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How Does Venture Capital Financing Improve Efficiency in Private Firms? A Look Beneath the Surface

Thomas Chemmanur, Karthik Krishnan and Debarshi Nandy

Review of Financial Studies, 2011, vol. 24, issue 12, 4037-4090

Abstract: We use the Longitudinal Research Database (LRD) of the U.S. Census Bureau, which covers the entire universe of private and public U.S. manufacturing firms, to study several related questions regarding the efficiency gains generated by venture capital (VC) investment in private firms. First, do VCs indeed improve the efficiency (total factor productivity, TFP) of private firms, and if so, are certain kinds of VCs (high reputation vs. low reputation) better at generating such efficiency gains than others? Second, do VCs invest in more efficient firms to begin with (screening), or do they improve efficiency after investment (monitoring)? Third, do efficiency improvements due to VC backing arise from increases in sales or reductions in costs? Fourth, do VC backing and the associated efficiency gains affect the probability of a successful exit (IPO or acquisition)? Our analysis shows that the overall efficiency of VC-backed firms is higher than that of non-VC-backed firms at every point in time. This efficiency advantage of VC-backed firms arises from both screening and monitoring: The efficiency of VC-backed firms prior to receiving financing is higher than that of non-VC-backed firms, and further, the growth in efficiency subsequent to VC financing is greater for such firms. The above increases in efficiency of VC-backed firms are spread over the first two rounds of VC financing after which the TFP of such firms remains constant until exit. Additionally, we show that while the TFP of firms prior to receiving financing is lower for high-reputation VC-backed firms, the increase in TFP subsequent to financing is significantly greater for these firms, consistent with high-reputation VCs having greater monitoring ability. We disentangle the screening and monitoring effects of VC backing using three different methodologies: switching regression with endogenous switching, regression discontinuity analysis, and propensity score matching. We show that while overall efficiency gains generated by VC backing arise primarily from improvements in sales, the efficiency gains of high-reputation VC-backed firms arise also from lower increases in production costs. Finally, we show that VC backing and the associated efficiency gains positively affect the probability of a successful exit. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail:, Oxford University Press.

Date: 2011
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