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Venture-Capital Financing and the Growth of Startup Firms
ABSTRACT
Venture capital firms have unique capabilities in terms of dealing with high uncertainty, high
degrees of information asymmetry, and providing access to a strategic network. This study
examines the association between the presence of venture capital and the growth of startups. It
explores whether venture capital leads to growth or, alternatively growth signals the need for
venture capital. It also investigates the impact if any of venture capital financing events and
the growth of these firms. ... This study investigates the impact that
venture capital investors, the timing of their investments, and past growth have on the growth
of start-ups. ... As a further contribution, we investigate the relationship between this measure of
growth and the change in the valuation of startups (as valued by venture capital firms’ at the
time of providing new funds).
Existing evidence indicates that startups using venture capital are different from startups
using more traditional financing alternatives (Hellman & Puri, 1999a). These authors find
that venture-backed startups follow more innovative strategies and take shorter time to
introduce their products to the market. Previous research has also found that the presence of
venture capital affects the emergence of human resource practices in startups (Baron, Burton,
& Hannan, 1996; Hellman and Puri, 1999b). Venture capital has certain characteristics that
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set it apart from more traditional capital markets or debt financing alternatives (Gompers and
Lerner, 1999, chapter 7). Venture capital firms devote significant management resources to
understanding new technologies and markets, finding promising startups in those spaces,
providing them with financial resources, and coaching them through the early part of their
lives. ... In contrast, venture capital firms have the capabilities
required to deal with these factors and contribute to the management of startups. ...
First, we explore whether the presence of venture capital is significant in explaining
differences in growth rates across startups. Strong evidence is found that companies with
venture-capital financing grow faster over time than companies using other sources of
financing. Second, we explore past growth as a factor that may potentially affect current
growth and relevant to our understanding of venture capital and startup growth. ...
A time-series analysis of headcount growth in both venture-backed and non-venture backed
firms supports this past growth—future growth momentum hypothesis. The third research
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question probes whether venture capitalists self-select investments in already growing firms or
whether growth only arises after venture capitalists bring their financial and managerial
resources. We find little evidence of prior growth in startups before they receive an initial
round of venture finance.
The fourth question investigates the potential impact that the provision of venture
financing may have upon growth in headcount. ... In other
words, startups receive venture capital before they need the funds in order not to delay their
growth because of lack of liquidity. However, the sizable ramp-up on employee hiring
immediately after a new round of venture financing that we find suggests that the timing of
new funding rounds delays startup growth. The finding indicates the existence of frictions
between the venture capital market and the growth needs of startups. ... Each new round of financing by a venture
capital firm requires the start up be revaluated. ...
Our sample includes venture-backed as well as non-venture backed startups within the
same industries, primarily technology industries. ...
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THEORY
The Role of Venture Capital Funding
Venture capital firms have some unique characteristics (Gompers & Lerner, 1999, chapter
7). Venture capitalists aim to rapidly grow businesses such that they earn a high rate of return
from their investment. They raise money through venture funds that have a finite life.
Gomper and Lerner (1999) state that “almost all venture and buyout funds are designed to be
“self-liquidating,” that is, to dissolve after ten or twelve years” (p. ... In order to reach the
high investment returns required by the risk of their investment (30% per year is one
benchmark) over a relatively short time-period, at least a subset of the startup companies in a
venture fund need to have rapid growth at the operations level. ... It is unlikely that
either type of liquidity event for small companies will be able to attract the large
considerations that translate in high venture fund returns. Venture capital firms have an
interest in their startups growing fast. But our sample needs to meet two conditions to identify
this pattern: (a) the venture capital funds represented in our sample are able to grow their
startups, and (b) the growth must happen in a broad enough range of their startup portfolio.
Multiple rationales exist for expecting venture-backed companies to have higher than
average growth rates. Venture capitalists typically augment the skill set of the existing
management team in a more proactive way than other financing methods (such as bank loans). ...
Venture capitalists’ knowledge of the industry and their business network also includes
potential business partners for their startups. ...
Venture capitalists themselves bring a reputation effect over and above a skill
augmentation role for a startup. ...
Successfully passing a venture capitalist screen and receiving funding (often in multiple
rounds) is a powerful signal to multiple parties, both inside and outside the startup. ... The combination of this skill augmentation and
reputation signaling can result in a venture-backed startup having an advantage in attracting
high quality employees, in gaining new customers, and in negotiating alliances and joint
ventures with key players.
Venture-capital backed startups may also have lower agency costs. As mentioned in the
previous paragraph, the reputation that the venture capitalist brings to the startup provides a
positive signal to the labor market that reduces adverse selection (Eisenhardt, 1988). In
addition, venture capitalists typically provide stock options to a broader set of employees than
do owner-managed or debt-financed firms. ...
Hypothesis 1: Venture-backed startups grow faster than non-venture backed firms. ...
Initial Growth and Attracting Venture Funding
Hypothesis 1 posits that venture capital firms bring both management skills and a
reputation/signaling contribution that accelerates the growth of a startup. The underlying
assumption is that the presence of venture capital not only funds the financing needs of the
startup but also signals to external parties (such as prospective employees, prospective
customers, or potential partners) the quality of the firm. ... In this case, venture capitalists self select companies that have
already exhibited relatively high growth (venture capital screening criteria are discussed in
Zacharakis and Meyer (1998, 2000)). This rationale presumes that venture capitalists’
screening process flags companies with higher growth in the same way that it identifies
innovative firms (Hellman and Puri, 1999a). The initial growth of the startup before it
receives venture funds signals to the venture capital firms its attractiveness as an investment
alternative. ... In this setting, growth is
prior to the presence of venture capital. ... Hypothesis 1,
relates firm growth with the presence of venture capital. However, it does not distinguish
whether (a) it is the presence of venture funds that signals to external parties and facilitates
growth, or (b) it is growth that signals and makes a startup more attractive to a venture capital
fund. The next hypothesis relates the initial growth of the firm with receiving venture capital
funds.
Hypothesis 3: Venture capital firms fund startups that have higher prior growth rates.
Approximate Word count = 6039
Approximate Pages = 24.2
(250 words per page double spaced)
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