Exchanges of innovation resources inside venture capital portfolios

Abstract

I explore the prevalence of exchanges of innovation resources inside venture capital portfolios. I show that after companies join investors’ portfolios, several proxies of exchanges between them and portfolio companies (relative to matched nonportfolio companies) increase by an average of 60%. The increase holds when joining events are plausibly exogenous and when VCs’ bargaining power and potential conflicts of interest are low. Three novel mechanisms are supported: carve-outs, spawning, and recycling, whereby entrepreneurs divest innovation units, start new ventures, and reuse assets in other portfolio companies, respectively. Results suggest that returns to innovation are higher in venture capital portfolios.

Introduction

Young companies’ difficulties in profiting from inventions have long been recognized by academics and policy makers alike. In almost all cases, the successful commercialization of an innovation requires the inventor's knowhow to be combined with other innovation resources that the original inventor lacks and seldom develops herself (Teece, 1993).¹ The challenge lies in the many frictions that can obstruct exchanges of innovation resources among young firms. For example, firms’ investments may be constrained by information asymmetries, expropriation risk can prevent inventors from selling their inventions (cf. Arrow, 1975), and conflicts in arranging complete contracts can preclude trade (cf. Allen and Phillips, 2000).

In this paper, I explore the prevalence of exchanges of innovation resources between companies sharing common venture capitalists (VCs). As strategic investors, VCs have incentives to finance firms with complementary innovation resources in an effort to increase investment returns; for example, by internalizing innovation spillovers (cf. Teece, 1980, Hellmann, 2002) or increasing product prices (cf. Azar et al., 2018). In theory, VCs can also facilitate innovation exchanges; for example, by punishing expropriation behavior (e.g., as advisors and board members; see Lerner, 1995 and Hellman and Puri, 2002), bridging information asymmetries (e.g., in their role of screeners and monitors; see Sørensen, 2007 and Kaplan and Stromberg, 2001, Kaplan and Stromberg, 2002), or financing otherwise constrained firms. In practice, however, competition for investors could also obstruct collaboration inside investors’ portfolios (cf. Fulghieri and Sevilir, 2009). Ultimately, how prevalent exchanges of innovation resources are inside VC portfolios is an open question.

The main obstacle in exploring this question is that directly observing exchanges of innovation resources, especially among young, private companies (the usual targets of VCs) is not possible: no public markets for innovation resources exist. However, I can, and do, look for empirical evidence inside venture capital portfolios of measurable cross-company interactions that typically lead to the successful commercialization of industrial innovations (as validated by prior work), such as patent citations (Hall et al., 2005, Kogan et al., 2017), patent reassignments (Akcigit et al., 2016, Serrano, 2010, Hochberg et al., 2018), worker mobility (Almeida and Kogut, 1999, Kaiser et al., 2015, Azoulay et al., 2012), strategic alliances (Mowery et al., 1996, Stuart, 2000, Gomes-Casseres et al., 2006), and mergers and acquisitions (cf. Teece, 2010, Seru, 2014). I use an event time framework that exploits differences in both the timing when and the investors from which companies secure venture capital. I focus on innovative US companies that were financed by US VCs, and filed at least one patent in the US Patent and Trademark Office during the 1976–2008 period.

The results show that after companies join the portfolio of a VC for the first time, several proxies of exchanges of innovation resources between them and other companies in the VC's portfolio (portfolio exchanges) increase by an average of 60% (over the sample mean) relative to exchanges between them and matched nonportfolio companies (nonportfolio exchanges). The increase holds for both portfolio exchanges led by joiners and those led by portfolio firms, and is robust to excluding companies with within-portfolio alliances (cf. Lindsey, 2008). The data support three novel mechanisms of within-portfolio exchange: carve-outs—whereby restructuring companies divest some of their innovation units inside the portfolio, spawning—whereby entrepreneurs move on to start new companies also financed by the same VCs, and recycling—whereby the residual assets of restructured companies are absorbed by other portfolio firms.

My interpretation of these results is that portfolio exchanges can be facilitated and used as a basis for investment selection by VCs. Consistent with potential selection effects, there is evidence that some portfolio exchanges begin to increase before the joiners enter the portfolio. On the other hand, the relative increase in portfolio exchanges is concentrated in some situations where, absent common VCs, such exchanges may not arise. For example, the increase is larger for exchanges financed by portfolio companies that are in the same industries as joiners, and thus possibly subject to expropriation risk and negative product rivalry effects, unless a common VC serves as arbiter.

Other more mechanical explanations are less consistent with the findings. For example, potential industry, scale, technology, and location clustering effects have limited ability to explain the results. Nonportfolio and portfolio companies are matched by technological focus, size, industry, and geography, and any fixed differences between them are absorbed by the difference-in-differences nature of the methodology. Unobserved differences between companies in and out of the venture capital industry cannot explain the findings either: results continue to hold when I instead use a matching methodology based on amounts of venture funds raised as well as company age, location, and technology. A battery of robustness checks shows that results are also not driven by influential observations at the state, firm, or company levels or by serial correlation and spurious trends.

The main implication of the results is that exchanges of innovation resources appear prevalent in venture capital portfolios. As the successful commercialization of inventions typically requires such exchanges, results suggest that returns are higher when innovations are backed by VCs.² This suggestion is consistent with the salience of VCs in the finance of high-value innovation: since the 1980s, patents awarded to venture capital-backed companies amount to circa 6% of US patent grants and command twice as many citations (a standard proxy of innovation value) as patents awarded to other types of owners (see Online Appendix 1 and González-Uribe, 2013). However, whether such potential higher returns trickle down to original inventors is unclear and hard to test: VCs face a complex set of incentives, and no comprehensive data exist on return distribution between investors and founders. While alternative interpretations cannot be fully ruled out, additional results provide some supporting evidence that potential returns trickle down to founders. In particular, I show that exchanges continue to increase in situations where VCs’ conflicts of interest and bargaining power over founders are plausibly low (such as when the portfolio companies involved in the exchange with the joiner are mature firms that the VCs have likely already exited because they entered the portfolio more than five years prior).

The question remains: if companies were randomly assigned across venture capital portfolios, would sharing a common VC causally facilitate exchanges of innovation resources? If so, this would constitute evidence of an additional channel through which VCs could add value to their investments (cf. Sørensen, 2007) and provide some support for the policies worldwide that encourage the development of venture capital markets (see Lerner, 2009). Answering this question is, however, challenging given the low feasibility of a large scale randomized trial in the venture capital setting.

Here, I exploit the staggered adoption of “prudent man rules” (PIR), which allow local pension funds to invest in venture capital across states in the US, as plausible exogenous variation in the composition of local VCs’ portfolios (cf. González -Uribe, 2013).³ I estimate that a state's PIR adoption increases the capital commitments to the local venture capital industry that are made by local state pension funds by 175 million USD (relative to pension funds located elsewhere), possibly because of home bias in state pension funds’ venture capital investments (see Hochberg and Rauh, 2013).

I show that this influx in local venture capital commitments indeed changes the composition of local VCs’ portfolios. PIR adoption in a state roughly doubles the mean probability that joiners first enter local VCs’ portfolios, conceivably because these investors have more capital to invest, rather than because of happenstance shocks to the joiners’ potential for cross-company exchanges. This influx also increases (roughly triples) relative portfolio exchanges, even in subsamples of joiners and portfolio companies that are located outside VCs’ home states (and further, also outside of “coincidental states” that adopt PIR at the same time as the home states of VCs), which mitigates concerns that results are driven by the endogeneity of PIR adoption (or the potential impact of PIR adoption on other local investments not related to venture capital). I present evidence against other methodological concerns such as aggregate trends in PIR adoption, California and/or Massachusetts effects, and biases from mis-measurement in the actual implementation dates of PIR adoption across states. Under the assumption that PIR adoption in VCs’ home states does not disproportionately increase relative portfolio exchanges through channels other than portfolio joining events, these additional results constitute evidence that sharing common VCs causally facilitates exchanges of innovation resources.

This paper contributes to the literature on organizational design and innovation (e.g., Seru, 2014, Branstetter and Sakakibara, 2002, Spence, 1984, Bernstein and Nadiri, 1989). As described by Teece (2010), the most significant transformation in the organization of corporate innovation during the last five decades has been the shift away from centralized laboratories (popular in the 1950s) toward new, more decentralized models such as horizontal and vertical alliances across firms. My contribution is to show that VCs appear to select their investment portfolios based on the potential for these organizational models. Moreover, the PIR adoption results suggest that VCs can also facilitate some of these organizational models among young companies, where, absent common owners, frictions such as information asymmetries may prevent them from arising on their own.

This paper also contributes to the literature on the role of venture capital in the real economy (e.g., Kortum and Lerner, 2000, Mollica and Zingales, 2007, Hirukawa and Ueda, 2008, Popov and Rosenboom, 2009, Bernstein et al., 2016). Most related work quantifies the contribution of VCs but remains agnostic about how VCs contribute. My results point to one potential mechanism through which venture capital can influence innovation: appropriation of innovation returns inside VCs’ portfolios. This mechanism is consistent with theories on how investors’ portfolios provide complementary resources to support venture capital-funded firms (Hellman, 2002) and are reminiscent of prominent VCs’ claims on how common cross-company collaborations are in their portfolios. Relative to the wider literature on private equity, results show that the role of this industry in the redeployment of innovative assets to efficient use extends to venture capital and is not confined to the long-documented role of buyout funds (cf., Jensen 1989; Kaplan and Stromberg, 2009).

My work is most closely related to Lindsey (2008), who shows that strategic alliances are disproportionately likely among companies sharing common VCs. Using a different methodology and sample, I show that the potential role of VCs in expanding firm boundaries is much more extensive than previously known and how it ranges from informal knowledge exchanges to more formal transfers of human and other capital resources. In addition, I offer new evidence on the timing of these exchanges, make a first pass at parsing selection from causal effects, and introduce three novel complementary mechanisms of within-portfolio exchange. My work also relates to Gompers and Xuan (2012), who explore mergers and acquisitions when the bidder and target share a common VC. There, however, the focus is on merger announcement returns and the structure of such transactions.⁴

The rest of this paper proceeds as follows. In Section 2, I describe the data. In Section 3, I explain how I measure portfolio exchanges. Section 4 describes the empirical strategy and shows that there are significant increases in relative portfolio exchanges after joiners first enter VCs’ portfolios. In Section 5, I describe the PIR adoption effect on the local venture capital industry and on relative portfolio exchanges. Section 6 concludes the paper.