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2 strong predictors of startup success

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New research from MIT Sloan entrepreneurship and strategy professors highlights two strong predictors of a startup’s growth and success.

In their working paper on founder choices and venture capital investment, Christian Catalini and Scott Stern show that founders who registered in Delaware and acquired a patent and trademark protection were “278 times more likely to achieve an equity growth event than firms that are associated with none of these choices.”

Additionally, the same founders who registered in Delaware and protected their firms through patents and trademarks were more likely to get venture capital funding and “more importantly, the likelihood of receiving venture capital (as reflected by founder choices) is predictive of growth even for those firms that do not receive venture capital.”

 

In researching their paper, “Passive Versus Active Growth: Evidence from Founder Choices and Venture Capital Investment,” the professors collected business registrations from 1995 – 2005 in 34 U.S. states to look at founders’ choices at the early stages of their companies, venture capital investment, and “skewed growth outcomes such as the achievement of an IPO or significant acquisition.” 

The research, which was co-authored by Jorge Guzman, an MIT Innovation Initiative research affiliate and Columbus Business School assistant professor, included more than 10 million firms, accounting for 95% of all venture capital financing.

This allowed the researchers to study and compare the trajectories of “active” and “passive” firms, which could mean changes for business policy, the professors write.

On one hand, if business growth comes from proactive founders, policies could be focused on accelerators, or tax breaks for venture capital investment, the researchers proposed.

On the other hand, according to the co-authors, if most growth comes from passive founders, policies could be directed toward “a higher level of entrepreneurial experimentation” such as simpler, low-cost business registration, or subsidized small business loans.

It turns out the former is true.

Passive and active growth

According to the research, about 50% of all firms in the study that showed $10 million or more of equity growth had founders that didn’t make those early-stage choices such as  registering in Delaware or applying for a patent. They also received no venture capital. This is passive growth.

But 78% of firms that showed $100 million or more of equity growth had founders who made at least one of these decisions and/or received venture capital money. This is proactive growth.

“Under the theory of passive growth, founders are relatively uninformed about the growth potential of their venture, and so any choice they make at founding is unlikely to be predictive of growth itself,” the researchers write. 

For example, in 1993, Steve Ells opened a Mexican grill in Denver with only the hope of being successful enough to open a nicer fine-dining spot. By 2017, after “unanticipated market success,” Ells had refocused his goals and grown his one grill to more than 2,000 Chipotle restaurants.

Founders who “make informed decisions” based on early signs of early growth potential are part of a proactive growth model, according to the paper.

Another example: Jeff Bezos founded Amazon in 1994. Early on he applied for copyrights and patents, and also registered the company as a Delaware corporation. He also got funding from Silicon Valley venture capital firm Kleiner Perkins.

Doubling down on Delaware

According to the researchers, registering a company in Delaware was a benefit to founders for three reasons:

  • The Delaware General Corporate Law provides a long list of court decisions that help with complex contract predictability.
  • The state has an “advanced” system for handling corporate arbitration.
  • The state’s legal framework is “generally regarded as pro-business.”

Registering in a state other than where a company operates costs money, an expense that wouldn’t be necessary for a business that wants to stay small, the researchers write. A Delaware registration is a good sign of a proactive company — and one that might attract venture capital investment.

Intellectual property

For their study, the researchers included patents filed within the first year of registration, or patents assigned to a business within the first year from another firm or inventor.

Patents, the researchers write, provide intellectual property protection for startups, and also “facilitate transactions with venture capitalists.” The researchers also factored in firms that applied for trademark protection within a year of registration.“Firms with an active trademark could use the sales of products and services to bootstrap their growth without relying on external funding,” the paper stated.

Also …

Other findings from the study include:

  • Naming a company after a founder (ex. Mike’s Pastry, Angie’s List) is predictive of higher productivity but lower growth.
  • Successful startups often have names with three words or less (ex. Amazon, Google).
  • Companies that only register in Delaware are 17 times more likely to grow than companies that don’t register in the state.
  • Companies that have only a patent are 87 times more likely to grow than companies that don’t acquire a patent. 
  • Companies with both a Delaware registration and patent (but no trademark) are 342 times more likely to grow than companies that have neither.
  • Companies backed by venture capital are five times more likely to grow than those that are not.
  • About 50% of proactive firm growth came from companies that didn’t raise venture capital.

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