Performance Persistence in Entrepreneurship and Venture Capital

In the paper, Performance Persistence in Entrepreneurship and Venture Capital, forthcoming in the Journal of Financial Economics, my co-authors (Paul Gompers, Anna Kovner, and David Scharfstein) and I address two basic questions: Is there performance persistence in entrepreneurship? And, if so, why? Our answer to the first question is yes: all else equal, a venture-capital-backed entrepreneur who succeeds in a venture (by our definition, starts a company that goes public) has a 30% chance of succeeding in his next venture. By contrast, first-time entrepreneurs have only an 18% chance of succeeding and entrepreneurs who previously failed have a 20% chance of succeeding.

The answer to the second question of why there is performance persistence is more complex. Performance persistence is usually taken as evidence of skill. This is certainly the most straightforward explanation of our finding. However, in the context of entrepreneurship, there may be another force at work. The perception of performance persistence – the belief that successful entrepreneurs are more skilled than unsuccessful ones – can induce real performance persistence. This would be the case if suppliers and customers are more likely to commit resources to firms that they perceive to be more likely to succeed based on the entrepreneur’s track record. This perception of performance persistence mitigates the coordination problem in which suppliers and customers are unwilling to commit resources unless they know that others are doing so. In this way, success breeds success even if successful entrepreneurs were just lucky. And, success breeds even more success if entrepreneurs have some skill.

To distinguish between the skill-based and perception-based explanations, it is important to identify the skills that might generate performance persistence. Thus, we decompose success into two factors. The first factor, which we label “market timing skill,” is the component of success that comes from starting a company at an opportune time and place, i.e., in an industry and year in which success rates for other entrepreneurs were high. For example, 52% of computer startups founded in 1983 eventually went public, while only 18% of computer companies founded in 1985 ultimately succeeded. The second factor is the component of success that is determined by the entrepreneur’s management of the venture – outperformance relative to other startups founded at the same time and in the same industry. We measure this as the difference between the actual success and the predicted success from industry and year selection. By these measures, an entrepreneur who ultimately succeeded with a computer company founded in 1985 exhibits poor market timing, but excellent managerial skill. One who failed after founding a computer company in 1983 exhibits excellent market timing, but poor managerial skill.

Is starting a company at the right time in the right industry a skill or is it luck? It appears to be a skill. We find that the industry-year success rate in the first venture is the best predictor of success in the subsequent venture. Entrepreneurs who succeeded by investing in a good industry and year (e.g., computers in 1983) are far more likely to succeed in their subsequent ventures than those who succeeded by doing better than other firms founded in the same industry and year (e.g., succeeding in computers in 1985). More importantly, entrepreneurs who invest in a good industry-year are more likely to invest in a good industry-year in their next ventures, even after controlling for differences in overall success rates across industries. Thus, it appears that market timing ability is an attribute of entrepreneurs. We do not find evidence that previously successful entrepreneurs are able to start companies in a good industry-year because they are wealthier.

Entrepreneurs who exhibit market timing skill in their first ventures also appear to outperform their industry peers in their subsequent ventures. This could be explained by the correlation of market timing skill with managerial skill – those who know when and where to invest could also be good at managing the ventures they start. However, we find that entrepreneurs who outperform their industry peers in their first venture are not more likely to choose good industry-years in which to invest in their later ventures. Thus, it seems unlikely that there is a simple correlation between the two skills, though it is certainly possible that entrepreneurs with market timing skill have managerial skill, but not vice versa. Rather, this evidence provides support for the view that some component of performance persistence stems from “success breeding success.” In this view, entrepreneurs with a track record of success can more easily attract suppliers of capital, labor, goods and services if suppliers believe there is performance persistence. A knack for choosing the right industry-year in which to start a company generates additional subsequent excess performance if, as a result, the entrepreneur can line up higher quality resources for his next venture. For example, high-quality engineers or scientists may be more interested in joining a company started by an entrepreneur who previously started a company in a good industry and year if they believe (justifiably given the evidence) that this track record increases the likelihood of success. Likewise, a potential customer of a new hardware or software firm concerned with the long-run viability of the start-up will be more willing to buy if the entrepreneur has a track record of choosing the right time and place to start a company. Thus, market timing skill in one venture can generate excess performance (which looks like managerial skill) in the next. Note that this is not necessarily evidence of the extreme version of “success breeding success” in which the misperception that skill matters generates performance persistence. Instead, we are suggesting that if successful entrepreneurs are somewhat better than unsuccessful ones, the differential will be amplified by their ability to attract more and better resources.

As has been shown in other studies, companies that are funded by more experienced (top-tier) venture capital firms are more likely to succeed. This could be because top-tier venture capital firms are better able to identify high-quality companies and entrepreneurs, or because they add more value to the firms they fund (e.g., by helping new ventures attract critical resources or by helping them set business strategy). However, we find a performance differential only when venture capital firms invest in companies started by first-time entrepreneurs or those who previously failed. If a company is started by an entrepreneur with a track record of success, then the company is no more likely to succeed if it is funded by a top-tier venture capital firm than one in the lower tier. This finding is consistent both with skill-based and perception-based performance persistence. If successful entrepreneurs are better, then top-tier venture capital firms have no advantage identifying them (because success is public information) and they add little value. And, if successful entrepreneurs have an easier time attracting high-quality resources and customers because of perception-based performance persistence, then top-tier venture capital firms add little value.

The full paper is available for download here.