What, besides money, do venture capitalists contribute to start-up companies? The lack of systematic evidence thus far has led to persistent disagreement about the role of venture capitalists in the economy.
In the new study “How Smart is Smart Money? An Empirical Two-Sided Matching Model of Venture Capital,” University of Chicago Graduate School of Business professor Morten Sørensen investigates venture capitalists’s (VCs) access to different investments in the market and measures VCs’ influence on their investments.
Sørensen finds that more experienced venture capitalists make more successful investments, but VCs and entrepreneurs tend to differ on the reasons behind the experience/ success relationship. Generally speaking, their arguments can be summarized into the “influence” argument and the “sorting” argument. Sorting refers to the phenomenon of top-tier investors tending to invest in the best deals because of their market position. The second-tier investors can then invest in the second-best deals, and so forth down through the market.
Not surprisingly, venture capitalists tend to support the influence argument. When VCs are more experienced, they are able to add more value to a company’s investment. They may work closely with entrepreneurs to monitor and manage their companies, bringing contacts to different networks, and contributing their expertise about growth strategies. The influence school argues that the more experienced investors are better at these things, and that this is the main reason for their better performance.
Entrepreneurs tend to favor the sorting argument, namely that the most successful VCs are successful because they are in a position with access to the best investments to begin with, and that VC skill is less of a factor. Among some entrepreneurs, this view has earned venture capitalists the nickname “vulture capitalists,” reflecting the perception that VCs are investors that prey on entrepreneurs and provide expensive financing, but contribute little added value in return for the high price. Is the performance of top-tier VCs a result of their market position or their influence on their investments, or both? What is the value of having a top-tier investor involved in a deal?
To separate and measure the effects of influence and sorting, Sørensen developed a new statistical model of the market for venture capital. He studied a sample of 1,666 investments by 75 venture capitalists over a 14 year period, and he found that investments by the most experienced investors were almost twice as likely to result in public offerings as investments by the least experienced investors. Sørensen found a substantial amount of sorting in the market. More specifically, more experienced investors tend to invest in late-stage companies and biotechnology companies—companies that are more successful on average. But, there also is a significant element of influence, and when two investors invest in similar companies, the more experienced investor is more likely to turn it into a successful investment.
“The effects of VC influence and sorting are both present in the results, which meshes with the opinions of people in the industry,” notes Sørensen. “While the result may not be surprising, what is new is being able to take the two effects and put them through a statistical model to determine how much of each effect there is in the market.”
Sørensen’s model built on an existing matching model called the College Admissions Model, which was developed to study the matching between students and colleges. In this market, students typically want to attend the best colleges and colleges want the best students. In the end, the best students end up attending the best colleges, the second-best students attend the second-best colleges, and the same kind of sorting results.
In fact, there is a very similar distinction between influence and sorting in start-up communities and in the educational system. In the latter, students graduating from better schools tend to perform better after graduation. The question is to what degree this is because better schools better educate their students and to what degree it is due to the fact that better schools can attract better students. Because of this close similarity, the College Admissions Model provides a natural starting point for the modeling of the market for venture capital.
In Sørensen’s model, on one side of the market is the investor/VC firm and on the other side is the entrepreneur/ company. A company prefers a more experienced investor who is able to add more value. For each VC firm at the time of each of the investments, Sørensen calculated the VC’s experience by counting the number of previous investments the VC had participated in. The experience measure is taken as a measure of the VC firm’s abilities and reputation. The investment’s performance is simply measured by whether the company eventually goes public. Sørensen combines the two-sided model that matches VCs and companies with the specific outcomes of the investments, namely whether the companies go public. The combined model is then estimated simultaneously and it can separately measure the investors’ influence and the degree of sorting in the market.
The study is a large sample study based on the SDC Venture Intelligence (now Venture Xpert) database. For the study, Sørensen used a narrow set of investments involving similar groups of investors and companies. The final sample was restricted to investments made from 1982 to 1995.
After gauging the relative importance of sorting and influence, Sørensen finds that if an investor without any experience were to make random investments, the probability of success (as measured by the likelihood of a public offering) would be 15.1 percent. The observed probability of success for an investor with 225 prior investments (95 percent of the investments are made by investors with an experience of 225 or less) would be 38.9 percent. The difference in IPO rates is 23.8 percent, and Sørensen finds that the influence effect of the more experienced investor accounts for 10 percent of this difference. Sorting accounts for the remaining 13.8 percent of the difference.
In other words, sorting explains approximately 60 percent and investors’ influence explains 40 percent of the increase in IPO rate for the most experienced VCs in the market. Broadly viewed, biotechnology investments are the most successful investments in the study. Sørensen finds that the average biotechnology company has a 39 percent greater probability of going public than the average company in a default group. Biotech companies also attract the most experienced investors, followed by companies in the electronics, medical, and communication industry groups.
Late-stage companies also are attractive to top-tier investors, not only because they go public more often, but also because they go public faster. Again, experienced investors are found to have a larger weight of these companies in their portfolios than less experienced investors. Experienced investors can place a greater weight on late-stage and biotech companies, and this explains part of their superior performance. However, after controlling for this sorting, more experienced investors still add value to their investments, and they can achieve higher rates of success for their investments.
“ For entrepreneurs, the results indicate that VCs are not just ‘vulture capitalists,’” says Sørensen. “The choice of investor does matter, because more experienced investors are associated with higher IPO rates.”
From a general economic perspective, sorting is shown to be an important feature of the market, which has implications for interpreting other studies of the venture capital industry. Prior studies have found systematic differences between VC-backed companies and companies funded by other investors. These studies tend to conclude that these differences are due to the impact of the venture capital investors. However, sorting means that care must be taken when interpreting these differences as being caused solely by investors. Ignoring the effect of sorting may lead to overestimating the influence of VCs by as much as 60 percent.
The positive influence of the investors has a direct economic value, but sorting also may be valuable in terms of facilitating an efficient allocation of capital in the market. With sorting, top-tier investors are able to sustain a reputation for making high-quality investments. This reputation allows them to certify the quality of their investments to the market. Sorting combined with reputation and certification thus creates a way to fund high-quality companies and credibly communicate their quality.
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