Study Disputes The Value of VCs “Buying Local”

Venture capital outperformance is correlated to a portfolio company’s distance from a a VC firm’s office, according to new research from The Harvard Business School. But not in the way you might think.

Specifically, the paper found that VC firms based in San Francisco, Boston and New York generally return more money on investments outside of their local geographies than on investments close to home. This isn’t to say that such firms do badly on their local deals – a Palo Alto-based firm still does better on a typical Menlo Park deal than would a Cleveland-based firm – nor does it take into account organizational costs (travel, etc.). But, again, that Palo Alto-based firm will probably generate a higher return on a Cleveland-based portfolio company than on one based in Menlo Park.

The paper suggests that this differential could be caused by VC firms using higher hurdle rates for long-distance deals. Such portfolio companies may require a higher level of managerial/monitoring effort, so more thought is given before offering up a term sheet.
 
“A takeaway might be that firms should think very carefully about their decision-making process in terms of geographic criterion,” says HBS professor Josh Lerner, who co-authored the study with Henry Chen, Paul Gompers and Anna Kovner. “I think there’s a mental trap in saying that because a company is so nearby, it’s not as costly to do the transaction.”

The paper also found that a VC firm’s outperformance on distance deals will lessen if the firm opens a satellite office in that new location. Again, the theory is that the burden of proof has been lowered, now that the firm has a staffer nearby.

Finally, Lerner et all took a look at satellite office performance by firms based in the big three markets — SF, Boston and NYC – when they open shop in another of the big three (i.e., a Palo Alto firm expanding to Cambridge): “We thought we’d see a big difference in success, because of a home court advantage, but we couldn’t find anything along those lines.”

We’ve posted the entire working paper, for your reading pleasure:

Buy Local- The Geography of Successful and Unsuccessful Venture Capital Expansion.06152009

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7 Comments

  • You didn’t explore the possiblity that VCs can’t meddle as much with companies that are not in their back yard and that this may have a net positive effect on the companies, just saying…”

  • Not that I necessarily (or at all) believe this, but to play devil’s advocate – one could also argue this “anomaly” could be due to management efficiency…if the company/management isn’t always worried about a VC/owner dropping by, or looking over the company as frequently – they are able to devote more time/energy to the company itself. Of course you could also argue that VC’s spend more time looking over management due to the distance factor…

  • Could it be because the VCs are not micro managing and breathing down the teams’ necks? Performance is driven by operational actions not by what is on the term sheet. Also, ventures in the major VC hubs do not necessarily have a lock on all available talent.

  • [...] Harvard Business School study out today: Found that VC firms based in San Francisco, Boston and New York generally return more [...]

  • [...] Venture capitalists do better investing far away from home.  (peHUB) [...]

  • With both VC-backed companies I’ve run, the slowest growth periods were always when the VCs were breathing down our necks. Now whether that says they caused the slow growth or that we got out of the slow growth due to their, erm, “motivation” it’s impossible to say. Still, I’ve yet to see an instance where greater VC involvement was a guarantee of greater returns.

    Personally, I prefer my VC firms 1 hour away (either by plane or by car), just like my parents. Close enough to drop by, but probably not unannounced.

  • As this is a working paper, and obviously open for discussion, it will probably evolve, but:

    1. The paper does not analyze the pre-money valuations of companies in CSAs vs rest of the country. This could explain why investments are more profitable out of these CSAs for VCs venturing out.

    The reasons of higher pre-money valuations in the CSAs are:
    i) a higher level of costs locally (that would need to be sustained with national statistics on office space prices and salaries as well).

    The volatility of costs in CSAs and the rest of the nation could also be analyzed to see if this explains why investing in a downturn (when resource prices are depressed) is more profitable, even in CSAs.

    ii) a higher level of competition as for VCs willing to invest in a company based in a given CSA (number of term sheets issued and eventually declined could be a useful indication).

    In that respect, the statement (page 24) “While branch office investments and outside investments are more likely to IPO, exit multiples are similar across main office investments, branch office investments and outside investments”. How is this substantiated that? I may have missed the data. I thought that IPO exits presented almost systematically an upside in terms of multiple of investments compared to trade sales. Otherwise, it would make no sense to go through the costly and painful process of an IPO.

    2. Assuming that companies have a higher pre-money valuation in CSAs than in the rest of the country (this can be checked with the Dow Jones VentureSource database), we would then need to see what is their exit price in CSAs vs the rest of the country.

    My guess is that if valuations for VC rounds can significantly change according to local conditions (i.e., belonging to a CSA or not), exit prices are valid nation-wide. Said differently, a company bought out
    or going public will not be priced differently if it is based in Milwaukee or San Francisco. This creates however a significant difference for the investors, as they earn the difference, of course.

    3. The reputation effect of VCs, which enables them to negotiate discounts if they are highly regarded in a region versus other term sheets, is another factor which could explain the discrepancies
    between the VCs in a given CSA (otherwise, the effect should be homogeneous). See HSU D., What Do Entrepreneurs Pay for Venture Capital Affiliation?, 2004
    (http://www-management.wharton.upenn.edu/hsu/files/VC_Affiliation_JF04.pdf)

    4. Another reason of the subsequent performance (which could be measured by the mortality rate of companies in a given VC portfolio located in a CSA or not), is that the screening is probably tougher
    for distant deal flow. Bengtsson and Ravid (2009) are rightfully quoted as for the contractual clauses which are tougher as the investor is more distant. The introduction should be more qualified, notably
    because the reputation effect is lower (unless the VC fund manager is known nationwide) and it is more difficult to attract co-investors in a distant investment.

    5. Given the level of management fees charged (2 to 2.5% p.a.), and the costs supported by the firm, costs of visiting are not a determining factor. If you think so, maybe you could provide some hard
    data on this ground, because my experience is that this does not play any major role in investments decisions. Due diligences are made on-site, that’s true, but phone is the major contact medium post
    investment (actually, going from San Francisco to San Jose can take as much time with the traffic than going by plane to Seattle). Onsite presence once the investment made is not so frequent – at least not
    enough to weight in the choice of a VC fund manager to invest or not.

    If you look at the amounts of money spent in travelling for fund raising purpose (which means that there is no guarantee whatsoever of success for a given travel), that should put some perspective on
    travelling to monitor and investment. As for due diligence travelling, this is usually pooled with other purposes such as monitoring, networking, etc.

    I hope that these comments will be useful.

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