Venture Capital’s Role in Innovation-Driven Entrepreneurship and Economic Growth

Venture Capital's Role in Innovation-Driven Entrepreneurship and Economic Growth

Producing new insights and sharing third-party or academic research on the impact of venture capital 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 with active management is oftentimes misunderstood, and startups receiving VC funding can be mischaracterized with other segments of the economy. Research, like the one highlighted in this blog post, that quantifies and better explains the positive relationship between high-growth startups on economic growth is important to both VC investors and industry outsiders in understanding the broader impact of the venture industry beyond innovation and financial returns.

Innovation-driven entrepreneurship (IDE) is the principal driver of economic growth among all forms of entrepreneurship. Such is the finding of a growing body of academic literature which distinguishes between the contributions of self-employment, small and medium size enterprises, and technology- and innovation-driven startups to increases in gross domestic product (GDP). A new NBER working paper by Professors Botelho, Fehder, and Hochberg highlights this literature and the fact that a small subset of innovation-driven, high-growth startups are responsible for the bulk of the relationship between entrepreneurship and economic growth. That IDE startups have a principal role in this relationship has important implications for venture capital (VC) and the U.S. economy, since venture funding is the most prominent source of financing for IDE entrepreneurs.

IDE Startups Drive Entrepreneurial Economic Growth

Researchers have documented the contribution of the small business sector (where a small business is defined as an employer firm with fewer than 500 employees, per the research definition of the Small Business Administration) to U.S. GDP for decades. U.S. government estimates  place this contribution at 43.5% of GDP in 2014, down from 48.0% in 1998. Equally important is the contribution of small businesses to GDP growth, a critical factor in the rise of living standards, especially in nations with growing populations. The concepts of entrepreneurship and the introduction of new ideas into the economy are central to current understandings of economic growth.

Entrepreneurs are commonly thought of as the conduits by which new ideas are introduced into the economy through new products and services. This idea goes at least as far back as Schumpeter in the 1940s, who characterized entrepreneurs as engaged in a process of “creative destruction,” displacing existing modes of production with more productive ones. Many researchers seized and built upon Schumpeter’s observations, creating an expansive body of theoretical literature focused on entrepreneurial discovery and economic growth which, in recent decades, has emphasized the importance of new firm entry for economic growth.

The importance placed by researchers on new firm entry gave birth to a belief that business dynamics (the process of firm entry, expansion, contraction, and exit) play a fundamental role in economic growth, with some studies showing that new firms disproportionately drive job growth. However, the growth rate of these new firm entrants exhibits positive skewness (i.e., the probability distribution has a “long” right tail with large outliers driving up the mean), hinting that a smaller subset of high-growth, innovation-driven businesses (IDE startups) is responsible for most of the relationship between entrepreneurship and economic growth (instead of new firms in general). This trend holds not only in the U.S., but also across many other developed countries, underscoring the importance of IDE-run businesses in developed economies compared to “traditional” business entrepreneurs who create new businesses but have little desire to grow, innovate, or bring new products to market.

The Critical Role of Venture Capital to IDE Startups

Access to capital is critical for all entrepreneurial endeavors. According to Professors Botelho, Fehder, and Hochberg, most IDE startups are financed through equity—specifically venture capital—given the high degree of uncertainty surrounding the market value of IDE startups whose main asset is commonly intangible, like intellectual property, and who are incapable of collateralizing loans due to a lack of tangible assets. The high-risk nature of funding IDE startups makes venture capital the most sensible form of financing, since successive rounds of VC financing are predicated upon the achievement of business-related milestones intended to ensure the startup is on a path to success while also reducing the riskiness of the venture. Most IDE ventures fail, and the staged format of venture financing allows VC investors to acquire information and judge the venture’s success over a meaningful period with the option of abandoning the venture entirely if sufficient progress is not made.

Although the provision of capital is paramount, VC investors provide much more than a system of financing well-suited to the uncertain nature of IDE startups. VC investors can also be quite active compared to other types of investors and frequently add value to their portfolio companies through the professionalization of startup teams, advising on time to product market, monitoring behavior, board involvement, improving company governance structures, and producing mutually beneficial relationships between portfolio companies and VCs’ networks. Recent research indicates that IDEs are cognizant of the nonpecuniary value-adding benefits of VC investors and are willing to accept tradeoffs to have access to a high value-adding VC. The performance differential between VC and non-VC backed companies attributed to added value services from VCs has been estimated to equal approximately 40%. And VCs with better networks have been found to add more value to their portfolio companies than VCs with weaker networks.

All this is to say that venture capital may play an even more important role in the fortunes of the macroeconomy than was previously thought. Standards of living only increase when the rate of GDP growth exceeds the rate of population growth. Small businesses, and new firms in particular, have long been thought to play a key role in economic growth. But recent research on the disproportionate role that IDE startups may have in this activity merits further investigation on the relationship between entrepreneurship and economic growth, the nature of IDE startups, and the conditions that best allow them to prosper. Given that venture capital is the most suitable form of financing for innovation-driven businesses, further analysis concerning the circumstances and environments that incentivize VC investment will be important to any subsequent research on how best to promote an economy driven by IDE startups.