The Vital Role of Venture Capital in Economic Growth and Innovation

Introduction

Venture capital is widely recognized as a driver of innovation and new company formation in the United States. By providing early-stage funding and guidance, venture investors help entrepreneurs transform promising ideas into groundbreaking new technologies, industries, and markets.

In recent years, venture capital has set new records in terms of investment levels and the sheer pace of dealmaking. Unprecedented sums have poured into startup ecosystems across the country, fueling a wave of innovative new companies with the potential to solve major problems and create jobs.

However, the venture capital industry operates within a complex policy environment that can either support or hinder its efforts. Short-term shifts in regulations and economic conditions also introduce uncertainties that did not exist in earlier eras of steady growth.

To gain insight into these dynamics, Bobby Franklin, speaking on behalf of the National Venture Capital Association, recently addressed the industry's continued impact and discussed challenges on the horizon. Drawing from data and examples, Franklin shed light on how policies can best promote the conditions for innovation to thrive.

This article will summarize Franklin's discussion of key topics, including the historical policy shifts that powered venture capital growth, benchmarks demonstrating its outsized economic impact, and perspectives on navigating an evolving landscape. The hope is that greater awareness of this crucial industry's relationship with public policy can help drive reasoned decisions to sustain America's leadership in entrepreneurship and technology well into the future.

Historical Growth of Venture Capital

Venture capital is a driving force behind innovation, economic growth, and even national defense, yet its pivotal role is often overlooked. Bobby Franklin, speaking on behalf of the National Venture Capital Association (NVCA), recently shed light on this critical industry's impact and the policy environment it operates within.

Venture capital kick-started its significant growth trajectory in the 1970s with two game-changing policy shifts: the adjustment of ERISA regulations, allowing pension funds to invest in alternative assets, and a substantial reduction in capital gains taxes to encourage long-term investments. These changes coincided with the founding of the NVCA and led to a surge in venture-backed company formations.

Research reveals that over 50% of companies that went public since the 1970s had venture capital backing. The distinction between venture-backed and non-venture-backed companies is stark, with the former seeing a 960% employment growth rate from 1990 to 2020, compared to a 40% rate for the latter.

These high-growth, blitz-scaling companies are not just creating jobs at an astounding rate; they're innovating at an annualized growth rate of 8.2% versus the 1.1% of the total private sector. This innovation is seen as key to combating economic challenges like inflation.

Disconnect Between Policymakers and VC-Backed Companies

Despite these impressive figures, a disconnect remains between policymakers and the unique needs of venture-backed companies. Large corporations and small mom-and-pop businesses have clear representation and advocacy, but the companies poised for hyper-growth often fall between the cracks in policy discussions. The Kauffman Foundation has highlighted that these high-growth firms are the primary source of net new job creation, differentiating them from the expansion and contraction patterns of large enterprises and the relatively stable numbers of small, local businesses.

Bobby Franklin further notes the potential of venture capital to seed innovation not only within companies but also within individuals. He references Elon Musk's journey from Zip2 to PayPal, suggesting that venture capital can play a crucial role in empowering serial entrepreneurs whose later ventures may produce life-changing innovations.

However, current policy trends, particularly concerning mergers and acquisitions and antitrust regulations, pose challenges to the venture capital ecosystem. The current administration's skepticism towards company acquisitions is creating a chilling effect, potentially stymying the growth and success of innovative ventures.

Venture capital is not just about the VC firms but also about the limited partners, such as university endowments and pension funds, whose investments drive this ecosystem. Their returns are critical, and their successes often fund the next generation of entrepreneurs.

Venture capital is a linchpin of American economic dynamism and innovation. A greater understanding of its importance and the right public policy environment are essential for fostering the growth of companies that could become the industry giants of tomorrow. As the NVCA continues to educate lawmakers, the hope is that policies will evolve to support rather than hinder the venture capital industry, paving the way for continued innovation and economic prosperity.

Bobby references the Bayh-Dole Act, which facilitated the commercialization of university research, as an example of successful policy. However, the current political climate puts this progress at risk by considering the use of march-in rights, which could undermine the commercial viability of federally funded research.

Franklin argues that such a policy shift could deter investment in university research, especially that which has benefited from federal funding. Such a chilling effect on investment would not only impact the pharmaceutical industry but could also undermine the broader entrepreneurial ecosystem.

Franklin stressed the importance of a supportive ecosystem for innovation, one that encourages faculty and students to engage with the commercial sector. He contrasts universities that facilitate this transfer of knowledge and ideas with those that, often due to overprotective legal concerns, stifle potential innovation.

NVCA's Mission to Foster Rational Policy Discussions

The NVCA's mission, as Franklin describes, is to ensure that policymakers understand the fragility of the innovation ecosystem. He warns that the United States cannot take its leadership for granted, as other countries are eagerly studying and replicating its success formula. For Franklin, the NVCA's role is to foster rational policy discussions to preserve and enhance the nation's innovative capacity.

Franklin revealed a startling statistic that emphasizes the significance of VC in the business world. From 1975 to 2015, a mere 0.18% of companies received venture backing. Yet, this tiny fraction of companies represented an astounding 57% of the total market capitalization of public companies at that time. This showcases that VC-backed companies have created value far beyond their non-VC-backed counterparts, despite their small numbers.

Franklin emphasized the importance of encouraging engagement with VC-backed companies. He advocated for the role of academia and other sectors in fostering an environment where such companies can thrive. His message was clear: the policies that support new company formation are crucial for the sustained health and growth of the economy.

Unpacking "Crossover Investors"

The term 'crossover investors' was then unpacked by Franklin. These are entities that do not explicitly identify as venture capital firms but make significant investments in venture-backed companies, often in late stages before an IPO or an acquisition. Crossover investors include mutual funds, hedge funds, and other financial players who see opportunities in these high-growth potential companies.

Franklin pointed out that while there was a surge of crossover investment activity in 2020 and 2021, there has been a noticeable retreat from this class of investors due to changing market conditions, such as rising interest rates and adjustments in public market valuations.

When asked about the reasons behind the recent exodus of crossover investors, Franklin attributed it to economic shifts, including rising interest rates and a downturn in public markets. These factors forced crossover investors to reassess their portfolios and often led to a reallocation of their assets.

Some VC-backed companies have faced the necessity of down rounds, where the company's valuation decreases from one investment round to the next, challenging the notion that valuations should consistently rise.

Seed and Pre-Seed Investments Indicators of Health

Franklin emphasized that the way venture capitalists introduce themselves often revolves around the stage they invest in and their preferred industry verticals. Seed and pre-seed investments typically represent the earliest institutional checks written to entrepreneurs. These initial investments are crucial indicators of an entrepreneurial ecosystem's health.

Franklin noted that seed and pre-seed investments are critical for entrepreneurs to advance their ideas. These stages often involve small teams working with limited resources, sometimes humorously described as "a dog in a garage," seeking capital to transform an idea into reality. The NVCA views the volume of first-time financings as a vital barometer for the ecosystem's robustness. Despite fluctuations, as long as there is an overall upward trajectory in deal activity, it signals that entrepreneurs continue to receive vital early support.

Over the past few years, particularly in 2021 and 2022, the definitions of seed and pre-seed have become more specific, with new terms like "pre-pre-seed" and "dirt investing" emerging. Despite a recent dip from record highs, current deal activity remains above 2020 levels, suggesting a positive landscape for startups.

When distinguishing between seed, pre-seed, and early-stage investing, Franklin pointed out that early-stage is just past seed, typically involving Series A rounds, where companies are still relatively young. Resources like PitchBook can provide detailed definitions of these stages.

Impact of Economic Cycles on Investment Stages

Franklin also discussed how different economic cycles impact investment stages differently. For instance, fluctuations in the public markets have a more immediate effect on later-stage growth investors due to their proximity to public markets. In contrast, seed and early-stage investments are less directly affected by such changes, with potential impacts taking longer to manifest.

Current insights suggest that while investment levels in early-stage ventures have decreased compared to the previous two years, they are still higher than in the years preceding 2020. This normalization, or "reverting back to the mean," hints at a healthy investment climate, still more active than earlier years like 2016 and 2017.

An interesting point raised by Franklin pertains to the structure of venture capital funds. Unlike hedge funds with redemption rights, venture capital funds typically operate on a 10-year timeline, often with provisions for extensions. This timeframe is crucial for understanding venture capital data, as the real harvesting of investments often extends beyond a decade.

Franklin highlighted that periods following record investment years, like 2021 and 2022, could be seen as opportune times for disciplined investing. With high valuations expected to normalize, due diligence becomes paramount. Investments made during these "good vintage years" could yield better returns than those made during the boom years, as they are based on more realistic valuations and growth strategies.

Continued Investor Confidence in Mega-Rounds

Mega-rounds, or investment rounds exceeding $100 million, have been a point of interest and considerable activity in the venture capital space. While these rounds are not occurring at the frenetic pace seen in 2021 and 2022, they remain a substantial part of the investment landscape. According to PitchBook data, after a plateau in the mid-2010s, mega-round activity more than doubled in 2018 and maintained high levels for the subsequent three years.

Despite a decline from the peak years of 2021 and 2022, the current rate of mega-round investments still exceeds the earlier plateau, signaling continued investor confidence in high-value deals. This trend is influenced significantly by crossover investors, who have been instrumental in driving high valuations and, consequently, the notable data points we observe in this segment.

Unique Landscape of Life Sciences Investing

The life sciences sector presents a unique contrast to the tech industry, which sees a considerably higher number of deals. The life sciences field, diverse and ever-evolving, includes pharmaceuticals, biotechnology, medical devices, digital health, and subsets of AI-focused companies. However, it faces distinct challenges, particularly the regulatory hurdles such as FDA approval, which often prolong the time it takes for investors to see returns on their capital.

Progress in public policy, particularly changes at the FDA, has positively impacted the venture-backed companies responsible for nearly half of the new drugs approved each year. Yet, the investment landscape within life sciences is complex. For instance, new drugs enjoy automatic reimbursement post-FDA approval, whereas medical devices must undergo further clinical trials to prove cost-effectiveness, delaying potential returns on investment.

Despite these challenges, investment in life sciences has seen a steady increase. The sector continues to grow, reflecting broader trends in venture investing and the potential for significant returns and societal impact.

Unicorn companies, valued at over a billion dollars, are a testament to the robustness of the venture capital ecosystem. While recent years have seen a slight decline in unicorn deal activity from the heights of 2021 and 2022, the numbers still align with the strong performances of 2018 to 2020. An interesting observation is the role of educational institutions in fostering this growth. For example, Tel Aviv University in Israel stands out for producing a significant number of graduates who go on to found or co-found unicorn companies, highlighting the global nature of entrepreneurial talent.

Importance of Immigration Policy for Innovation

This global perspective brings attention to the importance of immigration policy, particularly in the United States. Studies have shown that over half of the unicorn companies in the U.S. were founded or co-founded by immigrants. This underscores the need for a startup visa that can attract international entrepreneurs to the U.S. and facilitate the creation of new ventures and jobs.

Despite bipartisan support, such a visa category has yet to materialize, hindered by broader immigration debates. However, as countries worldwide strive to emulate the success of the U.S. venture capital model, it is imperative for the U.S. to establish clear immigration pathways for entrepreneurs to maintain its leadership in innovation and competition.

Concluding Discussion

Bobby Franklin's discussion highlighted the vital role that venture capital plays in driving innovation, job creation, and economic growth. Despite facing challenges from shifts in policy and market conditions, the venture capital industry continues to see strong investor interest and deal making activity.

While certain investment stages and sectors may see short-term fluctuations, the long-term indicators remain positive. Mega-rounds, unicorn companies, and sustained life sciences investment demonstrate continued confidence in high-potential ventures. Importantly, early-stage seed funding is showing resilience, ensuring entrepreneurs have resources to turn ideas into reality.

As the global innovation landscape evolves, maintaining U.S. leadership will require rational public policy that supports rather than hinders venture-backed businesses. Targeted programs like startup visas can also help attract international founders critical to America's competitive edge.

With further education of policymakers, the NVCA aims to foster conditions where venture capital can optimally fuel the next generation of innovation, job creation, and economic opportunity. As Franklin discussed, rational long-term policy perspectives will be key to ensuring the U.S. innovation ecosystem remains the world's strongest well into the future.