The Geography of Venture Capital Expansion

One of the most important determinants of the number of VC offices in a region is success rate for all previous VC investments in that region.

Relative to the amount of capital invested, venture capital backed companies have disproportionately contributed to the creation of jobs, market value, and revenue to their local economies. As a result, states and municipalities are competing for the establishment of venture capital investors' offices in their communities.

In Buy Local? The Geography of Successful and Unsuccessful Venture Capital Expansion (NBER Working Paper No. 15102), authors Henry Chen, Paul Gompers, Anna Kovner, and Josh Lerner examine the location decisions of venture capital (VC) firms and the impact that venture capital firm geography has on investments and outcomes. They analyze data for 2,039 VC firms in the period 1975 to 2005, including their office locations and that of the businesses in their investment portfolios.

Currently, about half the VC firms and an equal percentage of the U.S.-based companies that they finance are concentrated in just three metropolitan areas - San Francisco/San Jose, Boston, and New York, which the authors refer to as "venture capital centers." Those VC firms outperform VC firms based elsewhere, regardless of the stage of the investment. These superior returns may result in part from the most successful venture capital firms being located in these three cities, with their reputations allowing them to be among the first to see the most interesting investment opportunities, regardless of the geographic region of the company.

VC firms tend to open satellite offices in cities where other VC firms already operate, rather than in regions with few other VC firms. This is consistent with VC firms chasing the success of other VC firms. "In fact, one of the most important determinants of the number of VC offices in a region is success rate for all previous VC investments in that region," the authors write.

However, "much of the VC outperformance in these venture capital centers arises from their non-local investments," that is investments outside of the three VC centers. That may be because VC firms apply more rigorous standards when considering new investments further away from their office base, since they expect to incur a higher monitoring cost of that business.

The location decisions of VC-backed businesses are affected by a number of factors. Entrepreneurs seeking VC capital may choose to locate their businesses in areas that are close to potential VC funding sources, but they also may be attracted to regions with pools of talented employees and academic researchers, which have been shown to result in a higher success rate for new ventures.

This study finds that one VC-backed success in a new geographic area usually leads to additional VC investment in other businesses in the region. "We find evidence that a venture capital firm's existing investments in a region affect expected success on other deals in that region, (so) bringing first-time venture capital investors to a region may be more effective than subsidizing existing investors."

Another interesting finding is that " some of the performance disparity between local and non-local investments disappears when the venture firm does more than one investment in a region, suggesting that (as) the marginal monitoring cost falls, venture capital firms may reduce their expected success rate for investment in a distant geography."

Therefore, if local governments outside the nation's three VC centers seek to attract VC branch offices, one strategy they might consider is providing support to VC-backed businesses in their communities. The study concludes that "anything that policymakers do that contributes to an increase in the number of successful venture-backed investments in a region will also increase the probability of a venture branch office opening in that region."

-- Frank Byrt