Labor Rights, Venture Capital, and Firm Performance

• DOI: http://doi.org/10.1111/fima.12137
• Date: 01 March 2017
• Author: Xuejing Xing,Shan Yan,John S. Howe,Randy I. Anderson
• Published date: 01 March 2017

Labor Rights, Venture Capital, and Firm

Performance

Xuejing Xing, John S. Howe, Randy I. Anderson, and Shan Yan∗

We investigate the role of labor unions in the performance of venture capital (VC)-backed firms.

Using a large sample of initial public offering firms from 1983 to 2013, we find that VC-backed

firms in highly unionized industries have lower Tobin’s Q and are less likely to survive. This

effect is robust to endogeneity concerns and to controlling for industry and firm characteristics.

The findings suggest that strong labor rights impede innovative firms’ performance and survival,

thereby adversely affecting innovation,economic growth, and employment.

In recent years, new legislation to weaken labor rights has generated considerable debate

among policy makers and academics.1Proponents of this legislation argue that strong labor

rights impede economic development, increase unemployment, and decrease job growth (Bruno,

2015). Empirical evidence on these claims, however, is scarce and mixed. In this paper, we

contribute to the debate by providing the first systematic evidence on the role of labor unions

in the performance of venture capital (VC)-backed firms. This venue is particularly attractive

because labor unions are synonymous with strong labor rights and because VC-backed firms play

an important role in economic growth (Samila and Sorenson, 2011; Puri and Zarutskie, 2012).2

Building on Tirole’s (2001) view that firm stakeholders interact in the “stakeholder society,”

we posit that when venture capitalists (VCs) meet unions, they confront each other as powerful

stakeholders with conflicting interests. The confrontation is a natural reflection of the fact that

labor unions provide employeesbargaining power and VCs typically are controlling shareholders.

When both parties are powerful, the usual conflict between shareholders and employees could

become even more pronounced (John, Knyazeva, and Knyazeva, 2015), which makes it difficult

for the manager to balance interests and set priorities (Tirole, 2001). Thus, the interaction between

VCs and unions could hamper the efficiency of the firm, and as a result, the joint effect could

be more negative or less positive than either individual effect. We therefore hypothesize that the

We are extremely grateful to an anonymous referee and Raghavendra Rau (Editor) for their guidance. Both provided

insightful and detailed comments that immensely improved the paper. All errors areour own.

∗Xuejing Xing is an Associate Professor of Financein the College of Business at the University of Alabama in Huntsville,

AL. John S. Howe is a Professor of Finance and the Missouri Bankers Chair in the Trulaske College of Business at the

University of Missouri in Columbia, MO. Randy I. Anderson is President at Griffin Capital Asset Management in El

Segundo,CA. Shan Yan is an Assistant Professor of Financein the Department of Management at Susquehanna University

in Selinsgrove, PA.

1In March 2013, right-to-work lawswere enacted in Michigan, prohibiting membership of a labor union as preconditions

of employment. “This controversiallegislation generated a signif icant amount of media attention not onlybecause of the

enormous power and presence of labor unions in Michigan, but the legal, political, and economic ramifications in this

state and beyond are enormous, particularly as other states grapple with passing similar laws” (Bradley,Kim, and Tian,

2016, p. 5).

2Although VC-backed firms account for only a relatively small fraction of US privatecompanies, they are a major source

of innovation, employment,and economic growth (Hand, 2008). According to the National Venture Capital Association,

VC-backed firms in 2010 employed over 11.9 million US workers and generated $3.1 trillion in sales, equal to 11% of

US private sector employmentand 21% of US g ross domestic product.

Financial Management •Spring 2017 •pages 129 – 154

130 Financial Management rSpring 2017

presence of both VCs and unions or the combination of VC involvement and strong labor rights

leads to poor firm performance.

To test this hypothesis, we construct a sample of 32,987 firm-year observations for initial

public offerings (IPOs) from 1983 to 2013. As a measure of the strength of labor rights, we use

the industry unionization rate, following a large number of studies (e.g., Klasa, Maxwell, and

Ortiz-Molina, 2009; Chen, Kacperczyk, and Ortiz-Molina, 2011, 2012; Chen, Chen, and Wang,

2015). We find that VC-backed firms with stronger labor rights (i.e., greater unionization rates)

have significantly lowerTobin’sQ than other f irms. In the long run, such firms are also less likely

to survive than other firms. The results are consistent with the notion that strong labor rights

impede the performance of VC-backed firms.

Although the industry-level measure of labor strength makes possible the use of a large sample

and accounts for the spillover effect of unionization, it has an obviousshor tcoming: the extent of

unionization at the industry level might be correlated with other industry characteristics. Thus,

it is possible that the variable captures an industry effect rather than a labor rights effect. To

address this issue, we follow Chen et al. (2011, 2012) and explicitly control for industry effects

in two ways. First, we include in our analyses fixed effects for all two-digit Standard Industrial

Classification (SIC) industries. Second, we control for a number of variables that proxy for the

stages of the industry’s life cycle. In both cases, we find that our results remain qualitatively the

same.

Another potential concern regarding the analysis is endogeneity. VC backing and union orga-

nization are not random assignments but choices made largely by VCs and unions, respectively.

If this choice is based at least partially on factors that also adversely affect firm performance,

our analysis would suffer a classic selection problem. Fortunately, this scenario is unlikely in

our setting because both VCs and unions are widely known to select better firms that are more

likely to survive and succeed (e.g., Brav and Gompers, 1997; DiNardo and Lee, 2004; Matsa,

2010; Lee and Mas, 2012; Cao, Jiang, and Ritter, 2015). Thus, if anything, the selection of VCs

and unions would make us underestimate, rather than overestimate,their negative impact on fir m

performance.

To further alleviate the endogeneity concern, we conduct a couple of empirical tests. First,

we examine whether the effects of labor rights in VC-backed firms are more pronounced in

high-tech industries. Our premise is that if the results we document are due to labor rights instead

of alternative scenarios (e.g., selection), they should be stronger when these rights matter more

(e.g., in firms that benef it from flexible and volatile labor markets). We find that the effects are

particularly strong in high-tech firms, which rely heavily on flexible and volatile labor markets

(Benner, 1999; Bozkaya and Kerr, 2014). Second, we account for the possibility that VCs might

select certain industries using an instrumental variable (IV) approach based on Ackerberg and

Botticini (2002).3In implementing this approach, we follow Bhattacharya, Borisov, and Yu

(2015) and construct local markets for the IPO firms in our sample by interacting the fir ms’

industries with their geographic locations (i.e., states). Using dummy variables for these local

markets as instruments for VC backing in a two-stage least squares (2SLS) framework, we find

that the negative effect of VC backing and unionization on Tobin’s Q and firm survival becomes

significantly stronger. This finding is consistent with the notion that VCs tend to back better

firms.

Our paper contributes to the literature in several ways. First, we provide new evidence that

strong labor rights hamper innovativefirms’ perfor mance and survival,thereby adversely affecting

3We focus on the role of VCs in the selection process because at the industry level,unionization is likely to predate VC

backing. This is particularly true for IPOs issued in the post-1980 era.