms of entrepreneurship that circumvent the creation of tax-based revenues for the government (Webb et al., 2009).

Limitations and Future Research

This work has limitations that can be addressed in future studies. First, any proposal in this work regarding a market failure of venture capital is by inference only, as our data do not permit us to observe potential transactions that were not completed—our theory makes predictions related only to completed transactions. Future research could uncover how failures actually occur and the conditions that lead to overcoming failure.

Another important limitation of this study is its generalizability, as our data are confined to Latin America. VC market actions—such as staging and how investment strategies are influenced by the dimensions we have considered—may operate differently in other developing country regions (Bruton et al., 2009; Cumming, Schmidt, et al., 2010). However, as previously mentioned, there are also multiple benefits in focusing on Latin America (Elahee & Vaidya, 2001; Nicholls-Nixon et al., 2011).

It would also be valuable to examine how the VC’s location with respect to the target venture, or even geographic distance (Sorenson & Stuart, 2001), impacts the investment strategy in a developing country setting. It is interesting to note that many ventures in our sample received funds from VCs located in a different country. Our analysis could be extended by further examination of the directional flow of investment, such as developed-to-developing country versus developing-to-developing country investments. Separately, building on previous and more recent work that has emphasized the effect of a VC’s accumulated experience within specific markets and/or countries (Guler & Guillen, 2010b; Sorenson & Stuart, 2008) would offer valuable insights to how VCs learn and adapt their strategies within developing countries.

A limitation in our data analysis is that we are not able to control much for unobserved quality differences across ventures. Despite our comparatively large sample of transactions within this region, we do not have extensive information on each target venture in the data set—a common problem when dealing with private ventures such as VC-backed ventures. For instance, we lack data on the affiliation of a target venture (or VC) with business groups. Business groups may actually lower transaction costs further by internalizing many functions that would typically take place in the open market within developed countries (Hoskisson, Johnson, Tihanyi, & White, 2005; Khanna & Rivkin, 2001; Young et al., 2008). VCs affiliated with these intermediaries might be able to deal with institutional deficiencies more effectively. To overcome this limitation, future studies could incorporate more field-based research methods to explore VCs and their relationships with target ventures and their affiliates (Bruton et al., 2009).