Dynamics of High-Growth Young Firms and the Role of Venture Capitalists
By Yoshiki Ando
Among all newly established firms in the United States since 1980, only around 0.2% of them have raised venture capital (VC) financing. Nonetheless, VC-backed firms accounted for more than 10% of net employment growth and more than 15% of net payroll growth in the economy. Moreover, they represent more than 30% of firms that went to initial public offerings. Thus, despite the small fraction of VC financing, it may matter for aggregate outcomes and for the firms that receive it. In the working paper “Dynamics of High-Growth Young Firms and the Role of Venture Capitalists,” the author examines the role that VC financing plays in fostering high-growth firms relative to other sources of financing and its macroeconomic implications.
The paper first documents descriptive evidence: VC-backed firms raise large upfront investments, are more R&D intensive, and have a high chance of achieving substantial growth. Specifically, a median VC-backed firm raises funding more than ten times its revenue at age 0. The chance of achieving high growth, as defined based on early growth and eventual firm size, is more than 20 times higher than for non-VC-backed firms. Conversely, relative to non-VC equity financing, VC investors acquire around 3.3% extra equity stakes in observationally similar financing deals.
This study develops a firm dynamics model consistent with these facts and explains the growth of VC-backed firms over the life cycle. Built on a state-of-the-art firm dynamics model that explains heterogeneous firm growth by ex-ante growth potential and ex-post productivity shocks, the model takes into account firms’ decisions on innovation investments and the source of financing. In the model, high-potential firms that require large funding for innovation investments choose equity-based funding instead of bank financing, as they would face a high bank loan rate due to their high default probability. Relative to non-VC-equity financing, VC investors provide managerial advice in exchange for extra equity stakes. The model calibrated with the data implies that VCs’ advice accounts for around 22% of VC-backed firms’ growth, separately from the sorting effect and the benefit of equity financing.
In general equilibrium, counterfactual analysis implies that VC financing enhances aggregate output and consumption by around 0.2% and 0.4%, respectively, in the long run. The findings suggest that the impact of VC financing on the economy is sizable but not as large as estimates by previous studies in the literature.