IPO

Venture capital financing, strategic alliances,
and the initial public offerings of Internet startups
Sea Jin Chang*
School of Business Administration, Korea University, Sungbukku Anamdong, Seoul 136-701, South Korea
Received 1 July 2002; received in revised form 1 February 2003; accepted 1 March 2003
Abstract
This study examines how Internet startups’ venture capital financing and strategic alliances affect
these startups’ ability to acquire the resources necessary for growth. Using the initial public offering
(IPO) event as an early-stage measure for Internet startups’ performance and controlling for the IPO
market environment, this study found that three factors positively influenced a startup’s time to IPO:
the better the reputations of participating venture capital firms and strategic alliance partners were, the
more money a startup raised, and the larger was the size of a startup’s network of strategic alliances.
D2003 Elsevier Inc. All rights reserved.
Keywords: Venture capital financing; Internet startups; IPO
1. Executive summary
Internet technology and the surge of Internet-related business startups have fundamentally
impacted the world economy. The Internet allows firms to offer products and services 24
hours a day throughout the world. According to the Securities Data Corporation (SDC)
database, $108.2 billion was invested in Internet-related startups during 1995–2000. Since
the plunge of the NASDAQ in April 2000, however, the markets’ perception of Internet
startups soured. Venture capital funds dried up and many firms that had successful initial
public offerings (IPOs) went bankrupt.
0883-9026/$ – see front matter D2003 Elsevier Inc. All rights reserved.
doi:10.1016/j.jbusvent.2003.03.002
* Tel.: [phone]; fax: [phone].
E-mail address: [email protected] (S.J. Chang).
Journal of Business Venturing 19 (2004) 721–741

In the aftermath of the Internet bubble, it is easy to discredit all Internet startups. To be
sure, capital markets funded many startups that lacked sustainable business models. Yet
some startups have done well since their IPOs, and many startups never had IPOs. There
have been few systematic studies on what factors contributed to the relative success of
Internet startups.
This study uses the IPO event to measure several possible success factors. It examines the
effects of venture capital financing and strategic alliances networks on startups’ performance.
Both venture capital financing and strategic alliances affect a startup’s performance in two
important ways. First, they provide a startup with much needed resources such as cash and
complementary resources. Second, they provide legitimacy to other resource holders, thus
indicating that it is worth investing in or providing resources to a startup. On average, a
startup that has such financing and alliances will go to IPO more quickly than will a startup
that lacks them.
With a sample of Internet startups founded between January 1994 and June 2000 in three
broadly defined Internet business areas—e-commerce companies that sell products, e-
commerce companies that sell services, and Internet portals—and controlling for the IPO
market environment, this study found strong evidence that venture capital financing and
strategic alliances significantly affected the IPO rate. We found that early entrants’ rate of
going public was more than 12 times higher than the rate of late entrants, which clearly
demonstrates that first movers have an advantage in the Internet business. We also found that
the reputation of participating venture capital firms in a startup had a strong positive impact
on the IPO rate. For instance, startups that were funded by venture capital firms with an
average IPO success rate of 30% had an IPO rate that was 2.12 times higher than that of
startups that were funded by venture capital firms with an average IPO success rate of 10%.
We also found that the reputation of alliance partners and the number of strategic alliances
had positive impacts on the IPO rate. One additional strategic alliance increases the IPO rate
by 1.17 times.
This study’s findings have several practical implications. First, entrepreneurs should get
funding from respectable venture capital firms so that they can enjoy the spillover effects of
these firms’ reputations. Second, entrepreneurs should develop strategic alliances with
prominent firms to access social, technical, and commercial resources that normally require
years to accumulate. These alliances also reduce the liability of newness and improve
performance.
2. Introduction
Internet technology and the surge of Internet-related business startups have fundamentally
impacted the world economy. The Internet allows firms to offer products and services 24 hours
a day throughout the world (Evans and Wurster, 1999; Hagel and Singer, 1999). According to
the SDC database, $108.2 billion was invested in Internet-related startups during 1995–2000.
Some Internet startups, such as Yahoo, Amazon, and e-Bay, were very successful, and
investors valued them highly: in June 2000, 2 months after the NASDAQ plunged, the market
S.J. Chang / Journal of Business Venturing 19 (2004) 721–741722

values of Yahoo, Amazon, and e-Bay were $77 billion, $16 billion, and $16 billion,
respectively. These companies’ founders became extremely rich. Entrepreneurs rushed to
start companies, and there was an abundance of venture capital funds to support them.
Since the NASDAQ began declining in April 2000, however, the markets’ perception of
Internet startups soured. Investors began to realize that many startups were overvalued.
Venture capital funds dried up, and many startups that had enjoyed successful IPOs began to
face liquidity crunches. Many startups, including Webvan and Pets.com, went bankrupt. This
boom and bust cycle resembles what happened in the disk drive industry in the 1970s and
1980s (Sahlman and Stevenson, 1985).
Given the rampant speculation in these startups, it is easy to discredit the viability of the
entire Internet business sector. Nonetheless, several Internet firms, especially early entrants
that had IPOs during the early period of Internet commerce, are performing well even at the
end of 2002. Amazon had its first operating profit in the fourth quarter of 2001. e-Bay and
Yahoo have been profitable, even though their market valuations are far below what they
were in early 2000. Given the enormous amount of money that was invested in these startups,
as well as the high mortality rate in this sector, it is important for both academics and
practitioners to understand what factors have affected Internet startups’ performance.
There have, however, been few systematic studies on what these factors might be.
Zacharakis et al. (in press) explored the development of the Internet sector from an
environmental ecosystem perspective, but did not examine individual startups’ performance.
To our knowledge, this study is the first attempt to use a large-scale database to examine
the performance of Internet startups, as reflected by these startups having an IPO. In doing
so, it controls for the IPO market environment, which has a significant impact on the IPO
event.
This study adopts the IPO as an early-stage measure for performance of Internet startups.
The IPO has been used as a measure for startup performance since conventional measures for
performance, such as profit or sales, are not available for very young firms. (Deeds et al.,
1997a; Stuart et al., 1999). Since Internet startups require huge up-front investments in
technology and branding, there may be a long lag before conventional financial variables
accurately measure their performance. There are also several reasons why the IPO event
reflects a startup’s performance early in its life. The IPO transforms a privately held venture
into a publicly owned company. Venture capital firms typically wish to take startups public as
soon as possible to realize their profits and invest the proceeds in other startups. For
entrepreneurs, the IPO is an opportunity to exchange stock for cash and reap personal gains.
For a startup, the IPO is an important means for raising capital to ramp up operations. Thus, a
firm’s IPO connotes a performance milestone and indicates the firm is ready for further
growth.
Using the IPO event, this study examines two ways that startups’ venture capital financing
and strategic alliances influence their performance. First, they provide resources such as cash
and complementary assets to Internet startups. Second, they signal to other resource holders
that a startup is worth investing in or providing resources to. Such endorsement provides
legitimacy to a startup, which in turn enables the startup to access additional resources. A
startup that secures funding from well-regarded venture capital firms and is engaged in
S.J. Chang / Journal of Business Venturing 19 (2004) 721–741 723

numerous strategic alliances with prominent customers and suppliers should attract more
resources and thus be able to go public earlier than startups that lack these resources. The
empirical findings from this study confirm these hypotheses and have important implications
for both academicians and practitioners.
3. Theory and hypotheses
3.1. Venture capital financing of Internet startups
Creating a new business organization involves considerable uncertainty. Researchers have
long noted that startups have higher failure rates than established firms do because they have
not yet established effective work roles, relationships with outside suppliers and buyers, and
bases of influence, endorsement, and legitimacy (Stinchcombe, 1965; Hannan and Freeman,
1984). Furthermore, startups tend to be small and do not have enough resources to withstand
sustained losses. Among organization and entrepreneurship scholars, this vulnerability is
referred to as the liability of newness (Stinchcombe, 1965; Baum, 1996).
Such uncertainty makes investors, potential employees, suppliers, and buyers hesitant to
provide resources to startups. Entrepreneurs try to reduce this uncertainty by gaining
legitimacy from well-regarded individuals and organizations. Zimmerman and Zeitz (2002)
argued that legitimacy, which connotes a social judgment of acceptance, appropriateness, and
desirability, is a resource by itself that enables startups to access other resources needed for
survival and growth and helps startups overcome the liability of newness.
Although startups can gain legitimacy by conforming passively to the demands and
expectations of the existing social structure (DiMaggio and Powell, 1983; Suchman, 1995),
they can also do so by acting strategically (Zimmerman and Zeitz, 2002). For instance,
startups can choose more favorable environments (Porter, 1980), manipulate their environ-
ment by teaming with other successful organizations (Oliver, 1991), and create environments
with new norms, values, and models (Aldrich and Fiol, 1994). Several studies have found
great variance in startups’ ability to gain access to resources and stable relationships, which in
turn leads to differences in these startups’ early performances (Baum, 1996; Fichman and
Levinthal, 1991).
One important way for startups to act strategically to gain legitimacy is to get endorsed by
respectable organizations such as venture capital firms. In startups’ early stages, entrepreneurs
rely heavily on venture capital firms for funds, contacts, and managerial advice. Venture
capital firms raise funds from investors and invest this money in a startup in exchange for
equity. Furthermore, other resource holders can view venture capital firms’ investment as a
strong signal of a startup’s quality and future prospects (Spence, 1974; Freeman, 1999;
Podolny, 2001; Stuart et al., 1999). Venture capital firms are evaluated on their ability to
generate high returns for their investors. Since they take a fraction of the proceeds, they are
motivated to generate high performance. Moreover, venture capital firms that have a history
of delivering extraordinary returns find it easier to raise funds from investors. Thus, venture
capital firms are unlikely to invest in startups that have poor future prospects. In addition,
S.J. Chang / Journal of Business Venturing 19 (2004) 721–741724

since venture capital firms often help startups by providing managerial advice, recruiting
senior managers, and arranging alliances with potential customers and suppliers, they increase
the chance that these startups become successful. Furthermore, prohibitions on entrepreneurs
and venture capital firms from selling all their equity immediately after the IPO provide these
parties an incentive to ensure that the firm will remain operationally viable for at least the
short term. Thus, endorsement by respectable venture capital firms not only signals the
quality of a startup but also serves as a vote of confidence in the startup. By doing so, the
endorsing organization’s legitimacy carries over to the recipient, providing it credibility,
contact, and support for the entrepreneurs, building a startup’s image, and facilitating the
startup’s access to resources.
1
Therefore, investors and other potential resource providers pay attention to the identities
of venture capital firms to evaluate whether they should support a startup. Deeds et al.
(1997b) showed that amount of capital raised by a biotechnology firm’s IPO is positively
related to both the firm’s and the industry’s legitimacy at the time of the IPO. Podolny and
Stuart (1995) demonstrated that technological inventions were more likely to be adopted
when they had been previously adopted by high-status organizations. Stuart et al. (1999)
also found that the reputation of investment banks helped startups in the biotechnology
industry go to IPO faster and earn greater IPO valuations than did firms that lacked such
connections.
The signaling and legitimizing role of venture capital firms may be especially important
in the Internet industry, which is in its formative years and is subject to great uncertainty
(Amit et al., 1998). As has happened with many new industries, great expectations
accompanied the beginning of Internet commerce. On-line retailers such as Amazon could
enjoy low costs yet offer a wide selection of products. Further, the Internet also made new
types of businesses possible. Priceline.com initiated a reverse auction business. e-Bay
developed an on-line auction business. Several pundits projected that nimble Internet
startups would soon replace old off-line incumbents (Evans and Wurster, 1999). Yet,
startups in new industries are especially vulnerable to the liability of newness (Aldrich
and Fiol, 1994), even when the industry in question holds considerable promise. Potential
investors and other resource holders thus had good reason to pay close attention to the
actions of venture capital firms. In this setting, we hypothesize that when venture capital
firms with good reputations invest in an Internet startup, the likelihood that a startup will
have an IPO will be higher.
Hypothesis 1: The higher the reputation of venture capital firms that invest in an Internet
startup is, the faster the startup will have an IPO.
Venture capital firms also provide financial resources to startups that significantly affect
startups’ survival, growth, and strategic options. Boeker (1989) and Churchill and Lewis
(1983) noted that lack of financial resources was the most limiting factor for the growth of
1
Zimmerman and Zeitz (2002) labeled such legitimacy as normative legitimacy.
S.J. Chang / Journal of Business Venturing 19 (2004) 721–741 725