venture-capital financing and the growth of startup firms
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- 1.Venture-Capital Financing and the Growth of Startup Firms Antonio Davila Graduate School of Business Stanford University Stanford, CA 94305-5015Tel: (650) 724 50 60Fax: (650) 725 04 68 Email: email@example.comGeorge Foster Graduate School of BusinessStanford UniversityStanford, CA 94305-5015 Tel: (650) 723 28 21 Fax: (650) 725 04 68Email: Foster_George@gsb.stanford.edu Mahendra Gupta John M. Olin School of BusinessWashington UniversityCampus Box 1133 One Brookings DriveSt. Louis, MI 63130-4899 Tel: (314) 935 45 65 Fax: (314) 935 45 65Email: firstname.lastname@example.orgAugust 2002The assistance of Trinet and VentureOne for this research is gratefully appreciated. We are grateful for the comments of Martin Babinec, participants in the Stanford University research workshop, and the reviewers of the paper. Financial support is from The Center for Entrepreneurial Studies at the Graduate School of Business, Stanford University. Research assistance was provided by Nicole Ang, Jiangyun Liu, Barbara Lubben and Jakub Wilsz.
2. Venture-Capital Financing and the Growth of Startup Firms ABSTRACTThis study examines the association between the presence of venture capital and the employeegrowth of startups. Grounded in signaling theory, it investigates the impact if any of venturecapital financing events upon the growth of these companies and whether the amount offunding affects the intensity of the signal. It further explores whether venture capital leads togrowth or, alternatively growth signals the need for venture capital. Finally, it documents therelationship between growth in startup financial valuation and changes in the number ofemployees over successive rounds of financing.Keywords: entrepreneurship, venture capital, growth of the firm, private equity 3. Venture-Capital Financing and the Growth of Startup Firms EXECUTIVE SUMMARYThis paper investigates the impact of venture capital funding on the growth of startups.Grounded in signaling theory, it examines the evolution of employee growth around the timeof a round of financing. Our findings indicate that the number of employees increases in themonths prior to the VC funding round and further increases during the months after the event.Thus, venture capital funding events are important signals about the quality of the startup.Moreover, the credibility of the signal builds up prior to the actual event as the probability ofthe event increases. The relevance of a funding event to the evolution of employee growthsuggests that startups may have to delay their growth because of lack of timely funds. Thestrategy of high-growth startups often relies on a timely execution to take advantage of earlymover advantages; delayed execution may have significant negative consequences in theability of the startup to be successful.This finding indicates that both venture capital firmsand entrepreneurs may benefit from a better financing process that provides funds in a timeliermanner. However, the results are not informative about the sources of this lack ofcoordination, a question open to future research.We also examine whether venture capital firms use high-growth as a signal to identifystartups amenable to venture capital funding. Given that venture-backed startups grow fasterthan their non-venture backed counterparts, we examine whether this distinctive growth pathis already identifiable before the first round of venture capital funding.Our results indicatethat the growth path of venture and non-venture backed firms cannot be distinguished beforethe former companies receive their venture funding. Thus while venture capital funding 4. events provide a credible signal to the labor market, previous startup growth does not appearto provide a useful signal to decrease the information asymmetry between venture capitalistsand startups. Given that venture capitalists appear not to use growth as a significant selectioncriterion, following a growth strategy to attract venture capital may not be an effectivestrategy.We also examine whether growth in number of employees, our proxy for growththroughout the paper, is associated with an alternative measure of growththe change in theequity value of the startup over successive rounds of funding. Our results indicate that largerchanges in number of employees are positively and significantly associated with changes inequity value.This finding is important for research in entrepreneurship. It indicates thatgrowth in employeesa variable that is typically more accessible and updated than equityvaluationmay be a good proxy for changes in the value of a startup.A final word of caution is relevant in interpreting the results.The data supporting thestudy was gathered in the period 1994-2000 mostly from Silicon Valley-based companies.This period has been characterized as unique and, accordingly, generalizing the results toother time periods should be done with care until the findings have been replicated. 5. Venture-Capital Financing and the Growth of Startup FirmsThe growth path of recently formed companies (startups) is important to managementtheory. Since the original theory of the growth of the firm in Penrose (1959), wheremanagerial resources played a pivotal role, several factors have been suggested as affectinggrowth. Some factors (such as environmental carrying capacity or market forces) are externalto the organization (Aldrich, 1990; Singh and Lumsden, 1990).Others are internal(capabilities, culture, or strategy) and have been addressed from the resource-based view ofthe firm (Wernerfelt, 1984; Teece et al., 1997; Boeker, 1997; Zahra et al., 2000; Canals,2000).Within the field of entrepreneurship, previous research has examined additionalresource endowments relevant to explain firm growth that are unique to entrepreneurial firms(Shane and Venkataraman, 2000). Venture capital is an important internal factor in the earlystages of a startup. Existing evidence indicates that the presence of venture capital funding isrelevant to explaining differences across startup companies (Hellman and Puri, 2000).Venture capital has characteristics that set it apart from more traditional capital markets ordebt financing alternatives (Gompers and Lerner, 1999, chapter 7). Venture capital firmsdevote significant management resources to understanding new technologies and markets,finding promising startups in those spaces, providing them with financial resources, andcoaching them through the early part of their lives. High information asymmetry (Petersenand Rajan, 1995) and high uncertainty documented in the organizational ecology literatureand reflected in the liabilities of newness and smallness (Hannan and Freeman, 1989)typically limit a startups access to traditional financing sources.In contrast, venture capitalfirms have the capabilities required to deal with these factors and contribute to themanagement of startups. 1 6. The purpose of this study is to present evidence on headcount growth of venture capitalbacked and non-venture capital backed companies and the role of venture capital in explainingthis growth.Our database covers employees in 494 mainly Silicon Valley based startups.The sample includes venture-backed as well as non-venture backed startups within the sameindustries, primarily technology industries. Grounded on signaling theory, our results indicatethat venture capital funding events are important signals internally and to the labor marketsabout the quality of the startup.Moreover, the intensity of the signal increases with theamount of funding and builds up prior to the actual event as the probability of the eventincreases. While venture capital funding events provide a credible signal to the labor market,our results suggest that previous startup growth does not provide a useful signal to decreasethe information asymmetry between venture capitalists and startups.We also find thatincreases in headcount of VC-based startups are positively correlated with increases in thevaluation of startups in their successive rounds of financing. THEORY AND HYPOTHESESMultiple rationales have been proposed for expecting VC-backed firms to have higheraverage growth rates than startups not receiving this type of financing including: (1) Self-selection of venture capitalists into startups that both have the potential to have high growthand a management pursuing high growth (Zacharakis and Meyer, 1998, 2000). (2) From agovernance perspective (Sapienza and Gupta, 1994), they take an active role in the board andin monitoring the evolution of the firm (Fried et al., 1998) as well as in structuring topmanagers compensation (Kaplan and Stromberg, 1999). (3) Venture capitalists bring anetwork of contacts with experienced infrastructure providers (such accounting firms, lawfirms, and executive search firms) and potential professional managers. (4) Venture 2 7. capitalists themselves bring a reputation effect that facilitates growth.Their due diligenceprocess requires detailed analysis of the management team, their technology, products and theviability of their business plan (Gorman and Sahlman, 1989; Fried and Hisrich, 1995). Our basic theoretical premise is that uncertainty and information asymmetry governs therelationship between startups and external marketslabor and financial markets.Thispremise is consistent with previous work that has adopted an agency perspective (Sapienzaand Gupta, 1994) or risk perspective (Fiet, 1995).However, we adopt a signaling theoryframework.We argue that the presence of uncertainty about the future of the start-up andasymmetry of information among the players in the game enhances the value of particulareventsfunding roundsas potentially valuable signaling mechanisms.Building on thisargument, we develop hypotheses relating firm employee growth with funding events. Wealso examine the association between growth in human capital and firm valuation.Timing of Financing and Startup Growth Venture-backed startup companies face hi