Rotterdam School of Economics, Erasmus University

International Bachelor Economics and Business Economics

Bachelor Thesis 2010 – 2011

Does Venture Capital Contribute to the Success of Startups?

A Literature Review

July, 2011

Coordinator

Italo Colantone

By

Georgi Nikolaev Filipov

George_vtbg@yahoo.com

314992

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Table of ContentsIntroduction.................................................................................................................................................3

Venture Capital and the startups................................................................................................................5

History of VC............................................................................................................................................5

Invest in young firms...............................................................................................................................6

Literature Review........................................................................................................................................7

Venture capital and the growth of Startups............................................................................................7

Venture Capital and Innovation...............................................................................................................9

Venture Capital and the contribution to IPO.........................................................................................11

Public Policies............................................................................................................................................13

Conclusion.................................................................................................................................................15

References.................................................................................................................................................17

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Introduction

Venture capital provides startup companies a long-term, committed share capital, in order to

help them develop and succeed. If an entrepreneur needs not only a financial aid, but also

someone to turnaround or revitalize the company, venture capital could help solving this.

Obtaining venture capital is significantly different from raising debt or taking a loan from a bank.

Banks have the legal right to interest on a loan, irrespective of the success or failure of a

business. The investment that Venture Capitalists do is compensated in exchange for certain

share of the business and therefore the interest that they receive is based on the growth and

profitability of the company. Finally the return is generated when the share of the new

businesses is sold to another owner.

In a wide variety of articles it is suggested that VC’s role in a company extends way beyond the

traditional financial aspect, based on their expertise in different areas

they are deeply associated with the management of the firms they finance. Gorman and Sahlman

(1989) observe that, on average, venture capitalists invest more than 100 hours per year

in consultant activity for each company. Even Hellmann and Puri (2002) examine

the influence of venture capital on the development rate of new businesses,

and underline the important job venture capital has on creating expertise and competence in the

internal organization of the firm. Their results imply that venture capitalists maintain new

businesses to build up their human resources within the company.

Fulghieri and Sevilir (2003) develop a theory of the organization and financing of innovation

activities, in which the decision of organization and financial structure of R&D plays a strategic

role. In particular, they show that independent venture capital financing is more likely to emerge

when: R&D projects have high research intensity, when competition in the R&D is less severe or

the R&D cycle involves early-stage research, and when the research unit is not financially

constrained.

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Jain and Kini (1995) show that funded companies that have been listed on a stock exchange

experience greater growth in cash flows and sales. Lerner (1999) studies this topic in depth,

taking into consideration Small Business Innovation Research (SBIR), an important American

initiative to support high-tech firms. Looking at the success of firms over the long period, for the

whole sample, he finds that occupation and sales growth rates are higher for SBIR funded firms

than non-SBIR funded firms for the entire period between 1983 and 1995.

Further more Megginson and Weiss (1991), Tykvova (2003) provide support for the certification

hypothesis and the role venture capitalists play in a firm’s IPO performance. The articles confirm

that the monitoring support venture capitalist provide is fundamental for the investments

they choose. So, according to the certification hypothesis, venture

capitalists obtain a major equity positions, protect their investments and serve in the board of

their portfolio companies.

The purpose of this paper is to review the existing literature on the relationship between venture

capital and the success of startup firms. In order to do so

we have concentrate our research on three main characteristics of startup firms that we

considered most distinctive for their success: Firm’s growth, Innovation and Initial firm’s

offerings (IPOs). We believe that after examining the already existing literature on topics we will

be able to distinguish if there can be significant pattern between VC and success of startups. The

paper will continue with the history of venture capital and the emergence of venture capital

funding. Section three is concerned with the analyses on the literature review and the 3 main

characteristics that we distinguished. Section four will draw some suggestions on

future policy implementations and in section five we will summarize our conclusions.

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Venture Capital and the startups

In this section the institutional details of venture capital organizations are briefly reviewed.

The discussion highlights the structure and function of venture capital organizations and how

venture capital is a distinct form of financing, separate from all other ways of generating funds,

for young, entrepreneurial companies.

History of VC

According to Kortum and Lerner (1998) the venture capital industry in the United States gives

its birth back in 1946, with the creation of the first venture fun, American Research and

Development. In the years between 1946 and 1977 a handful of venture funds were

established following the revolutionary new fund. Although the money flows back then was no

more than a few hundred million dollars annually and normally even lower. An important factor

that transformed the direction of classical venture investments was the change in the “Prudent

man” rule after 1979. Prior to that year pension funds had a limited rights to invest significant

amounts of money in venture capital by the Employee Retirement Income Security Act. The

major impact that this amendment had can be observed from the figures we have in the years

preceding and following to the correction in the rule. In 1978 when $424 million was invested in

new venture capital, only 15 percent of the money was supplied by pension

funds. However eight years later the amount invested in venture capital accounted to $4 billion

and more than half of it was accumulated by pension funds. In the years 1996 and 1997, there

was another significant leap in venture capital activity.

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Invest in young firms

Many start-up firms require substantial capital initially in order to set up

the business. A firm’s founder may not have sufficient funds to finance the planned

projects alone at the beginning and will most probably seek for external ways of

financing. Entrepreneurial firms lacked the possibility to obtain bank loans or other debt

financing, because they were characterized by large intangible assets, highly uncertain annual

earnings and low survival rates. A high percentage of these young companies had the potential to

grow fast and out-pay their investments, but due to their asymmetric information venture capital

was the only potential source of financing. Venture capitalist role was to provide those high-risk

companies with a financial support and in return they would receive equity stakes while the firms

are still privately held. Firms such as Apple Computer, Cisco Systems, Genentech, Intel,

Microsoft, Netscape, and Sun Microsystems were initially financed by venture capital

organizations.

The financial projects that venture capitalist get involved with differ significantly from

those undertake by corporate research laboratories. Applying different kind of mechanisms,

venture capitalists may finance a large portfolio of projects with a high degree of risk and at an

early stage with no tangible assets. An entrepreneurial venture is not restricted to a

technologically based firm, a commercialization of an invention which results from R&D or

an innovative cost reducing process. The appliance of already existing technologies, a product or

service innovation or simply a new way of operating a business can also be considered as an

entrepreneurial activity.(R. Amit 1990). The venture capitalist’s willingness to get involved in a

project is most likely made conditional on the identification of a syndication partner who agrees

on the investment’s attractiveness (Kortum 1998). Sahlman (1988) shows that staged financing

solves agency conflicts between the venture capitalist and the entrepreneur because in contrast to

the case when all the needed venture capital is provided in once now the entrepreneur has a

stronger incentive to create value. The company progressively decreases its level of risk as it

develops, and venture capitalist will receive a proportionately smaller incremental equity

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position for a given amount of investment at each successive stage. According to Martin Kenney

(2002) the use of equity investment rather than debt eliminates the problem of scheduled

repayment. It allows young companies to reinvest their earnings and provides an asset base

which can be used to attract external capital and improve a company’s credibility with vendors

and financial institutions. Equity financing enables venture capitalists to

undertake substantial investment risks since one enormously successful investment can more

than offset a series of break-even investments or outright losses.

Literature Review

Venture capital and the growth of Startups

Young, innovative and rapidly growing firms have to invest a substantial amount in resources

before they can obtain a viable market position. However, the start-up’s equity position

is very weak, and debt financing is often restricted by certain country specific or sector specific

regulations. According to Dirk Engel (2002) Venture capitalists take a major role in closing this

gap by providing the financial support. Moreover those investors often contribute not only with

the funding of such firms, but also with the implication of a monitoring control and strategic

management expertise in the early stage. Both types of support indicate a positive impact on

growth rates of the venture-backed firms. The role of venture capitalists offers some

favorable conditions for the growth of venture-backed firms.

In a vast amount of recent studies venture-backed firms are compared to those that have obtained

no venture capital at all and perform in similar sectors in order to examine the influence of VC

on the tendency to grow. Whether access to VC financing actually spurs the growth

of investee companies is a matter of empirical testing. For example, Alemany and Marti (2005)

compare the population of the 323 Spanish firms that obtained VC financing in the period 1993-

1998 with a control taste of similar but non VC-backed companies. Matching is based on

the region in which firms are located, sector of activity, age and size in the year in which VC

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financing was obtained. The researchers believe firms’ sales, employment and total assets; and

calculate average growth from the “event” year up to the third year after the event, making

a distinction according to the stage of the investee company’s life (i.e. start-up, growth, mature)

in which VC financing was obtained. VC-backed companies are found to outperform their non

VC-backed counterparts if VC investment takes place in the start-up or growth stage.

Massimo G. Colombo and Luca Grilli (2005) analyze the effect of VC financing on the growth

of sales and employment of startup firms in subsequent years. For this purpose, they examine

a sample of 537 new Italian firms for the period 1993- 2003. The purpose is to evaluate what is

the impact of VC on the firm’s subsequent growth and whether the degree of this effect varies

according to the nature of the investors (specialized venture capital or corporate venture

capital).Estimates reveal that venture capital financing has a significantly positive effect on the

development of startups. The marginal increase in the number of the firm's employees is

decreasing over time, indicating that VC has a higher impact on the firm’s growth in the first

years following the financing.

Manigart and Hyfte (1999) find that the rate of growth of total assets of a sample composed of

187 Belgian VC-backed firms is significantly greater than that of the control sample in each year

starting in the year in which the firm obtained VC financing and for the following five years.

Lastly, the growth rate of employment is greater in the VC-backed sample only when one

considers star performers that are the firms that belong to the percentiles with the greatest

growth, and a sufficiently long period (at least three years after the investment).

Moreover, Engel and Keilbach (2002) analyze the impact of venture capital

investment on growth and innovation of 142 young German firms. To test their hypotheses they

use the nearest neighbor criterion with an additional requirement that the firms have to operate in

the same industry and to be established in the same year as the venture baked firms. Based on

this method they found evidence that venture-funded firms exhibit significantly higher growth

rates compared to their non-venture-funded counterparts, thus venture capital firms make a

significant contribution in this respect.

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Other studies like (Gorman and Sahlman 1989, Bygrave and Timmons 1992, Sapienza 1992,

Kaplan and Strömberg 2004) focus on the fact that VCs perform a significant

coaching function to the benefit of investee firms. They provide portfolio companies with

consulting services in fields such as strategic management, marketing communication, finance

and human resource management, where these firms typically lack internal capabilities. For

instance, Hellman (2002) proves that VCs support the engagement of external managers, the

implementation of investments plans or participation in the HR polices of the invested firms,

thus reflecting in the company’s managerial expertise and growth. Moreover, venture-baked

firms can contribute from the already established networks of their investors such as suppliers,

prospective clients, partners or alliances.

Venture Capital and Innovation

According to R. and Kenney,M. (1988) venture capitalist are well known for two core activities:

providing funds and assisting in the emergence of new high technology businesses. They actively

cultivate networks comprised of financial institutions, universities, large corporation’s

entrepreneurial firms and other organizations. These networks and the data flow at their disposal

let them reduce many of the risks associated with new venture formation and thus go easier

through the barriers innovation cycle can have. Venture capital-financed innovation is a

“new model” of innovation which goes beyond both traditional entrepreneurship and corporate-

based innovation.

Kotrum and Lener test the possibility that venture capital and patenting may not be the only

factors that affect innovation and suggest that entrepreneurial opportunities is an unobserved

variable which can also be positively correlated to innovation. They try to reach the reasons

about causality by explaining two different factors. First, they observe the amendment in the

“Prudent Man” rule made after 1979 by the Employee Retirement Income Security Act and the

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followed discontinuity effect in the total investments. As discussed earlier in

the paper the change allowed pension funds to invest in venture capital industry which lead to a

substantial increase in the money flow. They argue that such an exogenous change

should confirm the significance of venture capital as an instrument to boast innovation, because

it is irrelevant to be connected to the appearance of entrepreneurial activity. Second, they

examine R&D expenditures to test for the occurrence of technological opportunities that were

expected during that time, but were not taken into account by econometricians. They use

a simple model framework to prove that the causality effect evaporates if

we asses the impact that venture capital has on patent R&D ratio, rather than on patenting itself.

Although these causality problems have been observed,

findings still support the major importance of venture capital on innovation. The results obtained

through different models imply that an investment made by venture capital fund can be up to ten

times more valuable to patent creation, compared to a traditional corporate R&D

investment. Moreover, they estimate that regardless of the fact that venture capital was

in total 3% less than corporate R&D in the last years, it contributed with 15% more to the U.S

industrial innovations.

Hellmann and Puri (2000) use a different way to show that venture capital leads to more

innovation. They suggest that higher levels on innovation are caused not just by venture capital

in general, but rather because venture capitalist have the incentive to respond

on important technological opportunities which are likely to lead to more innovation. In their

observations they use a sample of 170 recently formed firms, comparing venture-backed to non-

venture firms. After performing a questionnaire survey, they advocate that venture capitalist are

not only involved in the financing, but are also associated with the marketing strategies and

outcomes of the firms. Moreover startups that position innovation as an underlying strategy in

their work obtain venture capital significantly faster. They find a straight correlation between

venture capital presence in a firm and the time needed to promote a product to the market.

In addition, firms are more likely to mark involvement of venture capital in their business, as the

most vital point in their development, compared to other financial inflows. The results indicate

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significant interrelations between investor category and product market dimensions, and

a function of venture capital in encouraging innovative companies. Knowing the relatively small

sample of firms and the scars data available, just a moderate concerns about the causality can be

done. Unfortunately, we can not reject probability that innovative startups prefer venture capital

for financial reasons, rather than VC to create innovations.

Caselli, Gatti and Perrini perform another research on whether venture capital spurs innovation

inside funded firms by analyzing the number of registered patents before and after funding. They

analyze 37 Italian venture baked firms and by a matching way they choose 37 twin non-venture

backed firms. However the results differ significantly from the literature cited above. Before

funding, funded firms show 0.3327 more patents than non-funded firms do per year, on average;

after funding, they report 0.53825 fewer patents than their twins do per year, on average. The

propensity to innovate seems an essential requirement for passing the screening phase of the

venture capitalists’ selection process, but on the other hand, the entry of venture capital into the

company does not promote continued innovation.

Venture Capital and the contribution to IPO

Venture capitalists are similar to leveraged-buyout (LBO) specialists, who seem to contribute to

significant improvements in performance in corporations that go private. Like LB0 specialists,

venture-capital providers are involved in financing and monitoring their portfolio companies.

LB0 specialists and venture capitalists invest in different kinds of firms, however: LB0

promoters usually invest in mature companies with predictable cash flows, whereas venture

capitalists focus on young and high-risk entrepreneurial ventures. The venture-

capital market therefore provides a useful alternative setting in which to explore the role of

active investors with concentrated ownership claims.

The role of venture capital investment on initial public offerings has been extensively

discussed in the literature. Two papers can be significantly distinguished among others: those of

Megginson and Weiss (1991) and Barry, Muscarella, Peavy, and Vetsuypens (1990) as one of

the first to examine more deeply the topic. Megginson and Weiss (1991) suggest that because of

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the venture capital “certification”, IPOs of companies that are venture-backed are less under

priced than non-venture backed IPOs. The term venture capital certification represents the belief

that venture capitalist are concerned about their reputation, because of their repeat actions on the

IPOs market. Therefore they would value the IPOs of the firms they bake more realistically and

closer to the true intrinsic value of the firm. Matched by industry and offering size, indicates that

VC backed firms are significantly younger, have greater median book values of assets, and a

larger percentage of equity in the capital structure than their non-VC backed counterparts. In

addition, VC backed firms are able to attract higher quality underwriters than non-VC backed

IPOs. Barry et al (1990) also imply that same observations that venture-backed IPOs are

less under priced compared to non-venture backed IPOs. Although, they argue that the difference

in the pricing of IPOs is due to the fact that the capital market is aware of IPOs with better

monitors. More precisely, venture capitalist fund only the top part of the firms in the

market, therefore a better quality from these firms is expected.

According to Bharat A. Jain and Omesh Kini (1995) the market appears to recognize the

importance of monitoring by venture capitalists and the followed higher valuations at the time of

the IPO. They examine the proposition by comparing the post-issue operating performance

of venture backed IPOs with a matched sample of non-venture backed IPOs. The results show

that the involvement of VCs speeds up the process of development and allows the company to go

public earlier than it would be otherwise possible. The companies also go public with a higher

valuation than would be possible otherwise, providing issuers with additional capital at the IPO.

Further, in the initial stages of a public corporation, VC monitoring ads value as evidenced for

improved corporate performance. From the investors’ point of view, VC participation

signals quality. This should lead to increased interest in VC-backed IPOs compared to similar

non-VC-backed issues.

However, in more recent papers the contrary results have been documented. Lee and Wahal

(2000) suggest that for the period between 1980 and 2000, venture backed companies have

actually been more under priced than non-venture backed companies. Results show that VC

backed IPOs exhibit greater underprice than non-VC backed IPOs. The return differential ranges

from 5.0% to 10.3% over the entire sample period. During the internet bubble period of 1999–

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2000, the differential is significantly larger. The authors interpret these results with the

grandstanding hypothesis which in other words indicate a negative correlation

between venture firm reputations and underprice. Since establishing reputation is

so important for future fund raising, venture capital firms are willing to bear the cost

of underprice because taking a company public signals quality.

Reopening the debate about the role of VC in IPOs Thomas J. Chemmanur and Elena Loutskina

(2006) approach the debate from a different perspective and use a different hypothesis. What

they suggest is to distinguish between the hypotheses about venture funding mentioned above

and include a third probable hypothesis that they refer to as “market power”. It reflects the

possibility that venture capitalist can use their powerful positions on the market due to the strong

relationships they build with the participants in the market. These long-term connections allow

them to pull a higher participation by underwriters, institutional investors or analysts

and acquire higher prices for the IPOs of their firms. Venture capitalists may be motivated to

achieve higher valuations for the IPOs of firms backed by them, due to concern

for reputation with their own venture fund investors and entrepreneurs. This reputation is

essential for venture capitalists’ ability to raise financing for future venture funds. Results reject

the certification hypothesis and provide significant support for the market power hypothesis. We

find that venture backed IPOs are much more overvalued than non-venture backed IPOs and that

high-reputation VC backed IPOs are more overvalued than low-reputation VC backed IPOs, both

at the bid price and at the closing of the first trading day. The difference in valuation between

venture backed and non-venture backed IPOs (and between high-reputation and poor reputation

VC backed IPOs) becomes larger at the start of trading in the secondary market, but dissipates

over time, almost disappearing at the end of the third year after the IPO.

Public Policies

As already mentioned in the above literature review the impact of venture capital on

innovation is likely to differ with the venture capital cycle. Yet government policies have often

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been focused to provide support during periods when venture capital industry is most active and

also targeting sectors in the business that have already been strongly funded by venture capitalist.

A successful approach would be to address the gaps in the venture financing process.

Investments made by venture capitalist tend to be centered in mainly in technology areas that are

already supposed to have a high potential. The tools that have been used till now to increase

venture fund raising, such as shifts in the capital gain tax rates, seemed

to focus the competition in one sector rather than diversify the firms that receive

funding. Policymakers should try to react on these conditions by (i) drawing the attention on

technological opportunities that are still not explored by venture funds and (ii) providing support

to companies that have been financed by venture capitalist but are in a down period.

More generally, one of the best possible solutions for government polices to provide assistance

may be to increase the demand for venture capital, rather than the flow of capital.

Therefore the effort to build more attractive image of entrepreneurship activity through tax

policy, may result in a significantly positive way to the amount of venture capital investments

and the returns they yield. The less direct action can contribute the most for the survival of the

venture capital industry.

The analyzes on the growth of venture-baked firms showed that venture capital can without any

doubt foster the growth of startups. An important policy issue obviously is whether VC baked

startup investment can be influenced more directly by means of taxes or subsides. Indeed most

countries offer many programs to assist startup entrepreneurship, and part of it is explicitly

directed towards the VC industry. Most of these programs subsidize the cost of capital by means

of credit guarantees to facilitate bank finance at a lower interest rate. These subsidies have in

common that they are not performance related. Since these firms do not generate revenue during

the startup phase, the return to entrepreneurs and investors mainly consists of capital gains. For

this reason policy makers often propose to reduce the capital gain taxes.

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Conclusion

This paper has examined the contribution of venture capitalist to the success of startups. For

this purpose it was performed a literature review on an extensive volume of articles associated

with the effects of venture capital on entrepreneurship. We mainly focused our observation on

three key characteristics of the success for startups which we distinguish in the beginning of the

article: Firm’s growth, Innovation and Initial firm’s offerings (IPOs). Although not all of the

examined studies showed a clear pattern that VC contributes to the success of startups, the wider

part of the literature supports the assumption that VC has a main role in the future success of

startups.

Engel and Keilbach (2002) performed an empirical test on the impact of venture capital

investment on the growth of 142 young German firms. They found evidence that venture-funded

firms exhibit significantly higher growth rates compared to their non-venture-funded

counterparts, thus venture capital firms make a significant contribution in this

respect. Similarly Massimo G. Colombo and Luca Grilli (2005) proved the existence of a direct

causality relationship between VC investment and startup's growth after observing a sample of

537 new Italian firms.

Kortum and Lerner (1998) researched twenty different industries in order to determine whether

VC has an impact on the patent innovations Although some causality concerns occurred, the

findings support the positive impact of venture capital industry on innovation. Their estimates

suggest that regardless of the fact that venture capital was in total 3% less than corporate R&D in

the last years, it contributed with 15% more to the U.S industrial innovations. In addition

according to Bharat A. Jain and Omesh Kini (1995) the market appears to recognize

the importance of venture capitalist’s monitoring role in determining the IPOs

prices. They observe causalities for this by comparing a sample of venture backed IPOs to a

matched sample of non-backed IPOs.

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Nevertheless, Thomas J. Chemmanur and Elena Loutskina (2006) use a different approach

to examine the debate about venture capital and IPOs pricing. They include a third hypothesis,

which they referred to as “market power”, showing the possibility that venture capitalist can use

their long-term connections on the market in order to acquire higher prices for the IPOs of their

firms. Results reject the certification hypothesis and provide significant support for the market

power hypothesis. We find that venture backed IPOs are much more overvalued than non-

venture backed IPOs and that high-reputation VC backed IPOs are more overvalued than low-

reputation.

It can be identified from the literature cited above that VC perform a crucial role in the

development of startup firms. In order to summarize our research it should be mentioned

that empirical evidences, concerned with all the main characteristics observed in the paper,

confirmed the highly contributive function of VC to the success of startups.

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10. WILLIAM L. MEGGINSON and KATHLEEN A. WEISS. (July 1991). Venture Capitalist Certification in Initial Public Offerings. THE JOURNAL OF FINANCE. VOL. XLVI, (3),

2. Kortum and Josh Lerner. (Winter 2000). Assessing the contribution of venture capital to innovation. RAND Journal of Economics. 31 (4), pp. 674-692.–111.

3. Samuel Kortum and Josh Lerner. (December 1998). Does venture capital spur innovation . NBER Working Paper . 1 (6846), 1.

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8. Thomas J. Chemmanur* and Elena Loutskina. (September, 2006). The Role of Venture Capital Backing in Initial Public Offerings: Certification, Screening, or Market Power. 

9.Bharat A. Jain and Omesh Kini. (1995). Venture Capitalist Participation and the Post-issue Operating Performance of IPO Firms. MANAGERIAL AND DECISION ECONOMIC. 16 (1), 593-606.

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