Academics Weigh the Benefits of Bank, VC Financing for Startups

Bank or venture capital (VC) financing? This is one of the toughest questions that aspiring entrepreneurs and small firms must answer. A recent academic study contends that VC financing may be the superior financing structure for early stage capital. However, several other studies contend that both bank and VC financing can help create and grow successful startups. For potential entrepreneurs, each provides strengths and weaknesses that are highlighted in the studies.

In Do Banks or VCs Spur Small Firm Growth?, the authors compare the two primary sources of entrepreneurial finance small firm formation and growth – banks and VC. The authors make a number of findings based U.S Census data from 1995-2011. With regards to VC investment, there was both an economically and statistically significant relationship between VC investments and the stimulation of new firms, new establishments, new employment, and new payroll. On the other hand, the authors did not find similar evidence for banks. The primary difference between the successes of startups that received VC financing versus their peers that received bank financing may be driven by the value-added activities and service provider networks of VC firms, according to the researchers. In addition, VCs also are more likely to encourage talent recruitment efforts, thereby facilitating the entrepreneurial process.

While VC-backed startups show the potential for high growth, startups that receive bank financing show a lower risk of financial distress than both VC-backed firms and non-invested firms according to another recent study – Venture Capital Financing and the Financial Distress Risk of Portfolio Firms: How Independent and Bank-Affiliated Investors Differ. Using data collected from 1994 to 2004 for European startups, the authors concluded that banks are interested in the financial risk profile of the firms they invest in as well as the potential return on investment. In comparison, VC firms are more likely to take on higher risk investments due to the potential return on investment.

These findings were confirmed by a May 2015 study from the National Bureau of Economic Research (NBER), the authors found that banks prefer low risk investments for several reasons including:

• Banks do not share proportionately in the benefits when a startup does extremely well, but do suffer the losses; and,
• Lenient bankruptcy laws may encourage entrepreneurs to take on bolder experiments, but at the same time make banks less willing to fund the experimentation since their return is reduced if the project fails.

The authors found that while bank financing is an important element of a funding ecosystems for startups – regions with bank oriented economies are less likely to encourage startups engaged in innovation.

In Product Market Competition and the Financing of New Ventures, the authors contend that the opportunity for bank financing is important for a significant segment of entrepreneurs and small firms. For entrepreneurs that want to remain in almost full control of the startup, bank financing provides them the autonomy to grow their business without the hassle of investors. While VCs provide more services and access to services providers, they come with investor advice and requirements that include moving towards an exit, hiring of team members, and providing other advice. In comparison, bank financers typically maintain a hands-off approach.

VC remains the preferred and potentially more advantageous option for many tech startups, especially firms with the potential high-growth, due to the suite of services and network of services providers that VC firms provide. However, bank financing still plays a vital role in the startup funding ecosystem. For startups with less growth potential, but limited risk, or entrepreneurs not looking to exit, the passive role of banks financers may allows for more autonomy and time to grow their business. For startups, the question of bank versus VC financing comes down to three questions:

• How much autonomy does the entrepreneur(s) want?
• What is the risk profile of the startup and the potential for high growth?
• How important are the potential services/connections offered by VCs to the success of the firm?