The venture capital (VC) industry has been growing at a very fast pace for the last twenty years. In 1980 the total amount of money newly invested by venture capitalists in the US was estimated at $610 million. By 2005 this had increased to around $22.6 billion. Clearly, venture capital is growing as a significant source of financing for new firms, yet many questions about it as an institution – which types of firms get venture capital and how they do – remain. In particular, much of our understanding of VC-financed firms comes from analysis of firms that are successful and survive. We have little understanding of VC-financed firms that fail, as well as the counterfactual – the life-cycle dynamics of firms that could use VC but do not.
Research into these questions is difficult partly due to the scarcity of data on private firms – particularly non-VC-financed firms. To date, studies have mainly focused on differences between VC- and non-VC-financed firms that have had successful outcomes, such as an IPO, or on VC-financed firms in isolation (e.g., Gompers and Lerner 2001, Kaplan and Stromberg 2004). A few studies have examined smaller hand-collected samples of private firms but have been limited to certain geographies, time periods and industries (e.g., Baron, Hannan and Burton 1999, and Hellmann and Puri 2002). In a recent paper (Puri and Zarutskie 2008), we use a new panel data set collected by the US Census Bureau that tracks firms from their birth over more than two decades to address a number of questions related to the role of venture capital in new firm creation.
Which firms receive venture capital financing?
We first ask to what market-wide and firm-level characteristics venture capitalists respond in choosing their investments.
Many have argued that venture capital and investment banks fuelled a disproportionate number of new firms in sectors with “hot” IPO and public market opportunities, in the hope of early cashing out. Interestingly, we find that while more firms are created in sectors that experience greater IPO activity, the proportion of VC-financed firms created in these sectors does not change significantly during these periods of positive public market signals. It seems that different sources of capital for start-ups interpret economy-wide signals similarly, rather than venture capital driving waves of new firm creation in industries with positive public market signals of investment opportunity.
Our results also support the notion that venture capitalists invests in firms with ideas and no immediate revenues that require large initial investments. We find that firms born with no commercial revenues are disproportionately financed by venture capital. In fact, over 50% of new firms in the latter part of our sample which received VC financing were started without any commercial revenues. Moreover, most of these firms received venture capital before they realised commercial revenues. This is true in “high-tech” industries, such as biotech and computers, and in “low-tech” industries such as retail and wholesale trade.
We find that at every stage of the firm’s life cycle – at birth, at the time of VC financing, and beyond, VC-financed firms persistently tend to be an order of magnitude larger than non-VC-financed firms, as measured by employment and sales, on average. Interestingly, we see little difference in profitability before VC-financed firms exit via acquisition or IPO. These results suggest that venture capitalists focus on scale or potential for scale, rather than profitability.
Venture capital financing and firm exit
We then examine a number of hypotheses about firm failure to better understand venture capitalist behaviour towards companies that do not do well. Arguably, this is one of the least understood aspects of venture capitalist behaviour.
We first ask whether the larger scale of VC-financed firms reflects a higher failure rate for firms receiving venture capital. We find that the cumulative probability of failure is lower for VC-financed firms. The failure rate for VC-financed firms is significantly lower in the data and slightly lower controlling for initial size, industry, geography, and firm age. Thus, it is not the case that the average differences in size between VC- and non-VC-financed firms are being driven by higher failure rates at VC-financed firms.
Second, we ask whether the time to failure is different between VC- and non-VC-financed firms. Some argue that venture capitalists are impatient and push their companies to grow quickly, deciding relatively rapidly which firms have the best chance of achieving a successful exit and terminating those that do not in the interest of allocating more capital to the likely winners in their portfolios. Others argue that venture capitalists have a more difficult time judging which firms will be successful in the early stages of investment and equally nurture and invest in all of their firms over a certain period of time.
We find that the answer to whether VC-financed firms fail more often is a function of the time period under consideration. We find that venture capitalists are “patient” at least during the first five years after a firm receives venture capital. In our matched sample, the probability of a VC-financed firm failing is much lower than a non-VC-financed firm, but the probability of a VC-financed firm failing is higher than for non-VC-financed firms conditional on their having survived for more than five years. Thus, venture capitalists allow firms time to grow and appear to be “patient” but only to a certain point. There is a window in which they allow firms to continue and grow, but once this is crossed, venture capitalists are relatively quick to shut their firms down.
The third question we ask is: Do VC-financed firms have different thresholds for failure than non-VC-financed firms? Some argue that venture capitalists may terminate firms that other investors would keep alive because of higher VC hurdle rates, while others argue that venture capitalists give even their failed firms more opportunities to grow and prove themselves relative to investors in non-VC-financed firms in an attempt to learn which of their investments will be huge successes. We find that in our matched sample, VC-financed firms are significantly larger when they fail in terms of employees and sales, but they are not very different in terms of profitability at the time of failure. These results suggest that venture capitalists care about scale for all firms in which they invest, investing heavily in all their firms for an initial period until they have a better sense of which ones will be the successes in their portfolios.
Fourth, we ask if for VC-financed firms failure is disguised as acquisition. While we have observed that VC-financed firms have lower average probabilities of failure, it is possible that venture capitalists are able to sell their poor performers to other companies due to their connections or natural synergies with potential acquirers, whereas non-VC-financed firms simply must shut down. We find there is no significant difference in terms of size, as measured by employment or sales, or profitability at the time of acquisition between VC- and non-VC-financed firms. Hence there is no evidence to suggest that venture capitalist failures are being camouflaged as acquisitions.
Last, but not least, we ask if the patterns for VC-financed firms reflect the behaviour of certain kinds of venture capital, such as high- or low-reputed venture capital, or whether we see these broad patterns across the board. We find the pattern of failure that we observe in the overall sample is also observed in the subsamples of both high- and low-reputation venture capitalists.
Our analysis also informs the debate over whether venture capitalists behave in a short-term manner relative to non-VC sources of entrepreneurial capital in their growth and shutdown decisions. Overall, our analysis indicates that venture capitalists are a relatively patient source of capital. However, there is a limit to their patience. Getting venture capital significantly increases firms’ chances of survival in their early years and speeds their investment and growth, as venture capitalists invest in learning about which of their firms will achieve the scale and other criteria necessary for a successful exit. Once this trial period has finished, VC-financed firms face a higher probability of being shut down, as well as being acquired or going public, relative to non-VC-financed firms that also survive past the same initial period. While taking venture capital financing ex ante lowers the probability of firm failure, conditional on surviving for a number of years, the probability of failure as a VC-financed firm is higher.
Baron, J., M. Hannan and D. Burton. 1999, Building the Iron Cage: Determinants of Managerial Intensity in the Early Years of Organizations, American Sociological Review 64(4), 527-547.
Gompers, P. and J. Lerner, 2001, The Venture Capital Revolution, Journal of Economic Perspectives, 15, 145-168
Hellmann, T. and Puri, M., 2002, Venture Capital and the Professionalization of Start-Up Firms: Empirical Evidence, Journal of Finance, 2002, 57 (1), 169-197.
Kaplan, S. and P. Stromberg, 2004, Characteristics, Contracts, and Actions: Evidence From Venture Capitalist Analyses, Journal of Finance 59, 2177-2210.
Puri, M. and R. Zarutskie, 2008, On the Lifecycle Dynamics of Venture-Capital- and Non-Venture-Capital-Financed Firms, NBER Working Paper # 14250.