The Impact of Venture Capital Monitoring

• DOI: http://doi.org/10.1111/jofi.12370
• Date: 01 August 2016
• Author: RICHARD R. TOWNSEND,XAVIER GIROUD,SHAI BERNSTEIN
• Published date: 01 August 2016

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 4 •AUGUST 2016

The Impact of Venture Capital Monitoring

SHAI BERNSTEIN, XAVIER GIROUD, and RICHARD R. TOWNSEND∗

ABSTRACT

We show that venture capitalists’ (VCs) on-site involvement with their portfolio com-

panies leads to an increase in both innovation and the likelihood of a successful exit.

We rule out selection effects by exploiting an exogenous source of variation in VC

involvement: the introduction of new airline routes that reduce VCs’ travel times to

their existing portfolio companies. We confirm the importance of this channel by con-

ducting a large-scale survey of VCs, of whom almost 90% indicate that direct flights

increase their interaction with their portfolio companies and management, and help

them better understand companies’ activities.

IT IS OFTEN ARGUED that venture capital (VC) plays an important role in promot-

ing innovation and growth. Consistent with this belief, governments around the

world have pursued a number of policies aimed at fostering VC activity (Lerner

(2009)). However, evidence that the activities of VCs actually play a causal role

in stimulating the creation of innovative and successful companies is scarce.

It could be the case, for instance, that VCs simply select companies that are

poised to innovate and succeed, even absent their involvement. In this paper,

we examine whether the activities of VCs do affect portfolio company outcomes.

An ideal experiment to establish the impact of VCs would be to randomly

provide certain companies with VC funding and others not. Such an experi-

ment would eliminate the selection of companies (“screening”), thus allowing

us to estimate the effect of VC involvement (“monitoring”).1Unfortunately, it

∗Shai Bernstein is with Stanford University, Graduate School of Business. Xavier Giroud is

with the MIT Sloan School of Management, NBER, and CEPR. Richard Townsend is with the

Tuck School of Business at Dartmouth College. We are grateful to Michael Roberts (the Edi-

tor), two anonymous referees, Bo Becker, Jos´

e-Miguel Gaspar, Yael Hochberg, Dirk Jenter, Anna

Kovner, Josh Lerner, Laura Lindsey, Holger Mueller, Francisco P´

erez-Gonz´

alez, David Robinson,

Antoinette Schoar, Rob Seamans, Scott Stern, as well as seminar participants at Columbia (GSB),

Dartmouth (Tuck), Duisenberg School of Finance and Tinbergen Institute, EFA (Lugano), EPFL

and University of Lausanne, Economics of Entrepreneurship and Innovation Conference (Queen’s),

HKUST,Harvard (HBS), LBS Private Equity Findings Symposium, MIT (Sloan), MIT Micro@Sloan

Conference, NBER Entrepreneurship Meetings, Nanyang TechnologicalUniversity, Northeastern,

Northwestern (Kellogg), Norwegian School of Economics, SFS Finance Cavalcade (Georgetown),

Singapore Management University,Stanford (GSB), UCSD (Rady), UNC (Kenan-Flagler), Univer-

sity of Bergen, University of Illinois at Chicago, University of Maryland (Smith), and University

of Miami School of Business for helpful comments and suggestions. The authors declare that they

have no relevant or material financial interests related to the research in this paper.

1Kaplan and Str¨

omberg (2001) review the screening and monitoring roles of VCs and emphasize

the difficulty of disentangling them.

DOI: 10.1111/jofi.12370

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1592 The Journal of Finance R

is quite difficult to identify a setting that convincingly approximates this ex-

periment. That being said, another useful experiment would be to randomly

vary VC involvement after initial investments are made. This would allow us to

identify the effect of VC involvement, holding company selection fixed. In par-

ticular, if differences in outcomes for VC-backed companies are driven purely

by selection, postinvestment involvement of VCs should have no effect. In this

paper, we attempt to approximate this second experiment.

The source of exogenous variation in VC involvement that we exploit is

the introduction of new airline routes that reduce the travel time between

VC firms and their existing portfolio companies. Previous work suggests that

travel time reductions lower monitoring costs for firms with headquarters that

are geographically separated from their production facilities (Giroud (2013)). If

VC activities matter, reductions in the cost of monitoring should translate into

better portfolio company performance by facilitating VC’s ability to engage in

these activities.

To obtain direct evidence on whether VC involvement increases following

reductions in travel time, we conduct a large-scale survey of VC investors. Al-

most 90% of the 306 survey participants agreed that they would visit a portfolio

company more frequently following the introduction of a direct flight. Survey

participants also agreed that the introduction of a direct flight would help them

establish better relationships with management teams, improve their under-

standing of the state of their companies, and generally add more value. This

qualitative evidence supports our underlying assumption that VC involvement

is responsive to the introduction of direct flights, and is consistent with aca-

demic literature showing VC activity is sensitive to geographic proximity.2

We next explore how the introduction of new airline routes that reduce the

travel time between VCs and their portfolio companies affects company-level

outcomes. The primary outcomes we examine are the quantity and quality of

innovation (as measured by patent count and citations per patent, respectively),

as well as success (as measured by exit via initial public offering (IPO) or

acquisition). Using a difference-in-differences estimation framework, we find

that the introduction of a new airline route leads to a 3.1% increase in the

number of patents the portfolio company produces and a 5.8% increase in

the number of citations per patent it receives. Furthermore, the treatment

increases the probability of going public by 1.0% and the probability of having

a successful exit (via IPO or acquisition) by 1.4%. These results indicate that

VC involvement is an important determinant of innovation and success.

A natural concern is that local shocks, in the region of either the VC or the

portfolio company, could be driving the results. For example, a booming local

economy may lead to both increased innovation and the introduction of a new

airline route. In this case, we may estimate a spurious positive effect of travel

time reductions on innovation. However, since our treatment is defined at the

2For example, Lerner (1995) finds that VCs are more likely to sit on boards of geographically

proximate companies. Chen et al. (2010) further find that VCs are more likely to invest in a distant

region if they already visit one portfolio company in the region.

The Impact of Venture Capital Monitoring 1593

VC-portfolio company level, we can control for such local shocks. Specifically,we

include Metropolitan Statistical Area (MSA) by year fixed effects for the MSAs

of both the VC and the portfolio company. Moreover, we find that pre-existing

trends are not driving our results, and the results are robust to considering only

new airline routes that are the outcome of a merger between two airlines or the

opening of a new hub. Such treatments are likely to be even more exogenous

to any given VC-portfolio company pair.

We provide further evidence on the underlying channel through which these

effects operate by taking advantage of the fact that certain VCs should be

more sensitive to changes in monitoring costs than others. VCs often syndicate

their investments. When this occurs, one typically takes the role of the lead

investor.The lead investor is generally more actively involved in the monitoring

of the portfolio company, while others act more as passive providers of capital

(Gorman and Sahlman (1989)). Given that lead VCs play a greater role in

monitoring, their monitoring effort should be more sensitive to reductions in

monitoring costs, as should portfolio company performance. We find that our

results are indeed driven primarily by reductions in travel time for lead VCs

rather than other members of the investment syndicate.

Our paper contributes to a growing literature that studies the effect of VCs

on portfolio company outcomes. Much of this literature tries to disentangle VC

monitoring from screening by comparing outcomes of VC-backed and non-VC-

backed companies (e.g., Hellmann and Puri (2002), Chemmanur,Krishnan, and

Nandy (2011), Puri and Zarutskie (2012)). These papers are valuable given the

scarcity of data on young companies that are not affiliated with a VC. However,

even if both groups of companies are matched on the basis of observables,

it is possible that VCs select companies with higher potential ex ante—an

inherently unobservable characteristic. In contrast, our setting allows us to

identify the effect of VC monitoring while holding selection fixed, as we exploit

exogenous reductions in monitoring costs after initial investments are made.

Other papers rely on structural modeling. In particular,Sorensen (2007) models

the two-sided matching of VCs and entrepreneurs to structurally estimate the

relative importance of VC monitoring and screening as explanations for why

companies backed by more experienced VCs outperform. Similarly,Kortum and

Lerner (2000) structurally estimate industry-level patent production functions

with corporate R&D and VC as inputs to compare their relative potency. Our

paper differs from these studies in that it does not require any structural

assumptions for identification.

Our paper also contributes to a large, mostly theoretical literature that ex-

plores how financial contracts shape the interaction between entrepreneurs

and VC firms, alleviating moral hazard and agency problems. For example,

several papers consider the optimal contractual arrangement that leads both

entrepreneurs and VCs to contribute effort to promote a venture’s success in a

double moral hazard setting (e.g., Schmidt (2003), Casamatta (2003), Inderst

and Mueller (2004), Hellmann (2006)). Other theoretical work highlights the

importance of contractual arrangements on the VC refinancing versus termi-

nation decision (e.g., Cornelli and Yosha (2003), Repullo and Suarez (2004),