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First Quarter 2023, 
Vol. 105, No. 1
Posted 2023-01-20

An Elementary Model of VC Financing and Growth

by Jeremy Greenwood, Pengfei Han, Hiroshi Inokuma, and Juan M. Sánchez

Abstract

This article uses an endogenous growth model to study how the improvements in financing for innovative start-ups brought by venture capital (VC) affect firm innovation and growth. Partial equilibrium results show how lending contracts change as financing efficiency improves, while general equilibrium results show that better screening and development of projects by VC investors leads to higher aggregate productivity growth.


Jeremy Greenwood is a professor of economics at the University of Pennsylvania; Pengfei Han is an assistant professor of finance at Guanghua School of Management, Peking University; Hiroshi Inokuma is a PhD candidate at Washington University in St. Louis; and Juan M. Sánchez is a vice president and economist at the Federal Reserve Bank of St. Louis.



INTRODUCTION

There is a strong link between venture capital (VC) financing and firm growth. Akcigit et al. (2019) show that companies with VC financing grow faster over time than companies using other sources of financing. Greenwood, Han, and Sánchez (2022b) show that in the first years after going public, VC-backed firms have employment and sales growth higher (5 and 7 percent, respectively) than publicly traded firms that did not receive VC financing. These authors also show that a connection exists between VC financing and innovation by demonstrating that VC investment increases the number of patents that a firm will file in the following years: a 10 percent increase in VC funding will induce a 7.9 percent increase in the numbers of patents expected by the firm in the three years after funding.

There is also evidence suggesting that VC financing is important for aggregate economic growth. Greenwood, Han, and Sánchez (2022a) build a model in which financing occurs through an optimal contract similar to Bergemann and Hege (1998), Clementi and Hopenhayn (2006), and Cole, Greenwood, and Sánchez (2016). The authors then embed the VC contract in a Romer (1986)-style model of endogenous growth to analyze the connection between VC financing and economic growth. The complexity of the dynamic contracting problem forces the analysis of the link between financing efficiency and productivity that is performed mainly with the numerical solution of the model. Quantitative results performed with a model calibrated to the US economy suggest that debasing VC financing would reduce the economy's growth rate by almost 20 percent (from 1.8 percent to 1.5 percent).

This article aims to expand the analysis of the relationship between VC financing and growth by presenting a simpler model of VC financing and investigating how VC activity affects innovation and economic growth. The results demonstrate that more efficient VC financing—due to improvements in either project screening or development—increases both the probability that new projects are successfully developed and the share of the value of the project that the entrepreneur keeps. This same improvement in VC financing encourages entrepreneurs to choose a more innovative project. In turn, these results imply that on a balanced growth path, more efficient VC financing leads to a higher productivity growth rate.


Read the full article.