Venture Capital (VC)

Venture Capital is equity investment focused on financial returns. Research shows that companies receiving venture capital appear to grow faster, adopt more professional structures earlier, and are more likely to be acquired or go public (IPO). This is despite the fact that investment from venture capital firms comprises less than one percent of startup funding.

Introduction

Investment from venture capital firms comprises less than one percent of startup funding (Hellmann, Puri, and Da Rin 2011), yet venture-backed companies have a disproportionate impact on the economy:  in job-creation (5.3 to 7.3 percent) (Puri and Zarutskie 2008)IPOs (35 percent), (Hellmann, Puri, and Da Rin 2011) and in innovation (Kortum and Lerner 2000).

VC investors are heterogeneous in performance, driven by differences in non-financial benefits and expertise delivered to portfolio companies (e.g., advice, monitoring, connections), and by differences in selection effects (i.e., established VC firms can invest in better opportunities and more easily) (Sørensen 2007) (Kaplan and Schoar 2005).

Researchers consistently find that ventures receiving venture capital appear to grow faster, adopt more professional structures earlier, and to be more likely to be acquired or go public (IPO(Hellmann et al. 2011).

Despite these benefits, venture-backed companies exit across an broad distribution of outcomes:  about 75 percent see a zero value exit, most of the rest see positive but low-value exits, and a very small percentage see outsize IPOs or acquisitions (Hall and Woodward 2010). These few, exceptional cases drive VCs' returns to limited partners, and provide the disproportionate impact that VC backed companies have on the economy.

Discussion

Non-financial effects of VC on companies

Compared to companies without VC investment, venture-backed companies have greater sales, faster sales growth (Tyebjee and Bruno 1984), faster employee growth (Davila, Foster, and Gupta 2003), faster professionalization (Hellmann and Puri 2002), faster times to market (Hellmann and Puri 2000), better selection of technology strategies (Waguespack and Fleming 2009), an increased likelihood of an IPO (Shane and Stuart 2002), reduced underpricing of IPOs (Barry, Muscarella, Peavy, and Vetsuypens 1990) (Megginson and Weiss 1991), and greater post-IPO survival (Baker and Gompers 2003)

Research also indicates that some venture capitalists are better able to help ventures develop because of a combination of greater development abilities, greater networks, and higher reputation; in particular, higher-quality VCs have been associated with greater growth in valuation between rounds (Fitza, Matusik, and Mosakowski 2009), a greater likelihood of a successful exit (Sørensen 2007) (Beckman, Burton, and O'Reilly 2007), improved access to other high-quality investors (Hallen 2008), and higher valuations at time of IPO (Stuart, Hoang, and Hybels 1999) (Lee, Pollock, and Jin 2011).

Some of these benefits, though, are dependent on various contingencies, and higher-quality VCs appear to have a greater impact if they invest earlier, if they are geographically closer to the venture (Lee et al. 2011), if there is greater uncertainty about a venture's quality (Stuart et al. 1999), and when venture capital investments have been harder to obtain (Gulati and Higgins 2003). At the same time, venture capitalists may also pressure ventures to IPO earlier than might otherwise be optimal, and this behavior is more prevalent amongst venture capital firms that are newer and trying to establish their own reputation (Gompers 1995) (Lee and Wahal 2004).

On the whole, though, research suggests that venture capital is generally beneficial from the perspective of the young firm, that these benefits generally extend beyond the simple availability of capital, and that some venture capital firms offer greater benefits than others.

Selection from the VC perspective

A second stream of active research focuses on the process by which particular investors come to invest in particular ventures. VCs evaluate ventures according to the business concept, entrepreneurs, referral source, and match with their own investment preferences (Hisrich and Jankowicz 1990) (Hall and Hofer 1993) (MacMillan, Siegel, and Narasimha 1985) (Shepherd, Ettenson, and Crouch 2000) (Tyebjee and Bruno 1984). VCs also have a strong bias towards focusing on entrepreneurs within their social network, as those networks provide a greater degree of rich and reliable information (Hall and Hofer 1993) (Shane and Cable 2002). Additionally, while business plans have historically been a hallmark of entrepreneurship and training entrepreneurs, research indicates that business plans play a minimal role in the decisions of venture capitalists (Kirsch, Goldfarb, and Gera 2009). Likewise, while venture capitalists often report a strong emphasis on entrepreneur passion, experimental studies indicate that it is actually preparedness that may be particularly persuasive to investors rather than passion (Chen, Yao, and Kotha 2009).

Lastly, Eckhardt, Shane, and Delmar (2006) find that VCs can benefit by proactively searching for suitable investment candidates, because entrepreneurs seek financing using criteria different from the criteria VCs use to make investments.

Selection from the entrepreneur perspective

On the other side of the investment process, recent research increasingly looks at the entrepreneur's perspective, examining the specific means by which entrepreneurs may improve fundraising success. In terms of the speed to raising, Shane and Stuart (2002) find that entrepreneurs with more human capital and social capital are likely to raise venture capital sooner. Similarly, Hsu (2007) finds that these same factors are also associated with entrepreneurs receiving higher valuations.

In terms of from whom entrepreneurs raise, Hallen (2008) finds that entrepreneurs may garner high-status venture capital investors either by relying on the direct networks and prior successes of their founders or by relying on the early accomplishments of the venture. Focusing on the specific fundraising behaviors of entrepreneurs, Hallen (2008) and Sørensen (2007) find that, absent a strong prior direct relationship with an investor, entrepreneurs may improve the efficiency of their fundraising (i.e., their ability to raise, fundraising speed, and quality of the outcome) by engaging in four complementary catalyzing strategies:  casual dating, timing around proofpoints, crafting alternatives, and scrutinizing interest. At a higher level, while studies have found evidence of quality-based matching between ventures and venture capitalists (Hallen and Eisenhardt 2012), research also indicates that matching is constrained by social networks and influenced by the fundraising strategies of entrepreneurs (Wasserman 2003).

The VC-Entrepreneur Relationship

Despite such alignment, venture capitalists may also replace entrepreneurs currently in senior positions (CEO, etc.), bringing in new executives if the founding entrepreneurs are perceived as being insufficiently prepared to lead the venture to the next level – though interestingly, Wasserman (2003) and Graebner and Eisenhardt (2004) indicate that venture capitalists may be willing to forgo some returns to help a venture better achieve key goals (Wasserman 2006)

Despite these agency theory concerns, or perhaps because these mechanisms create a close alignment of interests, recent research has also begun to suggest a stewardship or syndicate model of entrepreneur/venture capitalist relations, whereby entrepreneurs may act in the best interest of the venture and not themselves  (Kaplan and Stromberg 2004) (Bergemann and Hege 1998) (Sapienza and Gupta 1994) (Gompers 1995)

A third key area of venture capital research is the post-investment relationship between entrepreneurs and venture capital investors. Here researchers have found that investments are structured in a manner that substantially addresses many agency theory concerns, including equity investments that align incentives (versus debt), the use of staging to gain control over entrepreneurs, and the use of liquidation rights, board control rights, and anti-dilution rights to address situations where incentives might otherwise depart. This research indicates that founders are most likely to be replaced following a successful investment round (as this indicates that the venture has sufficient potential to justify the change), while Pollock, Fund, and Baker (2009) find that founders with more prior startup experience and/or an MBA were more likely to retain the CEO position. For more on entrepreneur-investor post-investment interactions, see Garg (2013) for a rich treatment of how venture boards may differ from their public-company counterparts.

Heterogeneity in Venture Capital firms

A fourth key area of venture capital research examines the strategy of venture investing. Here researchers have identified a number of different factors that may help investors better identify and attract high-quality ventures. From the human capital perspective, Zarutskie (2010) finds that venture capital investment teams with more experience as venture capitalists, more startup experience, more industry management or consulting experience, and (to a lesser extent) engineering backgrounds have a higher fraction of successful exits. From the status/reputation perspective, Hsu (2004) finds that when entrepreneurs receive multiple offers, they are more likely to accept the offer from the highest-status investors even though these offers are generally at a 10 to 14 percent lower valuation, thus suggesting that there may be strong Matthew effects ("the rich get richer and the poor get poorer" phenomenon) in venture capital that help high-status VCs better acquire top-deals at good prices. Similarly, research indicates that such status may also make it easier for venture capitalists to raise capital from limited partners, while moderate-status VC firms may have to rely on intermediate investment brokers, and lower-status firms may have to struggle absent the advantages of either status or investment brokers (Rider 2009)

Venture capital firms may also gain an advantage through their social networks with other investors. Hochberg, Ljungqvist, and Lu (2007) found that venture capital firms that hold more central positions in the overall network of venture investment syndications have higher performance. Sorenson and Stuart (2001) found that prior syndication networks are a key means by which venture capitalists may gain access to geographically remote investment opportunities. Podolny (2001) found evidence that venture capital firms may foster different networks based on whether they focus on early or late-stage rounds. 

Finally, in terms of internal structure, Wasserman (2008) builds off the classic strategy-structure-performance paradigm to show that venture capital firms with an early-stage focus do best if they have an upside-down structure (relatively few associates per partner), whereas later-stage focused firms do best if they have a pyramidal structure (more associates per partner).

Taken as a whole, this research indicates that a variety of factors are associated with some venture capital firms performing better, though it is striking to note that many of these factors may be less available to new venture capital firms.

Future Research

Remaining Questions

While researchers have established several core facts around venture capital, many intriguing areas of inquiry remain. Despite some work, the drivers of success among venture capital firms are poorly understood. Ewens and Rhodes-Kropf (2015) pose some pertinent questions:

  • Does the locus of success lie at the level of the firm or the individual partners? 
  • How is the process of decision making and structuring of real options related to the ultimate performance of firms? 
  • What are the means by which new and less-established venture capital firms may achieve superior investment returns?  

Many opportunities remain regarding study of the strategy of venture capitalists:

  • How do venture capitalists compete and interact with one another?
  • What levers besides networks, status, and organizational structure can lead to greater firm-level performance? 
  • What contributes to the high degree of persistence across venture capital firms? 

Relatedly, many questions remain about how entrepreneurs do and should search for venture capital investments. While we know that entrepreneurs tend to seek out higher-quality VCs and that there is a rough degree of matching between high-quality entrepreneurs and high-quality VCs, it remains unclear what factors influence which VCs see which deals or how widely "shopped" are deals across investors. Likewise, while recent work has explored how entrepreneurs can best engage the VCs to whom they are introduced, how can entrepreneurs improve their ability to gain these introductions, or expand the pool of potential investors (Ewens and Rhodes-Kropf 2015)?

Another promising future research area relates to the ways in which venture capital is adapting to new opportunities (e.g., clean technology) and new financing approaches (angels, crowdfunding, etc.), and the ways in which this will impact performance. 

A final area of research that holds promise is understanding how the institutional environment relates to venture capital success: 

  • How does the U.S. model of venture capital translate to other geographies? 
  • Why has the U.S. model of venture capital had a hard time diffusing in other countries, especially in emerging economies? 
  • What needs to be adapted for it to play the same transformational role in other geographies? 

Barriers to research
Data hurdles stand as a major impediment to verifiable, reproducible, and timely research – most data sets are (understandably) proprietary, or else purchasable but expensive (limiting the number of scholars who can work in the field).

Data Sources

  • VentureXpert: Rolled into VentureOne. Relatively complete coverage of venture capital investments in the United States. Data is gathered from surveys by the National Venture Capital Association. Provides relatively complete coverage of who invested in which ventures and the net amount invested. Coverage of venture valuations is less complete, and generally fails to capture most angel investments. Requires paid access, though this is covered by most university libraries. VentureXpert has traditionally been the primary database used by most studies of VC in the strategy and management literatures. Also available as part of Thomson Reuters’ SDC Platinum suite.
  • Thomson VentureOne/Venture Economics – Offers more complete coverage of venture valuations. The data is gathered through entrepreneur surveys, and generally provides more complete coverage of venture valuations. Historically, VentureOne also provided more complete coverage of venture development at the time of funding. The primary drawback to VentureOne has been its higher pricing, and the fact that it is generally not provided by most libraries. Accordingly, while it has been used by some key studies of venture capital, its cost have prohibited more widespread adoption.
  • Dow Jones Venture Source: (cost)
  • Longitudinal Business Database (LBD): U.S. Census Bureau Data (cost). The LBD is a derivative of the U.S. Business Register (that is for all U.S. employer firms). Prior studies including Puri and Zarutskie (2011) have merged this with VentureXpert and used it to analyze venture capital backed firms; however, it is limited by the fact that users can only use birth and death dates of firms, employment, and payroll as the primary economic variables of interest. Cost may be a factor as one needs access to the Research Data Centers (RDCs) of the U.S. Census Bureau to work on these datasets. Further, processing delays for proposals, special sworn status (required for data access), and disclosure can also extend timeline of projects.
  • U.S. Patent and Trademark Office data: This database primarily contains innovation data on patents, citations, inventors, etc. for firms. This is available freely from the USPTO, and in a cleaner format from the Harvard University dataverse. Data on innovation is used to study innovativeness of startups and can be used in venture research.
  • Kauffman Firm Survey (KFS): (public and private versions, no-cost)
  • Compustat/CRSP: (cost, for post-IPO performance) In the context of venture research, Compustat/CRSP data is most directly useful for studying venture exits, and in particular IPO exits. Compustat contains mostly accounting data on all publicly traded firms in the U.S., as well as foreign firms that trade in U.S. markets. CRSP contains stock price, volume, shares outstanding, and related information. These databases can be accessed from Wharton Research Database Service (WRDS) or through subscription. Most university libraries or business schools subscribe to these.
  • Many private hand-collected datasets
  • Capital IQ: A database offered by S&P that also contains PE and VC transactions. 
  • CrunchBase: A newer, open contribution database overseen by the TechCrunch news organization (now part of AOL). Provides excellent coverage of venture financings in the Internet sector, and is relatively unique in also covering the investments of well-regarded angels (i.e., super angels) who may not participate in the other databases. The database is also increasingly used by the venture capital industry – i.e., one well-regarded VC, Fred Wilson at Union Square, referred to Crunchbase as "the premier data asset on the tech/startup world." Additionally, Crunchbase also makes data access relatively easy via a modern JSON interface. Crunch base data are self-reported, though they make data available for academic researchers freely after an short application process.

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