Venture capital funding validates a startup, research shows

Lessons learned by startups during the dot-com hiring frenzy may have lasting benefits, according to a study conducted by Washington University Olin School of Business professor Mahendra Gupta.

His paper, “Venture Capital Financing and the Growth of Startup Firms,” which focuses on the role human capital plays in starting a company, has been accepted for publication in the Journal of Business Venturing. Journal editor Sankaran Venkataraman called the paper noteworthy in its comprehensive examination of how human capital relates to success, the internal processes of a firm, and team characteristics. Companies able to get venture capital funding had an advantage over those who were able to find funding resources but not thru v.c. funding. They had an advantage not only through monetary resources but also a validation. “What this paper does is look at three very different constructs and puts them in one study, a very valuable contribution to our understanding of this area,” said Gupta.

Mahendra Gupta
Mahendra Gupta

Gupta, senior associate dean and professor of accounting, said while he and his co-authors, Stanford University Graduate School of Business professors Antonio Davila and George Foster, had done research on management and control issues previously, they could find no clear documents on what happens when human capital gets involved in the dynamics of a growing business, specifically, when venture capital is involved.

In the study, which uses data gathered from 1994 to 2000 in 494 mainly Silicon Valley-based companies, they write: “Our basic theoretical premise is that uncertainty and information asymmetry governs the relationship between startups and external markets—labor and financial markets.” The premise, they note, is consistent with prior work that adopted an agency or risk perspective. “However, we adopt a signaling theory framework. We argue that the presence of uncertainty about the future of the startup and asymmetry of information among the players in the game enhances the value of particular events — funding rounds — as potentially valuable signaling mechanisms. Building on this argument, we develop hypotheses relating firm employee growth with funding events. We also examine the association between growth in human capital and firm valuation.”

Gupta said they started out looking at the incremental knowledge of how startups evolve and perform. Next, they examined the extent the interaction of venture capital plays as a signaling role to the labor market. The money itself is not the signal that will attract and retain the right kind of talent, but the source of the money, he said.

And when the source is a venture capital firm, it sends a signal that the startup is a credible entity because those firms must perform extensive due diligence on the companies in which they are investing. Essentially, they do the legwork for potential laborers who typically would not have the resources, time, or money to do it on their own. Further, when a venture capital firm decides to invest, it is seen as an assurance to current and potential employees.

“What we found is that the companies able to get venture capital funding had an advantage over those who were able to find funding resources but not thru v.c. funding,” Gupta said. “They had an advantage not only through monetary resources but also a validation.”

Gupta said it is important to secure the validation, but what is even more important is from whom the validation comes. “Getting money from mom and pop is not going to have the same bearing as getting money from an outside investor. Venture capital firms also come with a network — accounting firms, law firms, and executive search firms — that can help build and sustain a startup’s infrastructure. And even though there may not be as much venture capital funding floating around as there was a few years ago, the study’s results are still valuable.

“I don’t think this is unique to the time period. The lessons learned here are universal, not restricted to the dot-com era or a geographic area. When it comes to the human capital growth of a startup, the lessons will apply to any startup,” Gupta said. “If you are talking about a lawn-mowing startup, there’s going to be less uncertainty there. If you are going to invest in new technology or new innovations, these lessons are going to be very applicable. Even though we documented human capital growth, we believe there is similar phenomena for most growth elements.”

Gupta said the study confirmed what they expected, but there was at least one unexpected aspect. “We were surprised by the intensity of the effect of the signal,” he said. “We didn’t think we would get that strong a result.”

Also, the research findings have led Gupta and his partners to do a follow-up study, “Staging Venture Capital: Empirical Evidence on the Differential Roles of Early Versus Late Rounds.” Gupta said it is still a working paper, but it builds upon the ideas from their previous paper, examining the questions: Do cash constraints more severely limit growth in early funding rounds than in later rounds? And is the signaling value of these funding events larger in early rounds compared with later rounds?