Dynamics of High-Growth Young Firms and the Role of Venture Capitalists

The role that venture capital (VC) plays in helping promising startups achieve high growth is examined. Three facts are documented from administrative US Census data and proprietary VC datasets. First, VC-backed firms achieve substantial growth in employment and payroll compared to non-VC-backed firms. Second, VC-backed firms typically raise funding more than 10 times their revenue at age 0 and intensively invest in research and development. Third, venture capitalists acquire around 3.3% extra equity stakes relative to Angel investors. Based on the evidence, I develop a firm dynamics model with endogenous firm productivity and choice of financing from VC, Angel (non-VC-equity) investors, and banks. Venture capitalists provide equity-based funding and managerial advice, but they are in limited supply. The model shows the benefit of VC and Angel financing over bank financing for high-potential firms because of their large investment in innovation, which creates a debt repayment issue with bank financing when innovation is unsuccessful. VC-backed firms achieve substantial growth as a result of endogenous sorting, equity-based funding, and managerial advice. The calibrated model implies that venture capitalists’ advice accounts for around 24% of the growth of VC-backed firms. Finally, policy experiments predict that subsidies to innovation expenditures or equity investments enhance aggregate output and consumption in the steady state in contrast to bank loan subsidies.

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