Home-State Investment Bias in Venture Capital Funds

A widespread assumption is that U.S. venture capitalists source their best investments locally, so out-of-state venture funds are at a disadvantage in relation to local competitors. This assumption drives most venture funds to focus their investments on local companies. The study reported here tested this hypothesis by analyzing IPO rates by the state of venture-funded companies for the past 25 years. Locally funded companies actually achieved a lower average IPO rate than that of nationally funded companies. Therefore, venture funds should seek to capitalize on any local advantage but should also seek to balance their investments by diversifying geographically.From 1980 through 2005, more than 26,000 venture-stage companies were funded in the United States by venture capital (VC) funds. Of these companies, more than 3,300, or approximately 13 percent, completed an IPO during the same period. Although the majority of venture-funded companies were based in a relatively few states, the geographical distribution of IPOs approximately equaled the geographical distribution of the VC-funded companies. VC funds, however, have demonstrated a strong bias toward investing in companies in their home states. This bias is predicated on the beliefs that VC funds in the United States source their best venture investments locally and that out-of-state venture funds are at a disadvantage in sourcing deals against the local competitors.In this study of VC deals and IPOs in the United States in the 1980–2005 period, approximately 57.7 percent of all venture investments were completed in the top five states (California, Massachusetts, Texas, New York, and Pennsylvania). The number of IPOs per state followed approximately the same distribution, with about 60.0 percent of all IPOs in the sample from the same top five states.Despite the relative diversification of successful companies across the country, venture funds tend to invest locally. In all but one of the states in the sample, the in-state investment rate of local funds was higher than the national average. For instance, 31.4 percent of all venture investments were completed in California, but California-based venture funds completed 56.6 percent of their investments in California-based venture-funded companies. The average in-state investment rate by local funds (i.e., the percentage of all investments by all venture funds in a given state made in venture-funded companies in that same state) was 28.8 percent, or 2.7 times higher (as a weighted average) than the expected investment rate based on the national average.This home-state investment bias could lead to one of two possible outcomes. Either the increased competition for local investments could result in a lower IPO rate for venture-funded companies funded by local funds, or (if local funds have an inherent advantage in selecting local venture companies) the local funds could experience an equal or higher IPO rate. In other words, if local funds get the first look at local investments, then they should logically make a higher percentage of their investments in local companies because these companies are their best source of deal flow.Venture funds often bring up the so-called home-court advantage when marketing their funds to investors. The data of this sample, however, do not, on average, support this popular hypothesis. Although the average IPO rate by state (for the 50 states with locally funded companies) in the sample period was 11.0 percent, the average IPO rate for locally funded companies by state was only 7.2 percent, or 34.0 percent less than the national average. In the 28 states with a minimum of 100 investments per state, the national average IPO rate was 12.4 percent whereas the average IPO rate for locally funded companies was only 10.1 percent, or 18.4 percent less.In summary, not only do the local funds appear not to have an advantage in investing in local companies, they actually appear to perform worse than out-of-state funds, as measured by IPO rate.Although concentrated in a few states, successful venture investments are spread across the United States. By concentrating investments locally, venture funds are possibly increasing competition for venture investments at a local level and, consequently, reducing their chances for achieving a successful exit—particularly in regions with a large number of venture funds and thus substantial competition. Although venture funds should seek to capitalize on their local advantage in sourcing local investments, the funds should also seek to balance their investments by carefully diversifying geographically.