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Recent Research: Venture Capital Proximity Means Larger Financing Rounds, But Not More Money

May 20, 2009

Despite the global growth of the industry over the past few decades, U.S. venture capital remains as concentrated as ever in the Silicon Valley region, and to a lesser extent, Massachusetts. Of the 87 venture capital firms included in the PricewaterhouseCoopers list of most active firms of 2008, 40 firms (46 percent) were located in Silicon Valley and San Francisco; only one California firm was located outside of that region (Santa Monica); another 18 of the most active firms were located in Massachusetts.

The dominance of Silicon Valley and Massachusetts also are reflected in the number of deals and dollars invested in local companies (see the April 18, 2008 issue of the Digest). When companies in other regions are able to obtain venture capital, the source of that funding is often a VC firm in Silicon Valley, Massachusetts or one of the few other select venture hotspots. A new study, however, suggests that although it may be more difficult for companies outside of those regions to obtain VC, proximity to venture firms has little to do with the overall amount of capital a company obtains from an individual firm.

In "Geography and the Structure of Venture Capital Financing", Xuan Tian of the Kelley School of Business at the Indiana University suggests that while proximity to investors affects the structure of venture financing, it does not affect the total amount of dollars invested. Funding, however, is often structured differently depending on distance. Companies located farther from their venture investors receive more frequent rounds of financing with lower cash amounts per round. According to the study, this difference is attributable to the higher cost of monitoring companies that are farther away.

Tian uses proximity as a proxy for monitoring costs. Investee companies that are located near their investors are able to meet with them regularly, minimizing the risk to the investor and the cost of gathering information.

Tian argues that monitoring and the staging of funding rounds are substitutes for each other. With the low-cost monitoring that is possible with nearby firms, venture firms can afford the larger risks associated with large, infrequent cash infusions. The cost of monitoring more distant companies means that venture firms are less willing to take those risks. More frequent funding rounds give investors the option of dropping a company that is not meeting its goals, with fewer losses.

These findings have several implications for entrepreneurs seeking capital from firms in other states. First, entrepreneurs may have to adjust their expectations for the size of capital infusions during individual rounds of financing, but not the overall capital infusion from an out-of-state firm. Second, entrepreneurs must be prepared to endure more rounds of financing for smaller amounts of capital than their in-state counterparts.

For states and regions trying to connect local entrepreneurs with capital, the findings suggest that more time should be spent preparing companies for the reality of frequent, but small, infusions of cash and the difficulties of constantly preparing for rounds of financing. This often means preparing in-depth documentation of a company's health, while an in-state firm might be able to assure its investors with less intense face-to-face meetings. Local entrepreneurial-assistance organization can play a vital role in supporting company efforts to prepare for these reviews.

"Geography and the Structure of Venture Capital Financing" is available: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=965803

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