Producing new insights and sharing third-party or academic research on the impact of venture capital (VC) is a key focus for Venture Forward in its mission to drive the narrative of VC and inform the public about the critical role the VC industry plays in the U.S. economy. Venture capital as an investment vehicle is oftentimes misunderstood, and startups receiving VC funding can be mischaracterized with other segments of the economy. Research, like the paper highlighted in this blog post that explores the impact of VC investment on large company growth, the benefits that accrue from it, and the regulatory conditions that allow for such growth, is important to both VC investors and industry outsiders in understanding the broader impact of the venture industry beyond financial returns. This post is the second in a series of articles that discusses research exploring the links between VC activity and the broader economy.
Venture Capital’s Contribution to Creating Highly Successful and Innovative U.S. Public Companies
How important is venture capital to the U.S. economy? “Very” is the answer, according to an updated research paper by Professors Will Gornall of the University of British Columbia and Ilya A. Strebulaev of Stanford University. Measuring an industry’s impact on the economy is an interesting endeavor, given the varied approaches in deciding which metrics to focus on and how to measure them. Gornall and Strebulaev’s method of measuring venture capital’s impact focuses on analyzing the contribution of public U.S. companies founded within the last 50 years that were previously VC-backed, and then comparing them to contributions made by all public U.S. companies founded within that same period. This approach neglects the contributions of private VC-backed companies to the economy, but the authors justify their sample selection by noting that the most successful and impactful U.S. companies are publicly owned. The authors point out, for instance, that 79% of the top 500 U.S. companies by revenue are public.
The authors’ findings are striking and underscore the importance of venture capital in developing some of America’s marquee companies that have fundamentally transformed society and reached virtually every American. As an example, the six largest U.S. public companies by market capitalization (Apple, Microsoft, Alphabet, Amazon, Facebook, and Tesla) all received most of their early external financing from venture capitalists. These six companies alone have contributed over $7 trillion dollars to the U.S. stock market over the past decade and account for more than one-quarter of the U.S. stock market growth over that period. Emphasizing the importance of VC to the success of American industry and equity markets is the percentage of U.S. public companies that began as VC-backed startups. Considering only companies founded after 1968 and going public after 1978 (corresponding to the advent of the modern VC industry), VC-backed companies account for half of such public companies by number and three-quarters by market value.
Eye-catching though the contributions to market capitalization might be, just 56% of Americans own stock, according to recent Gallup research, so other findings by the authors may provide a better sense of how venture capital benefits society more broadly. One such finding is the enormous contribution of VC-backed companies to innovative activities. Gornall and Strebulaev find that VC-backed companies account for 62% of research and development (R&D) spending and 48% of patent value for the companies in their sample. Restricting this consideration once again to companies founded after 1968 and going public after 1978, VC-backed companies account for 92% of R&D spending and 93% of patent value. Other statistics that leap out from the study are the number of employees who, as of 2020 or the most recent fiscal year, work at these companies (6.1 million employees), annual revenue ($2.8 trillion), annual net income ($291 billion), and total annual taxes paid ($55 billion).
Regulatory Changes and Their Importance to Fostering a Vibrant VC Industry
An important piece of Gornall and Strebulaev’s study is its exploration of whether VC financing had a causal impact on the success of these U.S. public companies. A skeptic could argue these companies would have flourished without early-stage venture financing and that the correlation between commercial success and VC investment is purely coincidental. To address this critique, the authors reviewed historical regulatory developments in the U.S. that coincided with the rise of the domestic VC industry, followed by a cross-country comparison of contemporaneous VC activity among developed economies.
The crux of this analysis is an evaluation of the impact of the 1974 Employee Retirement Income Security Act (ERISA), which reduced the legal risk for institutional investors to invest in assets perceived, at the time, as excessively risky. ERISA allowed pension fund trustees to invest in the “alternative” asset space for the first time, making it easier for VC funds to secure institutional capital. The 1979 clarification by the U.S. Department of Labor of the “prudent person” statutory standard (also historically referred to as the “prudent man” rule) helped accelerate the rise of these fund types. This standard stated that the “prudence of a particular investment decision should not be judged without regard to the role that the proposed investment or investment course of action plays within the overall portfolio” (i.e., a holistic view of an entire investment portfolio should be used when considering the prudence of any single investment in the portfolio).
Importantly, these regulatory changes were limited to the U.S., and similar adjustments to investment rules did not occur in other developed countries. In peer economies, therefore, pension fund trustees and other managers of substantial long-term capital like insurance companies and bank trusts essentially remained barred from investing in private and illiquid assets. The ERISA reforms thus serve as a useful natural experiment that allows for a comparison of the creation of successful new companies in the U.S. and other large, developed countries.
For this exercise, Gornall and Strebulaev chose to compare developments in the U.S. against contemporaneous occurrences in other G7 countries (Canada, France, Italy, Germany, Japan, and the U.K.). Their findings show a marked difference in the trajectories of VC activity and industrial growth, underscoring the importance of prudent regulation for producing an environment in which companies can scale and thrive as public entities. To summarize their findings: Prior to ERISA, the U.S. was very similar to other G7 countries in terms of new company creation. Following ERISA, a clear divergence can be observed during the following 50 years when the U.S. created numerous new, large companies while other G7 members did not. Significantly, 88 out of the 300 largest U.S. public companies received venture financing, compared to just 11 out of 300 companies in the other G7 companies. Removing the VC-backed companies from the analysis flips the script with the U.S. underperforming other G7 countries, underscoring the important role that venture financing played in the success of America’s largest public companies.
Top International Companies Founded in Each Decade
*Illustration depicts share of top 300 public companies from the U.S. and top 50 public companies from each of the six other G7 countries. Source: Gornall and Strebulaev (2021)
In conclusion, VC activity is closely linked with the success of a large share of the most successful U.S. public companies, unlike in other developed economies. This VC activity can be tied to regulatory changes and clarifications dating back some 50-plus years ago that allowed for the rise of VC funds and more widespread investments by institutional investors into alternative assets. These changes to investment rules of the road were followed by decades of large company creation in the U.S., which has contributed to substantial amounts of innovation, employment, and tax revenue, all of which are beneficial to the economy. If past is prologue and these benefits are to persist, prudent regulation that allows for a healthy VC industry like ERISA and the “prudent person” rule would appear to be essential.