Do Venture Capitalists Earn Their Keep?
Do venture capital firms contribute to the innovation and business success of their portfolio companies or merely back companies that were going to innovate even without VC investment? Shai Bernstein (Stanford Graduate School of Business), Xavier Giroud (MIT Sloan School of Management), and Richard Townsend (Tuck School of Business) suspected that a reduction in the cost of monitoring their investments would lead to greater VC involvement and improved portfolio company performance. Their study found that with the introduction of direct airline routes between VCs and their existing portfolio companies, the number of patents grew by three percent, the number of citations per patent grew by six percent, and the probability of IPO increased by one percent. They also found that better airline connections foster VC flows between urban centres. Giroud discussed the findings at a Queen’s School of Business entrepreneurship conference.
California’s Silicon Valley presents a compelling case study of a strong venture capital market greasing the wheels of innovation. Governments in Canada and elsewhere have taken notice, trying to foster greater venture capital activity, with mixed results.
Finance researchers, however, have wondered whether venture capital (VC) firms truly contribute to the innovation and business success of their portfolio companies or merely back companies that were going to innovate even without VC investment.
It has been a difficult question to answer due to the lack of data and the challenges of conducting a randomized study. Xavier Giroud, assistant professor of finance at MIT Sloan School of Management, working with Shai Bernstein of Stanford Graduate School of Business and Richard Townsend of Tuck School of Business, came up with a novel workaround.
They examined company outcomes, such as new patents and initial public offerings (IPO), following the introduction of direct airline routes between the VC firms and their existing portfolio companies. They suspected that a reduction in the cost of monitoring their investments would lead to greater VC involvement and improved portfolio company performance.
“There is anecdotal evidence that venture capitalists prefer to be a direct flight away from any company in which they invest because they want to keep close tabs on these firms through in-person visits,” says Giroud. Giroud reported on the team’s findings at the Conference on the Economics of Entrepreneurship and Innovation, held at Queen’s School of Business.
“The results indicate that better airline connections foster venture capital flows between regions"
Giroud and his colleagues gathered data on venture capital activity, patent applications, and airline flights between 1977 and 2006. They ended up with 3,157 VC firms and almost 23,000 portfolio companies.
Their hunch paid off. They discovered that the introduction of new airline routes between VCs and their existing portfolio companies led to an increase in innovation: the number of patents grew by three percent and the number of citations per patent grew by six percent. There was also a slight boost in financial fortunes: the probability of IPO increased by one percent.
“Results presented so far indicate that travel time is an important determinant of the performance of portfolio companies,” says Giroud.
The researchers took their study one step further by conducting a regional analysis. They looked at whether the introduction of new airline routes affected aggregate venture capital flows between Metropolitan Statistical Areas (MSA).
Their conclusion: introducing a new airline route between two MSAs led to an almost five percent increase in total venture capital investments as well as a 2.5 percent increase in the likelihood of VC activity between the two urban centres.
“These results indicate that better airline connections foster VC flows between regions,” says Giroud.
If true, the obvious implication is that governments interested in stimulating private equity activity should encourage more direct airline connections to VC hubs.
In Canada’s case, every little bit helps. Venture capital has had an up-and-down history here, bottoming out in 2010 but increasing by 31 percent in 2013, when $2 billion was invested by VC firms in Canadian ventures. According to Canada's Venture Capital and Private Equity Association, 35 percent of VC funds flow to Ontario firms, 30 percent to Québec firms, and 24 percent to B.C. firms.
— Alan Morantz