Research News

How Venture Capital Firms Compete

Competition, collaboration work in tandem, reveals IPR associate Michael Mazzeo


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How do venture capital firms choose which startups to invest in, and how do they compete for these companies?

When we store our files in Dropbox, stay in an apartment we found on Airbnb, or listen to a song on Spotify, we are engaging with companies that relied on venture capital (VC) firms to become successful. But how do VC firms choose which startups to fund, and how does that affect their own success in the marketplace?

In a recent article in the Review of Industrial Organization, associate professor of strategy and IPR associate Michael Mazzeo and his colleagues investigate VCs’ investment choices. The results of this investigation have potential implications for policy.

VCs could take one of two approaches to investment, explained Mazzeo: “They could evaluate any investment and, based on their evaluation, decide to take on startups in a variety of industries. Or they could develop expertise in evaluating and helping out just software companies, or just telecommunications, or just biotech.”

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Michael Mazzeo

In specializing in one industry, VC firms can gather more information about that industry and, presumably, make better choices about investing in it. In choosing not to specialize (that is, by being “generalists”), firms can invest in whatever company looks appealing—rather than being limited to those in one industry—and can also avoid competition among VCs in crowded industries.

Mazzeo and his colleagues looked at VC investments from 1975–2008, as captured in Thomson Financial’s Venture Economics database. They noted whether a VC was a generalist or a specialist, the number of competing VCs in one area, and the effects of this competition.

They uncover a surprising result: When a competitor VC enters a market, this does not immediately lead to more competition in that market.

“In most industries, additional competitors lead to intense competition right away. In this industry, the big competitive effects happen once there are two or more competitors,” Mazzeo said. “Venture capitalists, in addition to competing with each other, cooperate with each other, too.” Multiple VCs, for example, might invest in the same startup in the same industry, thereby giving that startup a better chance of survival.

This “cooperative effect” tended to be strongest when VCs had strong connections to one another, which the researchers could identify by looking at how many projects VCs had co-invested in over a five-year period.

These findings could have an impact on policy, according to Mazzeo: “We are always interested in understanding the competitiveness of these markets from a policy perspective because of anti-trust concerns,” he said. “Developing some additional nuance there…is important as input to anti-trust policy [and] anti-trust enforcement.”

Michael Mazzeo is associate professor of strategy at the Kellogg School of Management at Northwestern University and an IPR associate.