How Venture Capital Competition Can Turn Sour

Over the past three decades, the number of venture capital (VC) firms in the U.S. has more than quadrupled. Venture capital has come into its own in Canada as well. According to the Canadian Venture Capital and Private Equity Association, Canadian VCs invested $4.4 billion in COVID-19-ravaged 2020, second only to the feverish activity in 2019. 

With more VCs considering stakes in promising entrepreneurial projects, it’s worth asking whether the funded firms are better off as a result of the competition. Clearly, startups that would not have otherwise received VC funding benefit. But that’s not the entire story.

A recent study analyzed the relationship between the number of VC firms chasing deals and the rate of successful exits for VC-backed startups. Does all that activity lead to more successful exits via initial public offering (IPO) or acquisition? 

What did the study find?

• Highly-experienced VC firms tend to fund more successful startups, and relatively inexperienced VCs tend to fund less successful startups. Companies funded by VC firms in the top 10 per cent in terms of investment experience have a 24 per cent likelihood of a successful exit. In contrast, only 17 per cent of companies funded by VC firms below the top 10 per cent successfully exit.
• More VC firms competing for a given number of investment opportunities increases company valuations across the board. That is, VC firms get lower equity positions in the companies they fund, leaving more equity to the founders. 
• As the VC market becomes more competitive (when a common economic measure of industry concentration decreases by 50), the likelihood of a successful exit improves by 2.8 per cent for startups backed by less experienced VC firms. But the likelihood of a successful exit decreases by 3.6 per cent for startups backed by the most experienced VC firms. 

How was the study designed?

This study was based on a theoretical model tested by real-world data. The investment data included the dates and investment amounts for various financing rounds, the identities of VC firms, the development stages and industry groups of portfolio companies and the dates and types of exits (IPO, acquisition or liquidation). The final sample contained 5,254 VC firms in the U.S. investing in 12,246 portfolio companies that received their initial funding between 1991 and 2010. 

What do I need to know?

Why would greater competition among VC firms have a negative effect on the success rates of the most innovative startups? This is particularly odd considering these stars tend to benefit from the support and strategic knowledge of the most experienced VC firms.

The researchers suggest this can be explained by the lower equity positions that these VC firms hold in their portfolio companies due to greater competition. Less equity means less incentive to actively manage these companies. The effect for less innovative startups is not as pronounced, as VC firms have larger equity positions in these firms to begin with.

If greater VC competition diminishes the number of nascent star companies—the seedlings of innovation and economic growth—it raises a thorny issue for policymakers. In many places, it is de rigueur for governments to offer capital gains holidays, R&D subsidies and other inducements to spur ever more venture capital flowing from the private sector. If such measures create a more competitive VC market, more projects will be funded and successfully exit. But the most promising and innovative among them may struggle to stand on their own after the financing rounds are over.

“Given that high-quality startups are more likely to promote innovation, growth and employment in a region,” the researchers conclude, “policies that result in a more competitive VC market structure ought to take this differential effect of competition on success into account.”

Study Title: Competition in the Venture Capital Market and the Success of Startup Companies: Theory and Evidence
Authors: Suting Hong (Shanghai Tech University), Konstantinos Serfes (Drexel University), Veikko Thiele (Smith School of Business)
Published: Journal of Economics and Management Strategy