Venture capital (VC) has been influential in the growth of innovation ecosystems like Silicon Valley. VCs have traditionally been a primary source of funding for early-stage ventures, but there are recent concerns that they have been turning away from early-stage investing.
For example, according to Crunchbase in the second quarter of 2018, 64% of all VC investment in the US went to late-stage deals, while investments in early-stage deals were at their lowest levels in five years. Regulation might solve this emerging distortion in timing of VC investments if it provided information signals (Spence 1973) to enhance both the market and scientific viability of early stage ventures. Importantly, this new information may cause investments towards early-stage ventures, crossing back to the other side of the so-called 'valley of death' (Hudson and Khazragui 2013) for startups. In our recent work (Kim et al. 2018), we examine one example, namely, the European Union Orphan Drug Act (EU-ODA) and its relationship with VC investments in early-stage biopharmaceutical firms in the European Union (EU).
Some of the decline in early-stage investments by VCs is due to the increasing difficulty of valuing early-stage technologies. It is increasingly difficult to secure early-stage funding (Kerr and Nanda 2011, for example) because of the lack of verifiable measures such as publications, patents, or products necessary for accurate valuation. Instead, many early-stage firms use alternative signals to convey quality. These could come from:
- Status (Stuart et al. 1999, Podolny 1993)
- Star scientists (Higgins et al. 2011, Zucker et al. 2002, Zucker and Darby 1997)
- Alliance partners (Nicholson et al. 2005)
- Angel or venture capital backing (Meggison and Weiss 1991)
- Prestige of underwriters (Higgins and Gulati 2003, Meggison and Weiss 1991)
- University connections (Audretsch and Stephan 1996).
- Recent research has also shown that regulation can also provide signals (Gorry and Useche 2017).
All of these types of non-traditional signals should ease the difficulty associated with valuing early-stage ventures.
The impact of the EU-ODA
In order to explore whether the EU-ODA offered similar signalling benefits, we used data from VentureXpert to collect global VC investments between 1985 and 2015, in the medical, health and life science categories. The final dataset includes 54,970 investments made to 7,657 startups by 3,535 investing firms.
To identify the causal impact of EU-ODA on direction of VC investments, we use a difference-in-differences approach. Specifically, we compare biotechnology subfields primarily affected by EU-ODA to non-affected subfields. To assign the treatment and the control groups, we use the fact that EU-ODA disproportionately affects biopharmaceutical firms pursuing development of novel drugs for human diseases.
From the investment categories in VentureExpert relating to medical, health and life sciences, we categorised the following into our treatment group: Biotech-Human, Med/Health Products, Medical Diagnostics, Medical Therapeutics and Pharmaceuticals. The control group consists of investment categories in the medical, health and life sciences not directly related to developing treatments for human disorders: Biosensors, Biotech Equipment, Biotech Other, Biotech Research, Biotech Animal, Biotech Industrial, and Med/Health Services.
Figure 1 provides descriptive evidence. Panel A compares the change in the percentage of early-stage deals in the treatment to the control group over time. Panel B plots the average days a startup takes to receive a VC investment from firm founding across our treatment and control groups. Both figures show that the control group is comparable to the treatment group prior to EU-ODA, and also that the trends diverge around 2000. This provides initial evidence that EU-ODA may have impacted early-stage investment decisions by VCs.
Figure 1 Orphan Drug Act (EU-ODA) and timing of VC investments
a) Investments in early-stage startups
b) Time to receive investments
Source: Kim et al. (2018).
Overall, our empirical results indicate that VCs are 3-5% more likely to make early-stage investments in EU-ODA related subfields (our ‘treated’ sample) after the regulation. This translates into between 660 and 1,100 new early-stage investments. We also find that the regulation causes VCs to fund early-stage ventures more often. In our treated sample, this is one to two years earlier after EU-ODA came into force. The size of impact is strongest among early-stage ventures based in the EU, as they are more likely to benefit from the policy change in their home market, but our results show that the EU-ODA caused a movement towards early-stage deals in the US as well. The harmonisation between orphan designation procedures in the US and EU provides a possible explanation for this positive spillover on US-based startups.
Syndication and exit
To clarify the channel by which the EU-ODA impacts early-stage investments by VCs, we explore syndication behaviour (Lerner 1994). VC deal syndication refers to two or more funds participating in an equity stake for an investment and financing round. Previous studies show that VCs syndicate an early-stage deal to reduce uncertainty (Gompers et al. 2016). There are, however, potential costs to syndicating, such as the need to disclose promising deals to potential competitors (Casamatta and Haritchabalet 2007).
In our setting, we expect that VCs would decrease the use of syndication for early-stage investments if the EU-ODA provides them credible information that can replace the use of peer evaluation. Indeed, we find that the level of syndication declines in early-round investments after EU-ODA in the treated subfields. Critically, the amount raised in early-stage deals doesn’t change after EU-ODA. Taken together, this suggests that VCs had used syndication as a way to decrease portfolio risk, and that the information-provisioning role of the EU-ODA for early-stage startups reduces the need for peer evaluation that comes from syndication.
Finally, we document a significant improvement in exit performance for VC-backed biopharmaceutical ventures in the treated subfields. Notably, startups that received early-stage funding in EU-ODA affected subfields show higher propensity to exit through IPOs than acquisitions, reversing a trend observed over the recent past (Gao et al. 2013). It appears that the signals conferred by the EU-ODA allowed VCs to select higher quality firms earlier and move them to IPO.
This trend reversal should be viewed positively for investors since IPOs, on average, have higher returns than acquisitions (Smith et al. 2011). Importantly, we do not see any statistically significant difference in bankruptcies for firms affected by the EU-ODA. In sum, the improved investment performance suggests that the signals conferred by the EU-ODA are sufficient for VCs to make more informed decisions in identifying early-stage deals that are no more risky than pre-existing options.
Beyond the valley of death
Overall, our results demonstrate that regulation can play an important role in correcting the market failure that exists in early-stage venture funding or the so-called valley of death. Our findings have important policy implications. While many countries exert public efforts to establish a solid ecosystem for entrepreneurship and innovation in high-tech sectors such as biopharmaceuticals, artificial intelligence and new energy, many of the public attempts fail since significant information asymmetries hinder investors, who cannot make an accurate valuation of early-stage ventures.
If these firms are unable to communicate the genuine value of their early-stage innovations, they may end up being disproportionately underfinanced compared to other startups for which information is more available and discernible. This reduces the incentive for entrepreneurs and early-stage firms to pursue high-risk, high-reward innovations.
Our work so far has limitations. A cross-industry study would be helpful to test whether our findings can be generalised. While we provide initial evidence of how regulation could potentially move VCs from just depending on gut feel in making early-stage deal valuation (Huang and Pearce 2015) to a policy-complemented approach, more work needs to be done.
Audretsch, D, and P Stephan (1996), "Company-scientist locational links: The case of biotechnology", American Economic Review 86(3): 641-652.
Casamatta, C, and C Haritchabalet (2007), "Experience, screening and syndication in venture capital investments", Journal of Financial Intermediation 16(3): 368-398.
Chemmanur, T, and X Tian (2011), "Peer monitoring, syndication, and the dynamics of venture capitalist interactions", working paper.
Fleming, J J (2015), "The decline of venture capital investment in early-stage life sciences poses a challenge to continued innovation", Health Affairs 34(2): 271-276.
Gompers, P, W Gornall, S N Kaplan, and I A Strebulaev (2016), "How do venture capitalists make decisions?", NBER working paper 22587.
Gao, X, J R Ritter, and Z Zhu (2013), "Where have all the IPOs gone?" Journal of Financial and Quantitative Analysis 48(6): 1663-1692.
Gorry, P, and D Useche (2017), "Orphan Drug Designations as Valuable Intangible Assets for IPO Investors in Pharma-Biotech Companies", in Economic Dimensions of Personalized and Precision Medicine, University of Chicago Press.
Hall, A K, and M R Carlson (2014), "The current status of orphan drug development in Europe and the US", Intractable & Rare Diseases Research 3(1): 1-7.
Higgins, M and R Gulati (2003), "Getting off to a good start: the effects of upper echelon affiliations on underwriter prestige", Organization Science 14(3) 244-263.
Higgins, M J, P E Stephan, and J G Thursby (2011), "Conveying quality and value in emerging industries: Star scientists and the role of signals in biotechnology", Research Policy 40(4): 605-617.
Huang, L, and J L Pearce (2015), "Managing the unknowable the effectiveness of early-stage investor gut feel in entrepreneurial investment decisions", Administrative Science Quarterly 60(4): 634-670.
Hudson, J, and H F Khazragui (2013), "Into the valley of death: research to innovation", Drug Discovery Today 18(13-14): 610-613.
Kerr, W R and R Nanda (2011). "Financing constraints and entrepreneurship", in Handbook of Research on Innovation and Entrepreneurship, Edward Elgar.
Kim, Y, C Chatterjee, and M J Higgins (2018), "Moving beyond the valley of death: Regulation and venture capital investments in early-stage biopharmaceutical firms", NBER working paper 25202.
Lerner, J (1994), "The syndication of venture capital investments", Financial Management 23(3): 16-27.
Meggison, W, and K Weiss (1991), "Venture capitalist certification in initial public offerings", Journal of Finance 46(3): 879-901.
Nicholson, S, P Danzon, and J McCullough (2005), "Biotech-pharmaceutical alliances as a signal of asset and firm quality", The Journal of Business 78(4): 1433-1464.
Podolny, J M (1993), "A status-based model of market competition", American Journal of Sociology 98(4): 829-872.
Smith, R, P Robert, and S Vijay (2011), "VC fund financial performance: The relative importance of IPO and M&A exits and exercise of abandonment options", Financial Management 40(4): 1029-1065.
Spence, M (1973), "Job market signalling", The Quarterly Journal of Economics 87(3): 355-374.
Stockklausner, C, A Lampert, G F Hoffmann, and M Ries (2016), "Novel treatments for rare cancers: The US orphan drug act is delivering—a cross-sectional analysis", The Oncologist 21(4): 487-493.
Stuart, T E, H Hoang, and R C Hybels (1999), "Interorganizational endorsements and the performance of entrepreneurial ventures", Administrative Science Quarterly 44(2): 315-349.
Zucker, L G, and M R Darby (1997), "Individual action and the demand for institutions: Star scientists and institutional transformation", American Behavioral Scientist 40: 502-153.
Zucker, L G, M R Darby, and J Armstrong (2002), "Commercializing knowledge: University science, knowledge capture and firm performance in biotechnology", Management Science 48: 138-153.