November 20, 2019

Veronika Penciakova. Photo by David Fine

You've heard of "the 1 percent." Veronika Penciakova has been pondering the economic significance of the 0.1 percent.

That figure does not refer to the ultra-wealthy. Rather, it represents the tiny fraction of U.S. companies that are financed by venture capital. Despite their small number—some 8,000 firms received venture capital in 2018—those companies have a vastly outsized economic impact, according to new research by Penciakova, a research economist at the Federal Reserve Bank of Atlanta, and coauthors Ufuk Akcigit, Emin Dinlersoz, and Jeremy Greenwood.

Venture capital-backed companies "end up being some of the most successful firms in the economy," said Penciakova, who joined the Atlanta Fed in August.

Punching above their weight

To be sure, young companies backed by venture capital (VC) fail at a slightly higher rate than all companies—over a third are out of business within 10 years. But among those that survive for a decade, "their performance looks completely different from non-VC-backed firms," Penciakova said during an interview. Companies financed by venture capital on average have 38 times the employment of other firms after 10 years and create far more innovation as measured by patents received, her research shows.

Penciakova's work suggests that venture capital "plays a critical role in taking startups to stardom," according to the September paper. "Superstar" companies—Amazon, Google, Apple, Facebook (all VC-backed), and so on—are increasingly playing a dominant role in the U.S. economy.

Venture investing is high risk, high reward

Venture capital is money invested in young companies in exchange for an ownership stake. Investment in unproven firms carries great risk but also great potential rewards that come when the companies are acquired by larger corporations or sell shares in initial public offerings, or IPOs, at prices far higher than those initially paid by the venture capitalists.

Venture capitalists operate on the premise that a few highly lucrative returns will more than outweigh many less successful investments. "They know that a lot of them are going to fail," Penciakova explained. "But they are taking a bet on finding some superstars."

Staffed by seasoned investors who are often accomplished entrepreneurs in their own right, VC firms raise pools of money from "limited partners" including college endowment funds, insurance companies, foundations, public and corporate pension funds, and wealthy individuals. Venture capitalists carefully choose companies to back, and they then advise those companies' founders. In fact, Penciakova and her collaborators found that venture capitalists' expertise plays a significant role in the success of their portfolio companies. (She discussed her new research in an episode of the Economy Matters podcast.)

The VC industry has expanded yet remains comparatively small in the larger universe of finance. Thirty years ago, VC firms in the United States controlled less than $50 billion. At the end of 2018, more than 1,000 VC firms managed more than $400 billion, according to the National Venture Capital Association.

Still, that total is smaller than the assets of some individual private equity firms.

Growing body of research confirms big influence of venture capital

Penciakova and her collaborators are contributing to a growing body of research showing that venture capital is important both in narrow financial terms and in economic performance more broadly.

Consider that in 2015 about 20 percent of public companies had been backed by venture capitalists, compared to 4 percent in 1970, according to a June 2019 paper by Greenwood, Pengfei Han, and Juan Sanchez. The researchers also found that VC-backed public companies account for 35 percent of total research and development spending by public companies. Beyond this, VC-backed public companies hold 35 percent of the highest-quality patents held by public companies, based on a standard measure of patent value. Notably, they reached these levels while being among the less than 1 percent of all U.S. companies that receive VC funding.

Digging into economic dynamism and the role of financing

Penciakova's research focuses on business innovation and the financing of companies. Her recent work blends those interests by exploring how financing affects firm innovation and growth and thus contributions to broader economic performance.

Penciakova coauthored another working paper, this one with Dinlersoz, Sebnem Kalemli-Ozcan, and Henry Hyatt, that examines the effect of bank debt on privately held companies. Also published in September, this work matters because most of what is known about firm financing pertains to publicly traded companies, Penciakova and her coauthors wrote.

Yet, important as public companies are, privately held firms account for more than 70 percent of total employment and 55 percent of gross economic output in the United States. Therefore, it is important to better understand the financing dynamics of these companies, which rely heavily on bank loans for funding, as they lack access to stock and bond markets.

In particular, Penciakova said, it is crucial to grasp how disruptions in the flow of credit influence private companies' performance. The larger goal is to untangle the wider economic implications of credit crunches and their resulting effects on firms.

In brief, the research finds that in normal economic times, short-term bank debt appears to help private companies grow. Not so during the Great Recession, a time that was far from normal. Amid the downturn, many private companies were compelled to pay off debt, and they were unable to borrow more. This dynamic tended to diminish employment and revenue growth, Penciakova and her coauthors found.

"Private firms are more susceptible to the effects of financial shocks that impede lending and borrowing than their publicly traded counterparts who have easier access to different forms of financing," the researchers wrote. Unlike private firms, publicly traded corporations can readily sell bonds or shares of stock to raise capital.

With a wider array of financing options, along with longer-term debt, public companies generally faced little pressure to pare their debt levels during the recession and thus suffered few associated ill effects, the research reveals.

By resolving these sorts of puzzles, Penciakova aims to open windows onto the complex, interrelated forces of company financing and innovation that fuel the macroeconomy.

"I find questions about the dynamics of the economy interesting: How do firms respond to shocks? What aspects of firm financing promote and sustain growth?" she said. "I am interested in the implications of financing and innovation for economic fluctuations and growth."

photo of Charles Davidson
Charles Davidson

Staff writer for Economy Matters