Venture Capital

Venture Funding Signals Growth Strategy

LIMITED RESOURCES, lack of market history, and inability to widely communicate product quality make it difficult for most startups to survive. Prior research indicates that venture capital funding is the most significant resource for entrepreneurial success—it allows for faster product-to-market turnover and enables a company to “professionalize” management teams quickly. (See Stanford Business, “Making Startups Grow Up,” February 2001, and “Venture Capital: More Than Money,” June 1999.)

But how much does the amount of funding or its timing matter? New research by GSB faculty suggests that initially the amount is less important than the fact that venture funds were invested at all. Later on, the amount and timing significantly affect a startup’s growth path.

“There is a big difference in the relationship between VC firms and startups in early rounds of funding compared to later rounds,” says Antonio Davila, assistant professor of accounting and Morgridge Faculty Fellow in Entrepreneurship for 2001–02. “In early rounds, the startup needs money to think and try things. Money allows you to fund the ‘idea generation process.’ In later rounds, you have to implement a specific strategy.”

Early-round funding is typically used to increase a company’s intellectual capital by hiring new employees as well as bringing existing employee salaries up to the market average, Davila says. Later-round funding allows venture capital firms to more directly affect the specific strategy of a startup company’s growth. VCs invest less cash when they want to guard against growth that is too aggressive and more cash to assist in faster growth than a startup could fund on its own.

Overall venture capital activity grew from $2.3 billion in 1990 to $140 billion in 2000, according to Venture Economics. But it’s not the nineties anymore, and the economy is suffering a heavy dose of reality. As Davila says, being a venture capitalist is like playing for the NBA. “In the nineties everybody thought, ‘I could be Michael Jordan.’ But the truth is that most people are not Michael Jordan.”

To reach their conclusions, Davila and his coauthors, Stanford colleague George Foster and Mahendra Gupta of the John M. Olin School of Business at Washington University in St. Louis, began by analyzing payroll data from 606 entities covering January 1994 through May 2000. The data were useful in determining the effects of specific funding rounds on company growth.

The team examined both the number of employees and average salaries around the timing of financing events and compared the amount of funding made available. The results indicated that the average salary is lower before early rounds than at any other point, which is consistent with the financial constraints of startups. And in early rounds, the specific amount of funding is not as important to growth as the fact of the funding itself. In later rounds, growth happens both before and after the funding event, which suggests that later-stage startups have the resources to grow, as soon as the signal of an upcoming round is credible enough. And in later rounds, the amount of funding has a significant impact on the subsequent growth strategy of the company.

Davila and his colleagues use signaling theory developed by retired GSB dean A. Michael Spence, one of last year’s Nobel laureates, to explain some of their results. Each funding event communicates information internally to the employees and externally to the larger market. The researchers measured the internal signal by tracking employee turnover and found that in early rounds, turnover significantly decreased before the funding event, which suggests that the signal has credibility even before the salaries go up. “Employees start to believe that it will happen (not necessarily through a public announcement but simply because of the comments in the company) and decide to stay in the company. Believing that is going to happen is what we call the credibility of the signal,” Davila notes. “It tells the employees, ‘Hey, we’re a good company.’”

How should entrepreneurs take advantage of this information? Davila cautions them: “When you think about a VC, you shouldn’t think, ‘I’m getting money,’ as if you were going to a bank, and it doesn’t matter which bank. Here it makes a lot of difference, because the venture capital investment firm is going to affect the way you implement your strategy and the way you grow your company.”

—LISA EUNSON

The Impact of Rounds of Venture Capital Funding on the Growth Strategy of Startups, Antonio Davila, George Foster, and Mahendra Gupta, GSB Research Paper #1727, November 2001