"They're Really Punching above Their Own Weight": Venture Capital and Firm Growth

11/19/2019

Tom Heintjes: Welcome back to another episode of the Economy Matters podcast. I'm Tom Heintjes, managing editor of the Atlanta Fed's Economy Matters magazine. I'm so pleased you're with me today because we're going to talk to one of the Atlanta Fed's newest research economists, Veronika Penciakova. Welcome to the podcast, Veronika. I hope it's the first of many appearances here.

Veronika Penciakova: Thanks so much for inviting me, Tom. I'm excited to be here.

Veronika Penciakova, a research economist and assistant adviser in the Research Department of the Atlanta Fed during the recording of a podcast episode.

Photo: David Fine

Heintjes: Veronika has coauthored a very interesting piece of research. It's a paper titled "Synergizing Ventures." It's about the role of venture capital in the growth and development of businesses, and we're going to talk about that paper today. And before we go much further, Veronika, I should mention your coauthors on the paper—oh boy, I'm going to need help with these names. I will leave those names to you, in fact. [laughter]

Penciakova: Absolutely. This project is a joint work with some amazing coauthors: Ufuk Akcigit at the University of Chicago, Emin Dinlersoz at the U.S. Census Bureau, and Jeremy Greenwood at the University of Pennsylvania.

Heintjes: Okay, I'm glad I left those names to you. Veronika, let me start off by asking you: What led you and your coauthors to undertake this research? What was the original impetus behind it?

Penciakova: We really started off by thinking about what makes some firms into superstars, because in the U.S. economy, the vast majority of startups either fail or remain small throughout their lives. Very few firms take off, and those that do manage to take off can become really important for aggregate economic growth and innovation in the U.S. What we really want to do is, we want to understand how do these firms become so important? There are going to be a lot of factors that can play a role, and we focus in this paper on one in particular: access to venture capital funding. We think venture capital funding is super interesting because it plays these two roles, two complementary roles, in both identifying promising startups and then also subsequently fostering their growth and innovation. And so this really led us to the core question of the paper, which is: How important is venture capital funding for aggregate growth and innovation in the U.S. economy?

Heintjes: Yes, well, we're going to touch on that, but I wanted to get you to talk for a minute about the origin of what we know today as venture capital—or as you call it in your paper, VC. When did VC become a major force in the business environment?

Penciakova: That's a great question, Tom, and let me just take it actually one step back and answer an even more basic question: What actually is venture capital funding to begin with? Venture capital funding is money that's invested in usually young companies—your startups—and it's invested in exchange for ownership stake, so all that means is that the funder owns a piece of the companies that they fund. And generally speaking, venture capital funding is seen as pretty risky. Why? Because they're funding startups, and there's a lot of uncertainty associated with these startups. In particular, you can think about how these startups are potentially not going to be successful in bringing their ideas to market. Are they going to be successful in building a customer base?

But the reason why venture capital funding is important is because it can bring—or why venture capitalists do it—is because it can bring them a lot of profits. And that usually happens when the startups have gone through the initial phases and are either acquired by existing companies, or issue stocks on the stock market—"go public," as we say. And so going more to your question, venture capital funding has been around for decades. In the 1980s it accounted for I think about $600 million annually. It's gone through these ebbs and flows, so—probably unsurprisingly—it played a really important role during the tech boom of the late 1990s. Around 1999–2000, it accounted for about $100 billion, and then whenever the bubble burst, it became less important. But in recent years we've seen a resurgence. So if you think about, let's say, the last five years on average, VC has accounted for about $90 billion annually.

Heintjes: That's a lot of money. Is it spread across a lot of firms, or how would you characterize that?

Penciakova: No, actually. And that's super important: we're talking about a lot of money, but it's only going, on average, to about 8,000 firms each year.

Heintjes: Wow. Is there a way for you to give me an idea of how important venture capital is in today's business environment?

Penciakova: Yes. Remember, we're talking about few firms, and the core of this paper—the question—is, does it matter for the aggregate economy? And the reason it does is because the firms that get funded actually end up punching above their own weight. And so really what I mean by this is—we see it in our own lives, in everyday life—because firms like Facebook, Amazon, and Google all got funded by venture capital funding.

Heintjes: And they're household names now.

Penciakova: They're household names, they matter for the market, they matter for employment. And so because venture capital funding is a form of investment, and some of these firms end up becoming publicly listed, one way they matter is in terms of that market. Jeremy Greenwood, one of my coauthors, has another paper with two coauthors, Pengfei Han and Juan Sanchez, where they show that back in the 1980s venture capital–financed firms accounted for only 4 percent of firms that were publicly listed. Today it's 20 percent, and they account for 20 percent of market capitalization. So in terms of the market economy, venture capital funding matters. But in our paper we focus more on the real side of the economy—things like employment and innovation—and what we show is that while amongst all firms in the U.S. economy, venture capital–funded ones are only about 0.1 percent, they—over a 10-year horizon—account for about 4 percent of total employment in the U.S. So they're really punching above their own weight.

Heintjes: That really is above their weight. Your research mentions the importance of a firm having a patent or trademark early in its existence. What's the importance of this? Is it because of the importance of intellectual property (IP), or does the importance extend beyond just IP?

Penciakova: We think it does extend beyond just IP, and one way to think about it is in terms of a signaling device. There can be various ways of thinking about this. One is, as I mentioned, most firms in the U.S. that start don't grow—and in fact, don't have any intention of growing. And so the very fact that there are startups in the economy that are getting early patenting and early trademarks might be an indication that these firms are different, that they have some intention to become larger—to grow. Now from a financing side, there's an additional signal that they're sending. What they're sending is a signal that "my idea is novel," because to get a patent, to get a trademark, you have to prove that your idea is novel. So it's a signaling device both in terms of wanting to grow, and in terms of having a novel idea.

Heintjes: And that's obviously appealing to VC.

Penciakova: Absolutely.

Heintjes: Well, why would a firm have no intention of growing? You mentioned that, and to me that's a remarkable statement. Why is that?

Penciakova: Well, you can think of a lot of different sectors where you don't need to become a Facebook or an Amazon, right? Think about restaurants. Restaurants, generally—there are some conglomerates, but they are generally small. You can also think about dry cleaners, mom-and-pop shops. There are a lot of businesses out there when you think about your neighborhood, for example, that are not part of the Walmarts, that are not part of the Targets. And so there are a lot of firms like that in the economy.

Heintjes: Sure, great points. Veronika, is there a difference between a firm that seeks backing from a more traditional bank and one that attracts VC backing?

Penciakova: Yes, and we've already started talking a little bit about this. So when you think about it from the point of view of a venture capitalist, what they're really looking for is a firm that shows a lot of promise. You can think about the fact that firms that are going to get venture capital funding are going to be these firms that show a lot of promise. And so what you see, and we show in our paper, is that firms that get venture capital funding tend to be younger. So for example, about 57 percent of firms that eventually get venture capital funding actually get it by the time they hire their first employee. And in addition, because they want the most promising firms, they're also going to be looking for firms that are growing. So venture capital-funded firms are some of the fastest growing in the early years and also have some of the most promising early patents.

Heintjes: I see. Are there traits that VC backers tend to look for—common traits among the firms that will attract VC?

Penciakova: Like I mentioned before, venture capitalists have this incentive to find the most promising startups, and there can be different ways that they think about it. One, you're going to have firms that are young. About 57 percent of firms that get funded get funded by the time they have their first employee. They're also looking for firms that are innovative, so it's going to be these firms that have early patents or trademarks. They're going to be firms that have good business ideas or are entering into markets that maybe are growing. And then also you want firms that have an intention to—and have shown a promise to—grow. That's why you're going to also get VC funding going to firms that are fast growing in something like their first three years. Those are actually things that we emphasize in our paper, and we see in the data.

But there's also a paper by Gompers, Gornall, Kaplan, and Strebulaev where they actually do a survey of VC funders, and they find in addition to these tangible things that we just talked about, there are other more intangible aspects that venture capitalists care about. Those can be things like the quality of a management team, or those kinds of factors that are harder to quantify in the data.

Heintjes: You mentioned the importance of VC to young firms, and I wanted to drill down into that a little bit more. Your research says that over 40 percent of VC-funded firms receive their first funding in their first year as an employer business, and about 15 percent of them receive their first funding before they even hire their first employee. Why is this? Is it because their core idea has such a strong appeal to VC backers that there's a rush to get in on the ground floor of the next big thing?

Penciakova: So that's certainly part of it, Tom, but you can also think about it both in terms of why it's advantageous from the point of view of the firm that's getting funded—so the startup—and also of the VC that's doing the funding. So from the point of view of the startup, there's a lot of cost associated with starting a business, right? You have a lot of fixed costs associated with building your team, with bringing your idea to scale or to market, with finding a customer base, and all of that stuff costs money. And so venture capitalists can come in early and provide that kind of financing. But on top of that, there's also a reputation that comes with being able to actually get venture capital funding, and that might, moving forward, help the firms or the startups grow their business even more. And then the other thing that we emphasize in our paper is that—and we'll talk about this, I think, a little bit more—is that venture capitalists provide additional value to the firms that they fund. They're going to be able to provide some expertise that helps keep them moving forward and growing. And the best time from the point of view of a firm that's getting funded, that they can benefit from that advice, is going to be when they're pretty young.

Heintjes: And how about from the point of view of the VC funder, from that side?

Penciakova: There are several reasons, and you've touched on some of them. They want to find the next big thing because this is going to be the kind of venture that can possibly succeed, and it can bring them a lot of profits in the future. But on top of that, these VCs a lot of times are pretty hands-on, and so they're going to be able to have a bigger influence in molding the trajectory of the firm the earlier that they get involved.

Heintjes: But not all VC backers are created equal, are they? What characteristics do successful VC backers demonstrate that maybe are exceptional?

Penciakova: Absolutely—just as not all startups are the same, not all venture capitalists are the same. And there's actually some research going on that is trying to understand what makes some venture capitalists more successful than others. In particular, there is a paper by Nanda, Samila, and Sorenson that emphasizes the importance of early success of venture capitalists—so these funders being in the right place at the right time when they were founded. And what that does is it builds a reputation, and it can mean that better deals or better startups are approaching these venture capitalists, and that perpetuates their success. Another important thing is going to be networks, because as I mentioned, venture capitalists play a pretty hands-on role with the firms that they fund, and so having a broad network that they can use to connect the startups with customers or experts in their area can be beneficial.

Heintjes: So I guess that speaks to the role of VC experience.

Penciakova: Exactly, and that's how we summarize it in the context of our paper. We think that VC experience—and the way we measure it, in particular, is going to be the number of deals that they're involved in—is going to speak to these various aspects that I just discussed. What it's going to do is, if you've been involved in more deals, you're likely to have a bigger network. And because you've been involved in so many deals, you're likely to have had some early success that has let you continue to participate in this industry.

Heintjes: In your paper, Veronika, you write about the importance of the match between the VC backer and the firm, and that match can matter more than the actual money the backer brings to the table, can't it?

Penciakova: Absolutely. And so up until this point we've been talking about this channel, in terms of the importance of venture capital funding, as these venture capitalists targeting promising startups, but they play this additional role. As I've mentioned a couple of times, they can be pretty hands-on, and so in our paper we emphasize the importance of the synergies that are going to exist between the funder and the firms that they fund. And the synergies can take what kinds of forms? Well, we can look at this paper by Gompers and coauthors that surveyed venture capital funders, and what they found is that 60 percent of VCs actually interact on a weekly basis with the firms that they fund. And more than that, over 80 percent of them provide strategic guidance. Two thirds of them provide operational guidance, and on top of these important contributions, they also help firms connect to customers—they help even in the hiring process of board members and down to employees.

Heintjes: I guess that's more than a traditional bank would bring to the arrangement.

Penciakova: Exactly. And so while both funders—VC funders and banks—provide financing, VC funders, through their experience, provide these additional benefits that can support firm growth and innovation moving forward.

Heintjes: You write that a VC-funded startup that reaches the top 10 percent of firms has a much higher employment level than a non-VC-funded firm. For example, a non-VC-funded firm has only 16 percent of the employment of a VC-funded startup—that's "sixteen," not "sixty." What explains this discrepancy? That's pretty dramatic.

Penciakova: So this dramatic discrepancy is actually coming exactly through these two channels we've been talking about. On the one hand, the firms that are getting funded are already better than the average firm in the U.S. economy. So part of that discrepancy is going to be coming from just the higher overall quality of the firms. But the second aspect is the second channel. It's the synergies that exist between VC funders and the firms that they fund. In our paper, what we do is we compare the employment trajectory of firms that are funded by venture capitalists with other firms that never get funding, but that look similar whenever they're young. We find the discrepancy continues, and we think that part of that is actually coming from the networks, the expertise, that the venture capitalists are able to provide—which facilitate and foster the subsequent employment growth and innovation of the startups.

Heintjes: The nonfinancial traits, right?

Penciakova: The nonfinancial, exactly.

Heintjes: Veronika, one striking fact that you note in your research is, for every VC-funded startup there are more than a thousand non-VC-funded startups. And while they account for only 0.1 percent of all startups, VC-funded startups account for 3.7 percent of total employment 10 years after their first funding. I actually had to read that more than once to make sure I wasn't misinterpreting it. That's pretty remarkable.

Penciakova: Absolutely, it is. And this is exactly why we thought it was interesting and important to think about venture capital funding and its importance for the aggregate economy, because the firms that these VCs fund end up punching above their weight so much. And there are two reasons why this is probably happening: one is they're funding already better firms, right? They have higher quality patents to start with, they're growing fast early in their life. But beyond that, what we've been talking about is all of this additional value that venture capitalists are providing to the firms that they're funding via expertise, networks, and subsequent funding. This means that they're providing a supportive environment for these firms to succeed. They're providing an environment that allows them to invest in their growth, to invest in subsequent innovation. And all of this allows them to grow and become these important firms for the aggregate economy, both in terms of employment and ultimately innovation.

Heintjes: You note that VC-backed startups own an outsize share of patents. We've touched on IP some today, and I want to drill down a little more deeply into intellectual property. Non-VC-funded startups have only 20 percent of the patents that VC-funded startups have. Is that partly because VC backers, as you noted earlier, tend to seek out opportunities that include intellectual property?

Penciakova: That's certainly part of it. As a VC backer, you want to back ventures that are potentially novel, and in order to be able to get patents and have those patents approved, you need to prove that your idea is in fact different and it's novel, and it can provide something new to the market. And so that targeting or the identifying of promising startups is certainly part of it. But the other thing is, making subsequent innovations is costly, and it requires knowing what the market needs, it requires financing, it requires a lot of investment—both monetarily and in the form of expertise. And as we've talked about, these are precisely the kinds of things that venture capitalists can help provide to firms, either through their own expertise or through the expertise of their networks.

Heintjes: Veronika, in your paper you conduct what I thought was a really interesting thought experiment in which VC is shut down. Why don't you describe for us briefly the results of this experiment?

Penciakova: This is a great question because up to now we've really been talking about the empirical side of our paper, stuff that we can see in the data. So what we can see in the data is the impact that venture capitalists have on individual firms, but it's harder in that data to get a sense of how important venture capital is for the aggregate economy. So what we do is we build a model where we think about these two channels through which venture capital is going to matter. They're going to matter because they're better able to target firms that have higher quality, and they're also going to be able to provide additional value—these synergies that exist between venture capitalists and firms. And we put that in a model and we say, "Okay, now let's think about some thought experiments. What if we shut each of these channels down?"

So the first thing we start off with is shutting down the channel by which these venture capitalists are targeting the promising firms. So what we do essentially is put a blindfold on the venture capitalists and just let them randomly choose firms to fund. If we do that then growth declines by 1 percent, which is kind of small. And so what that tells us is that yes, venture capitalists are trying to find the best firms, but sometimes they're not successful. So we go to the other extreme and we say, "All right, what if instead we just put high quality firms in front of venture capitalists?" If we do that—so we're improving their ability to target—growth is higher by 9 percent, and so that really speaks to the importance of this targeting channel. Now the second channel that we've talked about is the ability of the financiers to provide extra value or expertise to the firms that they fund. And so now what we do in our second thought experiment is shut that channel down. It still means that firms are getting financing from venture capitalists, but they're not getting any additional value—so essentially, venture capital funding becomes equivalent to getting money from a bank.

Heintjes: And what do you find?

Penciakova: And we find that this channel is super important, because if you shut it down, growth declines by over 20 percent.

Heintjes: Wow.

Penciakova: Absolutely, yes. And so in all, through this thought experiment what we really show is that venture capital funding matters for the aggregate economy, and it matters through these two channels: through the ability of venture capitalists to identify promising startups, and also in their ability to provide additional value and foster the subsequent growth and innovation of the startup.

Heintjes: Wow. That's more than one fifth—that's a remarkable statistic. Well, Veronika, that's about all the time we have today, but I really want to thank you for being on the podcast. I hope it's one of many subsequent appearances.

Penciakova: Thanks so much, Tom. This has really been delightful.

Heintjes: I want to note that we'll have a link to the research we've been discussing on our website at frbatlanta.org. I encourage you to look at it, as it's very interesting and it delves into matters that we hear about a lot these days. And that's all for this episode of the Economy Matters podcast. I'm Tom Heintjes, managing editor of the Atlanta Fed's Economy Matters magazine, and I hope you'll also check out Economy Matters on our website at frbatlanta.org. I also hope you'll join me here next month for a new episode, when we'll talk to the Atlanta Fed's Nancy Donahue about different approaches to preventing and combating data breaches. Thanks for being with us today.