Financial Distancing: How Venture Capital Follows the Economy Down and Curtails Innovation

Sabrina T. Howell; Josh   Lerner; Ramana  Nanda; Richard  Townsend

Working Paper | HBS Working Paper Series | 2020

Financial Distancing: How Venture Capital Follows the Economy Down and Curtails Innovation

by Sabrina T. Howell, Josh Lerner, Ramana Nanda and Richard Townsend

Abstract

Although late-stage venture capital (VC) activity did not change dramatically in the first two months after the COVID-19 pandemic reached the U.S., early-stage VC activity declined by 38%. The particular sensitivity of early-stage VC investment to market conditions—which we show to be common across recessions spanning four decades from 1976 to 2017—raises questions about the pro-cyclicality of VC and its implications for innovation, especially in light of the common narrative that VC is relatively insulated from public markets. We find that the implications for innovation are not benign: innovation conducted by VC-backed firms in recessions is less highly cited, less original, less general, and less closely related to fundamental science. These effects are more pronounced for startups financed by early-stage venture funds. Given the important role that VC plays in financing breakthrough innovations in the economy, our findings have implications for the broader discussion on the nature of innovation across business cycles.

Keywords: innovation; recessions; Venture Capital; Innovation and Invention; Patents; Business Cycles; Economic Slowdown and Stagnation;

Language: English

Format: Print

56 pages

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Citation:

Howell, Sabrina T., Josh Lerner, Ramana Nanda, and Richard Townsend. "Financial Distancing: How Venture Capital Follows the Economy Down and Curtails Innovation." Harvard Business School Working Paper, No. 20-115, May 2020.

The treatment of foreign investors has been a contentious topic in U.S. entrepreneurship policy in recent years. This paper examines foreign corporate investments in Silicon Valley from a theoretical and empirical perspective. We model a setting where such funding may allow U.S. entrepreneurs to pursue technologies that they could not otherwise, but may also lead to spillovers to the overseas firm providing the financing and the nation where it is based. We show that despite the benefits from such inbound investments for U.S. firms, it may be optimal for the U.S. government to raise their costs to deter investments. Using as comprehensive as possible a sample of investments by non-U.S. corporate investors in U.S. start-ups between 1976 and 2015, we find evidence consistent with the presence of knowledge spillovers to foreign investors.

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Financial Distancing: How Venture Capital Follows the Economy Down and Curtails Innovation

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