Private or Public Equity? The Evolving Entrepreneurial Finance Landscape

Michael Ewens is Professor of Finance and Entrepreneurship at the California Institute of Technology, and Joan Farre-Mensa is Associate Professor of Finance at the University of Illinois at Chicago. This post is based on their recent paper.

The U.S. entrepreneurial finance market has undergone dramatic changes over the last two decades. Capital raised by privately-held venture capital (VC)-backed startups grew from $28.9 billion in 2002 to $118.2 billion in 2019 (in real 2012 dollars). At the same time, the number of annual IPOs in the U.S. has declined from an average of 436 from 1991 through 2000 to an average of 113 from 2001 through 2020. In Private or Public Equity? The Evolving Entrepreneurial Finance Landscape, we review the changes in the entrepreneurial finance market and provide a framework to analyze their causes and consequences.

We begin by describing the regulatory differences between publicly-listed and private firms, and how these regulatory differences translate into differences in the financing and informational frictions the firms face. Next, we explore how several regulatory, technological, and competitive changes affecting both startups and their investors have altered the costs and benefits of going public over the last two decades. These changes have impacted both early-stage and late-stage startups, leading to shifts in both the supply and demand for private and public equity capital.

At the early-stage level, technological innovations such as cloud computing in 2006 have decreased startups’ financing needs, particularly during the initial, experimental stage of the entrepreneurial process. At the same time, the emergence of incubators and of new online platforms that help connect investors to startups—alongside the regulatory changes that have facilitated them—have contributed to a marked increase in the fundraising options available to early-stage startups. We show that a key consequence of these changes is that entrepreneurs raising their first round of venture capital now retain 30 percent more equity in their firm and are more likely to control their board of directors than their earlier counterparts.

As these entrepreneurs’ startups mature, they gain access to a late-stage private equity market that has grown five-fold: In 2002, the aggregate amount of private equity capital invested in VC-backed startups raising a Series C or higher round was $14.2 billion; in 2019, it was $80 billion. Much of this late-stage capital is now supplied by non-traditional startup investors such as private equity (PE) funds, mutual funds, and hedge funds. This abundant supply of late-stage private capital means that many late-stage startups have little need to go public to finance their growth. As a result, firms are now less likely to go public and when they do go public, they are older and have raised more private capital than in the 1990s. In fact, we show that the number of startups raising over $99 million in a single financing round, a sum historically only available via the public markets, grew 31-fold from 2002 to 2019.

What explains the increase in the supply of late-stage private capital? First, regulatory changes such as the National Securities Markets Improvement Act (NSMIA) of 1996 have made it easier for VC and PE funds to raise large funds, and for private startups to raise capital from out-of-state investors. In addition, VC and PE funds have benefited from a sharp increase in allocations to private equity by institutional investors such as public pension funds and higher-education endowments—in the case of pension funds, perhaps in an attempt to close their ballooning funding gaps. Third, the entry into the private equity market of mutual funds and hedge funds—traditional investors in public equities—has likely been spurred by the increased competition they face from passively managed index funds: Investing in private firms can help active funds beat the returns of their passive counterparts, thereby justifying the active funds’ higher fees.

Of course, the fact that successful startups can continue financing their growth while remaining private does not mean that they have to remain private. We argue that, in addition to the increased supply of late-stage private capital, two demand-side changes help explain why many startups choose to remain private longer. First, founders’ increased control of their firms after raising their initial financing rounds means that they enjoy greater bargaining power vis-à-vis investors at the time of making exit decisions. Founders can use this bargaining power to fulfill their desire to maintain control of their firms by delaying their exit. Second, the secular growth in the importance of R&D investments and intangible assets means that firms face greater disclosure costs now than in the past. As a result, the benefits of staying private and avoiding the disclosure regulations that apply to public firms have increased.

We conclude our article with a list of open research questions motivated by the changes we document. We highlight here two of these questions:

  • How (if at all) should regulators respond to the continued growth in the private capital markets? Several policymakers and regulators have voiced concerns about this growth, pointing in particular to the greater oversight and transparency under which public firms operate (e.g., Kiernan 2022). But imposing regulations on high-growth private firms similar to those imposed on their public counterparts could undermine the private firms’ ability to grow and innovate.
  • How can other countries foster a thriving entrepreneurial finance market, particularly for late-stage startups? To illustrate, a recent European Commission (2018) report notes that in the EU, “later-stage financing in particular remains restricted.”

The full paper is available for download here.

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