It’s tough enough for startups to get venture capital (VC) funding, especially if they are in emerging industries, such as cleantech, where unproven technologies might seem risky.
Government research grants fund much of this new technology. And new research from Associate Professor Adam Fremeth shows such grants might also trigger an unexpected chain reaction. Winning a prestigious government research grant may help such startups to subsequently receive venture capital (VC) funding.
“Research grants prove to be good signals of startup quality in early-stage emerging industry contexts where few other proofs of quality exist,” said Fremeth.
Fremeth – along with Mazhar Islam, a visiting assistant professor at Tulane University; and Alfred Marcus, a professor at Carlson School of Management at the University of Minnesota – looked at the impact of 128 government grants from 2005 to 2011 on cleantech startups in the U.S. They found startups that received federal grants were 12 per cent more likely to receive VC funding in the next two quarters than those that did not. Moreover, startups lacking any patents were seven per cent more likely to attract VC attention if they had previously won a grant as compared to a similar startup without any patents that had not won a grant. Since patents are a typical precursor to funding, Fremeth said this suggests a grant might substitute for some of the other signals that typically attract venture capitalists (VCs).
Past entrepreneurship research has shown that certain signals, such as affiliations with prestigious suppliers or participation with a venture development organization, can attract VC attention. Fremeth’s study reveals grants also help startups to start or close a deal with VCs because winning a grant shows the companies have already impressed discerning evaluators.
Sealing the deal
“This doesn’t mean the conversations hadn’t been ongoing with the venture capitalists before – they may very well have been – but this just catalyzes that process,” he said.
The findings are valuable for startups in terms of helping them to focus their strategies on those with the highest potential for payoff so they can concentrate on improving their operations rather than making ties with investors. The study also proves grant programs are having a positive impact and policy-makers might even consider involving VCs in the design of the programs.
Following the 2007-08 financial crisis, Fremeth said there was more emphasis on developing a green economy to create jobs and address issues around climate change. This led to a rise in cleantech startups focused on reducing our reliance on traditional forms of electricity generation; such as through solar, wind, or tidal power; and transmission improvements. Governments around the world, especially the U.S., were trying to spur on this activity with different types of financial support, such as research grants and loan guarantees.
“There was a lot of negative attention around this and people were saying it’s a waste of money; you’re throwing funds at companies that won’t necessarily be commercially viable,” he said.
Fremeth said, due to the newness of the sector, the path to commercial viability is typically longer for cleantech companies than IT or software companies. When governments first rolled out such grant programs, a lot of attention was placed on the fact that cleantech firms may get started, but then run out of money before they can get their products to market – referred to as the “valley of death.”
“We wanted to examine the impact of such programs. If the government is conducting rigorous testing of the ideas that underlie these firms, does the venture capital market then use the information that is revealed from that process when deciding which companies to fund?,” he said. “Can we actually identify an additional benefit of these government support programs?”
Implications for north of the border
Although the paper focuses on the U.S., Fremeth said the findings have implications in Canada where new grant programs for cleantech innovation are underway. For instance, the recently launched Ontario Green Investment Fund is focused on projects that will reduce greenhouse gas emissions, enhance energy efficiency, and spur on cleantech innovation and jobs.
“An implication you can draw from our paper is that you need to not only think about how you’re going to be helping these firms as they emerge and perhaps try and cross that valley of death, but also what this means for our local VC market and private financiers that could also be picking up on this information,” he said. “We have to ensure the grant process is seen as rigorous so that the information that is revealed from these grant processes is valuable for private financiers.”
Some of the future work of the Ivey Energy Policy and Management Centre will contribute to the debate on how such grant programs are being developed in Canada.
“There isn’t a lot of information. It’s still being crafted. Something we are interested in at the Energy Centre is trying to inform that process,” he said.
The researchers’ paper, “Signaling by early-stage startups: U.S. government research grants and venture capital funding,” will be published in an upcoming edition of the Journal of Business Venturing.