Venture Capital and the Performance of Incumbents

Abstract

I study the effect of investment in young, private firms by venture capitalists (VC) on public firms in the same industry. I construct an instrument for VC investment that relies on individual VC's investment histories, holdings of equity stakes in IPO firms, and aggregate market returns immediately following those IPOs. I find that increased VC investment has a large effect on incumbent profitability.The effect arises due to higher costs and not depressed sales. The effect is short lived as firms respond by reallocating resources away from treated markets and by reducing their use of labor. * Federal Reserve Board of Governors; email: tim.dore@frb.gov. I would like to thank Paul Gompers, Steven Kaplan, Tobias Moskowitz, Marina Niessner, Robin Prager, Savina Rizova, Amir Sufi, and Jhe Yun for their comments and suggestions and seminar participants at the Federal Reserve Board of Governors and the University of Chicago and conference participants at the 2014 Conference on the Dynamics of Entrepreneurship for insightful comments. All errors are my own. The analysis and conclusions set forth are those of the author and do not indicate concurrence by other members of the staff, by the Board of Governors, or by the Federal Reserve Banks. Any opinions and conclusions expressed herein are those of the author and do not necessarily represent the views of the U.S. Census Bureau. All results have been reviewed to ensure that no confidential information is disclosed. 1What effect does venture capital (VC) investment have on incumbent firms? VCs have financed several of the largest companies in the United States -including Amazon, Apple, Facebook, and Google -and the success of these firms has led directly to the decline of previous industry leaders. More broadly, VC-backed firms grow and innovate at much higher rates than other firms; while Puri and Zarutskie (2012) find that only 0.13% of firms founded between 1991 and 2005 ever received VC investment, VC-backed firms accounted for 35% of IPOs, 8% of granted patents, and received 14% of patent citations between 1991 and 2007. This strong growth suggests that VC investment may create important competition for established firms.At the same time, the nature of the industry -investing in young firms with little to no revenue -means that VC investment typically results not in industry leaders but instead in failed firms. For instance, VCs invested approximately $100 billion in firms in 2000 but only 6% of those firms grew large enough to go public. Moreover, 43% of firms that first received a VC investment between 1998 and 2000 failed by 2005 (Puri and Zarutskie 2012). The frequent failure of these firms suggests that VC investment might have little effect on incumbents.In this paper, I study the effect of VC investment on the profitability of public incumbent firms. Estimating this effect is complicated by the fact that the econometrician does not observe the true set of investment opportunities but VCs and firms do. When there is a positive shock to investment opport...

When to Buy and Sell the Shares of the Publicly Traded Rivals of a Firm Making an Initial Public Offering: A New Model

“…Chod and Lyandres (2011) showed that a firm's IPO affects the value of their rivals' products negatively. Dore (2015) related a firm´s increase in equity with the negative returns of its rivals. He argued that the effects are due to an increase in costs and not a decrease in revenues.…”

“…Recently, Dore (2015) linked the increase of equity (positive share supply shock) with rivals' negative returns. He showed that venture capital investment in small private firms provoked a negative effect on the returns of their publicly traded rivals.…”