The geography of venture capital and entrepreneurial ventures’ demand for external equity☆
Introduction
Venture Capital (VC) investors are considered a fundamental source of finance for entrepreneurial ventures (Gompers and Lerner, 2001, Gorman and Sahlman, 1989, Kaplan and Strӧmberg, 2001, Sapienza, 1992). However, the number of VC-backed companies is small: in 2016, only 3134 companies in Europe (source: Invest Europe 2017 yearbook) and 7750 companies in the U.S. (source: NVCA 2017 yearbook) received VC.
One prominent reason for such a limited number of VC-backed companies is the fact that VC investors carefully screen investment opportunities and select for their investments only a tiny fraction of the proposals they receive: 2% according to Fried and Hisrich (1994), even lower based on Petty and Gruber (2011). While this “supply-driven” motivation for the small number of VC-backed companies has been studied at length in the literature, the demand side of the issue has received much less attention. Mason and Harrison (2001) identify three demand-side factors that can explain why so few companies obtain VC. First, the quality of many entrepreneurial ventures that look for VC is simply not high enough to attract VC investors. Second, even ventures with good prospects may fail to secure VC if the presentation skills of their owners are not adequate to impress VC investors. Third, entrepreneurs may simply not look for VC at all.
Most of the ventures created by these latter entrepreneurs are probably of low quality, and entrepreneurs correctly anticipate that they would be unattractive to VC investors. However, there might be entrepreneurs who abstain from seeking VC in spite of the high quality of their ventures. This issue has not received adequate attention by previous studies, in spite of its potential importance. The thickness of the VC market depends on both the supply and the demand for VC (Gans and Stern, 2010, Roth, 2008). If entrepreneurs who may have a chance of obtaining VC abstain from seeking it, the VC market becomes thinner and the likelihood of an effective match between entrepreneurs and VC investors decreases (Bertoni et al., 2018).
In this paper, we contribute to filling this gap. We look at the demand for VC and argue that the costs and benefits associated with VC investments, as they are anticipated by entrepreneurs, depend on the location of their ventures with respect to prospective VC investors. VC is an expensive source of funding for entrepreneurs (Brav, 2009, Bruno and Tyebjee, 1985) considering the dilution of ownership, the transfer of control rights and the direct search costs associated with establishing contacts and negotiating with VC investors. Arguably, geographic distance increases such costs and decreases the potential benefits of VC. If entrepreneurs with high-quality ventures anticipate that the costs of VC backing may outweigh its potential benefits because of geographic distance from prospective VC investors, they may not be willing to look for VC, with negative implications for the aggregate demand for VC, especially in peripheral regions.
Studying how ventures’ location influences the demand for VC contributes to enlarge the scope of the literature on the “geography of VC” (Chen et al., 2010, Cumming and Dai, 2010, Lindgaard Christensen, 2007, Sorenson and Stuart, 2001). The geographical distribution of VC investments is not even; most investments are concentrated in specific areas such as Silicon Valley, the Boston and New York metropolitan areas in the U.S., and the London and Paris metropolitan areas in Europe.1 The literature has focused on the supply side of the market to explain the uneven geographical distribution of VC investments. VC investors are spatially concentrated in “VC hubs” that are located in financial centers and high-tech regions, and exhibit a strong tendency to invest nearby.2 A few studies have suggested that the uneven geographical distribution of VC investments may also be a reflection of demand-side factors, as companies in peripheral regions are less likely to seek VC (Bertoni et al., 2016, Bertoni et al., 2018, Mason and Harrison, 2002). We take a further step by investigating how geographical distance, national borders and the characteristics of prospective VC investors influence the stimulus generated by the availability of VC on ventures’ demand for VC.
These issues are especially important for European ventures. The low level of VC investments in Europe compared with the U.S. and the fragmentation of the European VC market into separated national markets are considered prominent reasons for the underdevelopment of the European high-tech entrepreneurial ecosystem (European Commission, 2007). Elucidating how the location of European ventures and VC investors influences ventures’ demand for VC may help to clarify the source of the European anomaly.
Accordingly, our empirical investigation is based on a sample of 533 European high-tech entrepreneurial ventures extracted from the VICO database. The VICO database includes information on young high-tech ventures located in seven European countries – Belgium, Finland, France, Germany, Italy, Spain and the United Kingdom – and is particularly appropriate for our analysis. VICO is designed to include companies that are very likely to be potential targets for VC investments. The European dimension of the VICO database offers an ideal test bed to assess the impact of national borders on ventures’ demand for VC. The availability of VC differs remarkably across European countries and regions. In addition to two large VC hubs located in the London and Paris areas, several other VC hubs are heterogeneously distributed in other countries (Martin et al., 2005, for instance, show that in Germany, the VC industry is spread across six hubs). The panel dimension of the VICO database is also interesting for our purposes. Our dataset includes observations between 1984 and 2009, which gives us the opportunity to observe the development of the different VC markets over 25 years.
The 533 VICO companies included in our sample are the respondents of a survey that was administered in 2010. The survey asked ventures whether and when they actively looked for external equity3 in the first 15 years of their existence. We complement company-level information from the VICO database with longitudinal VC market-level data on the availability of VC across European regions and the level of competition in local VC markets. The latter information is extracted from Thomson One.
Our results show that proximity to VC hubs where there is a large availability of VC is a key driver of ventures’ propensity to look for external equity, but this effect rapidly declines with geographical distance and vanishes beyond 250 km. It also vanishes when crossing national borders. The negative effect of distance from prospective VC investors on the demand for VC varies with the characteristics of those VC investors in terms of their ownership and governance (Bertoni et al., 2015, Dimov and Gedajlovic, 2010) and reputation (Nahata, 2008, Pollock et al., 2015, Sorensen, 2007). Independent (i.e., US-style) VC investors have a strong positive effect on the demand for external equity in a radius of 250 km, while for governmental VC investors (i.e. VC firms owned by governmental bodies), the corresponding effect is much weaker, disappearing beyond 50 km. With respect to reputation, the stimulating effect on the demand for VC of highly reputed VC investors extends to ventures that are located abroad. In addition, we find that the level of competition (proxied by concentration) in local VC markets does not significantly influence ventures’ propensity to look for external equity. Finally, we investigate the effects of cultural and institutional differences across countries on the demand for VC and find that national borders represent a lower barrier if the cultural and institutional distance between two countries is lower.
Our findings are robust to endogeneity issues due to the potential reverse causality between location and the demand for external equity,4 concerns related to the attractiveness of our sample companies for VC investors, a possible non-response bias, the Internet bubble period, the presence of multi-office VC firms and changes in the model specification.
The paper proceeds as follows. In Section 2, we build on the existing literature to develop the theoretical framework of this study. In Section 3, we present the data used in our econometric analysis. In Section 4, we describe the econometric model. We discuss the main results and robustness checks in Sections 5 and 6, respectively. In Section 7, we provide additional evidence illustrating how the negative effects of geographical distance and national borders on the stimulus on the demand for external equity generated by the availability of VC depend on the characteristics of VC investors and cultural and institutional difference between countries. In Section 8, which concludes the paper, we summarize our main results and discuss the study's contribution to the VC literature, the study's limitations, directions for future research, and the study's managerial and policy implications.
Section snippets
The expected costs and benefits of accessing VC and the demand for VC
The benefits of VC are well documented. First, the injection of financial resources reduces financial constraints in entrepreneurial ventures (Carpenter and Petersen, 2002). Second, the “coaching” of entrepreneurial teams by VC investors and the network of contacts they bring to their portfolio companies enhance their value (Gorman and Sahlman, 1989, Sapienza, 1992).
Despite these benefits, only a minority of firms seek external equity (and VC) to finance their businesses (Ou and Haynes, 2006,
Sample
We test our predictions on a panel dataset composed of 533 European high-tech entrepreneurial ventures that were potential or actual targets of VC investments and responded to an online survey we administered in 2010. The sample companies were extracted from the VICO database,7
Dependent variable
In this section, we describe the econometric model used to test our predictions regarding ventures’ demand for external equity. Our dependent variable measures whether the sample entrepreneurial ventures looked for external equity in a particular calendar year. To build this variable, we used the answers that our 533 sample companies gave to the survey questions on whether and when they had ever sought equity finance from sources other than founders, their family members and their friends. We
Results
We use a panel random effects model to estimate the linear probability that company i looks for external equity in year t.14
Robustness checks
We performed several robustness checks based on the weighted distance specification, which we show in Table 5. Robustness checks based on the radius specification are shown in Table A1 in Appendix A. Results are similar across the two specifications and consistent with the estimates illustrated earlier, with few exceptions (e.g., the lower statistical significance of the VC_availability_national_50_250 variable in the radius specification).
The first concern one could raise is that potential
Additional analysis
In this section we investigate the effects of several moderators of the relationship between the geography of prospective VC investors and companies’ demand for external equity. We focus on the ownership and governance of VC investors and their reputation and on the institutional and cultural distance between the country of the focal company and those of VC investors. For this analysis, we use the compact radius specification. Indeed, the need to simultaneously calibrate several distance
Discussion and conclusion
The aim of this paper was to assess how the location of entrepreneurial ventures and of prospective VC investors influence ventures’ propensity to look for external equity. For this purpose, we have examined the external equity-seeking behaviour of a sample of 533 European high-tech entrepreneurial ventures, which we observe during their first 15 years of existence in an unbalanced panel covering a 25-year period (1984–2009). Our results indicate that the positive effect of the availability of
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We acknowledge support from the 7th EU Framework Programme VICO project on “Financing Entrepreneurial Ventures in Europe: Impact on Innovation, Employment Growth, and Competitiveness” (Contract no. SSH-2007-1.2.3-G.A. 217485). We are thankful to the Douglas Cumming and Minjie Zhang for their precious help in the collection of data on bankruptcy laws in European countries.