2011
Aalborg University
VIII Semester Project
Juan Martín Carriquiry
Student N. 20102013
MIKE-E
[A REVIEW ON VENTURE
CAPITAL]
This article reviews some of the most important theories and empirical evidence on venture
capital. In particular, it focuses on the two most debated issues in the field: (a) the selection
process, and (b) the value added by venture capitalists to their portfolio companies. The
author finds that the vast evidence on issue (a) is contradictory and hardly conclusive.
Qualitative studies conclude that the qualities of entrepreneurs are the most important
selection criteria. Quantitative analyses, on the other hand, show that venture capitalists
overemphasize human capital. In regard to issue (b), new evidence has shed some light on the
mechanisms and effects of venture capital on the portfolio firms and the economy. However,
there is still substantial work to do. Particularly, there has been few and inadequate analysis of
venture capital policy at national level. Methodological concerns, particularly at
macroeconomic and policy levels, remain key issues that researchers will have to address to
reach conclusive, unbiased analysis on how venture capital works –and what it can do. Lack of
available data on firms that fail or remain public is still a major issue that permeates the whole
field of research.
Table of content
Introduction .................................................................................................................................. 2
History of VC ................................................................................................................................. 4
The role of VC ................................................................................................................................ 7
The VC Investment process........................................................................................................... 9
Venture Capital, Innovation, Growth and Performance ............................................................. 16
Innovation ............................................................................................................................... 16
Performance and Growth ....................................................................................................... 17
Venture Capital Policy ................................................................................................................. 22
Concluding discussion ................................................................................................................. 29
References .................................................................................................................................. 30
Introduction
The surge in the size of venture capital (VC) investment in recent years is being increasingly
matched by a seemingly large body of academic articles in the field. The attention paid by
academics and policymakers to venture capital reflects the conception of this form of equity
financing as an increasingly relevant phenomenon, particularly in certain industries. Some
researchers (Lerner and Gompers, 1999) have found that investment in venture capital is up to
five times more effective for innovation than ordinary R&D investment. Yet, not everyone is so
positive about the potential beneficial effects of expanded venture capital markets or the
value that venture capitalists add to startups in the first place (see for example Zider, 1998).
The following paper aims at contributing to the debate on the effects of venture capital by
reviewing where we currently stand. By considering the most current and influential
theoretical and empirical literature on the field, it attempts to reflect on what we know about
venture capital, and point out some of the issues that need to be further investigated. This
paper is intended to form the basis for future empirical analyses on the effect of venture
capital on national economies and economic development. Therefore, it will focus on the value
added by venture capitalists both to firms and to the overall economic activity, and on policy
initiatives to stimulate venture capital. As an innovation and entrepreneurship student, this
particular form of equity financing represents a critical testing ground for understanding these
processes, since venture capital backed firms are considered to be among the most innovative
and entrepreneurial.
2
This review will thus start by summarizing the main theories and empirical evidence on
venture capital, how it works, why –and to what extent- it is an important phenomenon, and
to how it can be encouraged through public initiatives. The method used to finding relevant
literature has been two-fold: firstly, repeated keyword searches in journal search engines and
hosts such as JSTOR and Google Scholar. Keywords included: venture capital, VC, evidence on
venture capital, cross sectional evidence on venture capital, longitudinal evidence on venture
capital, panel data on venture capital, venture capital selection process, venture capital
fundraising, venture capital policy, venture capital and employment, venture capital and
innovation, and venture capital in Europe. In this search, the focus has been on the most
influential articles, which have been selected by the number of citations by other academic
articles, as documented by Google Scholar. The number of citations is by no means an accurate
measure of the relevance of an article in academics, since this number depends on many
factors, such as time since it was published. Nevertheless, it is a readily available, broadly
accepted indicator of the influence of the paper. The second method for the selection of
articles has been through the references made by the most influential papers on venture
capital. Most articles usually summarize part of the evidence in the field they investigate
previous to the development of their argumentation. We have therefore used these (short)
reviews as a source for references.
The paper will be split into six sections. The first part of the paper is dedicated to a brief
historical account of VC growth and development, and the current situation. The second
section describes the role of VC financing in the economy. The third part is a description of the
VC investment process itself. The fourth section discusses relevant theory and evidence on the
effect of venture capital on innovation, growth and performance. The fifth part focuses on
venture capital policy. The last section includes some concluding remarks and thoughts about
knowledge gaps the directions for future research.
Before we embark on our venture, some clarifications shall be made about its limitations. The
following analysis will not draw on the legal aspects of venture capital contracts1, which would
deserve an entire review in themselves. It will not include either a thorough discussion on the
syndication of investors –though it will be briefly mentioned-2 or a detailed financial account of
the investment process, or portfolio and exit strategies.
1
2
For an introduction to the topic from a legal perspective, see Kaplan and Strömberg (2003).
For a discussion on the topic, see for example Lerner (1994), Brande et al. (2002).
3
History of VC
Early History
Gompers (1994) provides a somewhat thorough account of the history of VC. Earlier forms of
risk capital were undertaken by wealthy families in the 19th and 20th centuries in the United
States. The market for risk capital remained unorganized and fragmented until 1930s and
1940s, and the first VC firm was not founded until 1946 in the U.S., the ARD, to finance
technologies developed during WWII (Gompers 1994, Lample 1989). One of its founders,
Doriot, is known as the “father of VC”, and provided the “hands-on” approach that now is
often associated with VCs. Early VCs started in Boston and New York, and in 1957 they also
started in the West Coast of the U.S. by Arthur Rock, leading to the creation of Fairchild
Semiconductor. Four years later, Rock moved to California to form the first of two early VC
funds in Silicon Valley, which invested in Intel, Apple, Scientific Data Systems, and Teledyne
(Gompers 1994, Lerner 2009).
In 1958 the Small Business Administration chartered the new Small Business Investment
Companies (SBICs) to provide early stage financing for small companies in several industries,
which provided almost exclusively capital. The SBICs scheme has been widely criticized for
decades, and it is now consider to have failed dramatically (Gompers 1994). The two major
problems with SBICs were that (a) they tended to focus on stable industries, and (b) that the
bail-out of the government reduced the incentive to closely monitor investments; there was a
certain incentive for institutions to gamble. The IPOs bubble of the 1960s and the massive hit
to young firms by the first oil embargo in 1973-74 prove disastrous for the scheme. By 1988,
SBICs provided only 7% of all VC investments, down from over 75% 25 years earlier (Gompers
1994).
The growth of VC
Until the 1980s, VC investment never reached 200m a year, and so it remained for the most
part a marginal investment (Gompers 1994, Zider 1998). In 1987, however, it had spectacularly
increased to over 4.9bn in the US, reflecting the significance of the regulatory and tax changes
that took place in that period. In 1978, the Revenue Act lowered capital gains tax from 49.5%
to 28%. Perhaps most importantly, in 1979 the change in the ERISA’s ‘prudent man’ rule,
allowed pension funds to invest in VC. Gompers (1994) argues that the role of changes in tax
4
rates was far smaller than the new interpretation of the “prudent man” rule, and that the
causality between the change in taxes and flow of VC is not straightforward. The reason for
this is that around 70% of funds allocated to VC come from tax-exempt sources such as
pension funds, endowments, trusts and foreign companies (Gompers and Lerner 2001).
Moreover, corporate VC usually looks for more than capital gains (for instance, a “new window
on now technology”, or reducing risks by sharing ownership). Therefore, taxes on gains are
likely to have only a minor impact in this market.
The surge in the 1990s
The venture capital market experienced a significant consolidation of the growing tendencies
during the 1990s. According to Gompers and Lerner (2001), the sharp increase in VC
investment reflected not only the preferences of institutional investors for VC funds, but also
some fundamental changes in corporations. Firms that have traditionally centralized R&D
activities redesigned the way they innovated, increasing collaborations with universities and
other companies, and acquiring small innovative companies that would add energy, new
technologies and fresh ideas to established companies. With the expansion of the Internet,
many companies needed to acquire the know-how in information technology communications
from outside, fostering investment in the field. VC funds also started collaborating with
corporations, structuring deals with partners that would advertise or stimulate the demand for
other portfolio companies. Gompers and Lerner (2001) also indicate that the 1990s saw the
revival of publicly traded venture funds.
The role of pension funds
The increased participation of pension funds in the industry has had large reverberations.
Pension funds are institutional investors that focus on short-term gains, instead of the longterm benefits typically associated with start-ups. As a consequence, seed and start-up
investment has fallen from 25% of total VC investment in 1980, to 12.5% in 1988 (Gompers
1994). Leveraged Buyouts (LBOs), on the other hand, accounted for much of the increase, and
by 1988 represented 20% of total VC investment. The shift towards late-round financing and
LBOs is a clear sign of short-term visions of these institutional investors.
5
The second major consequence of this participation was in the identification of opportunities.
The sudden increase in the size of funds meant that fund managers could now pursue many –
larger- projects. Gompers (1994) and Lerner (2009) argue that this resulted in a herd behavior,
by which fund managers paid far too much for projects to enter certain particularly attractive
industries. The case of Winchester disk drive industry is very illustrative of this point. In the
late 1970s and early 1980s, $400 million was invested in 43 disk drive companies. The market
was growing rapidly (from $27 million in 1978 to $1.3 billion in 1983), and by 1983 $800
million were raised in IPOs. By mid-1983, market valuation of the 12 publicly traded disk drive
companies was $5.4 billion. By the end of 1984, it had fallen to $1.4 billion, and industry
income had dropped by a staggering 98%.
The importance of small business in the economy makes VC a central part of future economic
growth and job creation. VCs have an important role to play in financing young and innovative
companies that will contribute to future growth and technological development in the future.
Gompers 1994 argues that we should not underestimate the need for a long-term perspective,
since many projects may take decades to show their full potential. Capital suppliers should
thus share this long term perspective, for the sake of new firm development, effective product
development and cutting-edge research.
Current situation
Zider (1998) argues that venture capital still plays a minor role in financing basic innovation,
contrary with what many people think. In 1997 in the US, only 6% of the 10 billion invested by
VCs went to start-ups, and less than 1 billion to R&D. Most went to follow-on investment for
projects backed by larger government (63) and corporate funds (133). More than 80% of the
investment of VCs goes to infrastructure to grow the business.
Black and Gilson (1997) argue otherwise. While the size of venture capital commitment is
relatively small, several industry leaders have received VC in early stages. Moreover, since
venture capital investment takes place in stages, much of the capital invested in later stages
goes to firms that have been first financed at start-up or seed level. A more recent evaluation
by Lerner (2009) shows that VC represents, indeed, a small fraction of total investment in the
economy. Nevertheless, he also notes that this is not the case in all industries. In some
industries, such as in semiconductors and internet related industries, VC-backed companies
are in fact market leaders. Moreover, by the end of 2008 13% of the firms in existence that had
6
gone public in the U.S. had been backed by VC, with a total market value of $2.4 trillion -8.4%
of the total. In addition, he finds that VC backed companies are far more innovative than
companies that have not been backed by VC (Lerner 2009, Kortum and Lerner 2001).
As Lerner (2002a), Gompers (1999), Black and Gilson (1998) and many others have
documented, both the fundraising and investment in venture capital markets is markedly
cyclical. Yet, despite the bums and bursts, the tendency for venture capital industry has been
marked by a sharp increase since 1979, and particularly since the 1990s. Samila and Sorenson
(2011) report that according to the National Venture Capital association, total funds raised by
venture capital firms have gone from $579 million (in 2007 dollars) in 1978 to $35.9 billion in
2007.
The role of VC
Throughout the review on the origins and current situation of the VC market, some of us may
have wondered why we actually need VC for. The answer is that VCs fill a gap left by the
structure and rules of capital markets. Entrepreneurs with innovative ideas or breakthrough
untested technologies but few collateral may find it hard –if not impossible- to raise capital at
any rate. Usually rules against usury ban credit institutions from charging the interest rates
that they would for such risky ventures. In general, firms looking for VC investment are small,
plagued with uncertainty and characterized by a significant asymmetry of information
between entrepreneurs and investors (Romain and van Pottelsberghe de la Potterie 2003).
Moreover, these companies tend to be in rapidly changing markets and have few collateral
assets, making them particularly risky borrowers (Gompers and Lerner 2001).
Thus, it often happens that entrepreneurs have relatively few other institutions to turn to. VCs
tap into this market niche by providing capital for equity, filling the gap left between
corporations, governments, friends and family, and those of traditional credits (Zider 1998).
Moreover, these type of innovative startups typically needs “patient” capital, which will not
require repayment for the first few years, since they are unlikely to make a profit in the first 34 years. In fact, many of these companies never made a profit before going public, and some
authors (see Zider 1998) argue that there actually is no guarantee that even those that have
gone public ever will do so.
Venture capital firms are usually active investors with a “hands-on” approach, as we will
discuss in the next section (Gompers 1994). These firms typically create and manage funds to
invest in innovative promising startups, expecting returns of 25% to 35% a year on investment
7
for shareholders, plus commissions, salaries and fees for managing the fund (Zider 1998).
Investors in these funds are usually large institutions, such as pension funds, financial firms,
insurance companies and university endowments.
Not just capital
One of the reasons why venture capital is so particular is that investors do not only provide
with money. Typically, their functions include identifying and attracting new deals, allocating
additional funds to the better deals, recruiting management, acting as consultants, serving as
directors and monitors, and assisting with exit strategies (Zider 1998, Gompers 1994). They
also provide the entrepreneur with access to consultants, investment bankers and lawyers
(Gompers 1994), and assist in the professionalization of the firm (Hellmann and Puri 2002). In
the same line, Amit et al. (1990) argue that VCs not only contribute with capital, but they also
share the risks associated with the new venture, and contribute to the general management of
the firms, including the design of strategy and contact to other investors and credit
institutions3. Moreover, receiving the backing of a VC enhances the reputation of the firm
towards other investors, customers and suppliers (Amit et al. 1990, Baum and Silverman 2004)
Venture capitalists, therefore, are considered by most researchers to be particularly good at
scouting promising ventures (Baum and Silverman, 2004). This stream, thus, sees VCs as being
particularly skillful at “picking the winners” from the rest. Yet, others emphasize the
“coaching” ability of VCs: that is, they are particularly good at bringing managerial expertise to
the startup (Hellmann and Puri 2002). This view sees VCs as being particularly good at ensuring
the good management of the startup after the investment. Whether venture capital firms
perform better than the rest because they are well selected or because VCs add substantial
value to them will be discussed in Section 4. But before that, let us get as grasp of how the
investment process takes place.
3
This argument, naturally, assumes that entrepreneurs are risk averse. Otherwise, sharing risk would
not be an issue. In fact, in this view venture capital markets may only have positive NPVs because
entrepreneurs need to share risk or have difficulties raising money on their own.
8
The VC Investment process
Fundraising
Venture capital funds raise capital from investors and channel it to privately held companies
with the aim of achieving superior returns on investment (Dimov et al. 2006). The total size of
VC investment has fluctuated significantly during the last four decades. Gompers and Lerner
(1999) find that there is a correlation between total VC capital commitment and capital gains
tax rate. The causality, however, is not that straight forward. Most VC investors are taxexempt. Yet, it seems that a lower tax rate on capital gains increases the demand for venture
capital, since it encourages corporate employees to become entrepreneurs (Gompers and
Lerner 2001). Thus, it seems that the reduction of capital tax rates affects fundraising mainly
not through the increase in the supply of funds, but through an increase in demand by
entrepreneurs (Gompers and Lerner 1999, 2001). Evidence of this is the fact that the highest
increase in commitment after reductions in capital tax gains was by tax-exempt pension funds.
Moreover, at an aggregate level, easing of restrictions on pension funds investment, and
industrial and academic R&D expenditure are positively related to venture fundraising.
It is also worth noticing that the fundraising ability of a venture capital firm will depend on the
reputation it has built throughout its history. Gompers and Lerner (1999) find that both the
performance of funds and their reputation lead to higher levels of venture capital fundraising
by organizations.
Black and Gilson (1997), on the other hand, find evidence that fluctuations on VC commitment
are related to the health of the IPO markets. Thus, they show that the willingness of investors
to commit capital to venture capital funds depends on the number of IPOs in the previous
year. The descriptive nature of their study, however, does not control for other variables that
might be simultaneously affecting both, the number of IPOs, and commitment to VC funds.
As will be noted in later sections, some authors have pointed out that adjustments in the
supply of venture capital take place rather suddenly and tend to “overshoot”. Fundraising
declines and increases rapidly through boom and burst cycles, with the relative efficiency of
the portfolio investments of funds also varying accordingly (Lerner 2002a).
9
Selection
Literature on the selection criteria used by venture capitalist to make investment decisions is
far from homogeneous. Yet, we do know that only about 1% of all business plans presented by
firms seeking venture capital have been funded (Kortum and Lerner (1998). Thus, it is relevant
to take a closer look at what theory and evidence say about the selection process.
One of the most influential papers on the screening process is MacMillan et al. (1985).
Perhaps the most relevant finding of this paper is the confirmation that the quality of the
entrepreneur is what matters the most in the decision of VCs. Particularly, the staying power
and the ability to handle risk are singled out as the most important qualities in an
entrepreneur.
In the same line, Kakati (2003) realized a questionnaire of and follow up interviews with
twenty-seven venture capitalists on the most and the least successful ventures they had
backed. He asks VC managers to rate the characteristics of examples of successful and
unsuccessful ventures they have funded. Kakati finds evidence in the direction of MacMillan et
al. (1985), that VCs value most entrepreneurial quality, resource-based capability and
competitive strategy.
On a follow up study on research by MacMillan et al. (1985), MacMillan et al. (1987) build on
the earlier results and enquiry into the criteria for successful and unsuccessful ventures on the
screening process by VCs. Based on a sample of 150 successful and unsuccessful ventures,
rated by 67 VCs, the study finds that the two most important criteria for success are the initial
protection from competition, and degree of demonstrated market acceptance for the product.
Because the 150 firms have all been backed by venture capital, the study does not explicitly
address the question of which ventures obtain financing, but rather what are the
characteristics of those firms that do obtain venture capital that make them successful or
unsuccessful. These results are highly relevant, since they are characteristics that have not
been initially considered as the most important criteria by VCs –otherwise, firms failing to
meet them would not have received backing in the first place. Interestingly, both of these
criteria are market-related, as opposed to entrepreneur or product-related. This suggests that
the market will be the judge deciding whether the venture is successful, given that it has
received venture capital financing.
Hall and Hofer (1993) support the notion that the role of human capital in the selection
process has been overemphasized by previous studies. Through a series of 16 semi-structured
10
interviews and verbal protocol –in which participants are basically asked to think aloud- they
analyzed the selection criteria used by VCs to evaluate new ventures proposals. Perhaps
surprising was the confirmation that VCs place substantially less emphasis on the management
team (entrepreneurs) than suggested by other research. More important were criteria on longterm growth and profitability of the industry (market-related), and compliance with the find’s
lending guidelines.
Baum and Silverman (2004), moreover, found evidence that VCs themselves have a tendency
to overemphasize the role of human capital –management skills- of entrepreneurs in the
selection process. VCs tend to finance firms with strong technology that are under strain,
perhaps where they perceived that most value can be added by their investment. In their
research, they identify three broad factors that affect VCs assessment of future startup
performance: alliance capital, intellectual capital, and human capital. Alliance capital confers
startups the ability to access complementary resources, knowledge and assets of partners, and
confers legitimacy to the venture. Intellectual capital is particularly important in strong
appropriability regimes, such as biotechnology, because patents are hard to circumvent.
Therefore, patents –and pending applications- are a strong signal of innovative capabilities and
thus they are particularly likely to increase the attractiveness of startups to VCs in strong
appropriability contexts. Human capital has been widely self-reported by VC managers as a
decisive factor behind their investment decisions, particularly when uncertainty is higher. Their
results show that for a ten years sample of biotechnology firms and startups in Canada, human
capital plays a smaller role in performance than intellectual and alliance capital. They therefore
find that VCs get better scouting signals from intellectual and alliance capital than from human
capital as indicators of future performance.
Zider (1998), Gompers (1994), Gompers and Lerner (2001), and Lerner (2002a, 2009) also
argue that VCs do not invest in good ideas or good people, but rather in industries that give
better profits than the market as a whole. They have observed that institutional investors in
particular follow a herd behavior by chasing deals in particular “hot” industries. The logic is
that it is far easier to grow quickly in a rapidly expanding industry than in a decaying industry.
These authors also point out that this behavior leads to too much money chasing too few
deals, generating market bubbles, as the case of the Winchester disk drive reflects.
Dimov et al. (2006), on the other hand, observe that most research on selection criteria have
focused on the similarities among VC firms to draw a general image of the VC selection
11
mechanism (MacMillan et al. 1985; Wright et al. 1997)4. They notice, however, that VC firms
make different degrees of early-stage investment, and so they investigate the reason behind
such decisions. Analyzing the investment allocation of 108 VC firms over a 6-year period (19972002), they study the relationship between the top management team members’ financial
expertise, venture capital firms’ reputation and status and the proportion of early-stage
investments in their portfolios. They find that financial expertise is associated with lower
proportion of early stage investment, and that this relationship becomes weaker the higher
the reputation of the VC firm, and stronger the higher status of the firm.
Petty and Gruber (2009) realize a longitudinal analysis of a European-based VC firm which
managed two funds that invested in 35 ventures over an 11-year period. The novelty in their
analysis is that they focus on the criteria that the VC firm used not to invest in a venture,
rather than to invest. They argue that researchers have focus on understanding the criteria for
acceptance of proposal, and have thus neglected the reasons behind the decision of a VC to
reject a deal. Through a historical case study, they attempt to shed some light on this issue.
They revise information on 3,631 applications for funding, of which 35 were successful. The
results show that criteria for rejection is similar than criteria for acceptance. Surprisingly,
however, they find that rejection arguments regarding the management team were less
frequent than literature suggests. Interestingly, they also find that the criteria evolve over the
time span, and arguments for rejection related to the VC fund itself grow with time. This
suggests that there are factors within the fund that increase in importance over time and lead
to the rejection of projects over other concerns. Also surprising is the finding that many
attractive companies (about 5%) were dismissed because they failed to provide further data
when requested by the VCs. They also find that not all rejections were definite, but some left
an open door for future reconsideration of deals. Some of the deals rejected were simply
because of a lack of time, regardless of its viability. Perhaps more interesting, the reasons for
dismissal accruing to external factors seem to fluctuate. This suggests that external conditions,
such as changes in market conditions and shifts of industries play a cyclical role in the selection
process. Lastly, they find that resubmission of applications have at least the same chances as
first time applicants of obtaining financing.
Alternatively, Cable and Shane (2002) emphasize the role of social ties in the selection of new
ventures. They argue that the social dimension of venture capital has been vastly overlooked
4
Although I agree, there are notorious exceptions that focus on highlighting the difference among VC
firms –Elango et al. (1995)- and the effect of these differences on performance –Engel (2004).
12
by economic explanations of the phenomenon. In their study, they combine a survey of the
202 seed-stage investors with field work with 50 high-tech enterprises. The purpose of their
analysis is to study the ties between entrepreneurs and the 202 seed-stage investors. Their
findings suggest that these ties have a significant effect on the selection on funds to be funded
through a process of information transfer among agents. Social ties provide indeed an
opportunity for entrepreneurs to obtain financing for their enterprises by allowing investors to
obtain more information about them, overcoming relevant information asymmetries.
Investment
In general, most venture capital is invested in high-tech companies in growing industries. In
the 1980s, most capital flowed into the energy sector. In the 1990s, it has turned from genetic
engineering, specialty retailing, and computer hardware to multimedia, telecommunications
and software companies. Most recently there has been a tendency towards heath care and
energy sectors, although information technology still takes the largest share of investment
(Lerner 2009). These characteristic waves of investment directed towards particular industries
are sometimes understood as a sort of herd behavior. Gompers and Lerner 2001 argue that
“too much money chasing too few deals” situations are common place in VC markets during
periods of rapid growth. This also raises the valuation of investments when there is increased
competition, leading to cyclical bums and bursts.
Venture capital usually avoids both very early stage industries, with high uncertainty, and later
stages, with slow growth rates. Growing within high growth sectors is much easier than in
sectors with limited or even negative growth (Gompers and Lerner 2001). At this adolescent
stage of high growth, it is not easy to pick the winners. The challenge is to find competent
management to supply the growing demand. VCs try to avoid investing in untested
technologies, and when they do those investments are known to yield a return only in a much
larger time period (Gompers and Lerner 2001).
According to Zider (1998) investment bankers will also be looking to those high growth
industries, so it will be easier to exit and support higher valuations in those sectors, and for
investment bankers to obtain higher commissions.
Gompers and Lerner (2001) consider that in this form of equity financing there might
sometimes be an incentive for entrepreneurs to rush products to market or research in areas
that are not profitable for the business, apart from lavish expenditure on things that add little
13
value to the firm. For this reason, VCs have to scrutinize firms before funding them and
monitor the company once investment is made. Perhaps the most powerful tool that they
have at hand is meeting out financing in stages over time, so that entrepreneurs have to come
back for capital several times, making it easier to control expending (Kortum and Lerner 1998).
VCs also syndicate investment with other VC firms, both to diversify away firm-specific risks
and to bring second opinion on projects. In addition, they frequently take sits on the board of
directors to ensure a close oversight of activities. Compensation arrangements between the
entrepreneur and the VCs usually include stock options, which further allow for the alignment
of incentives of employees and investors alike.
The deal
Venture capital financing agreements usually provide ample downside protection and a
favorable position for additional investment if the venture proves successful (Zider 1998). The
VC usually obtains preferred-equity, which offers downside protection: if the company fails,
the VC has preferred claims over the assets and technologies of the venture. The deal often
includes blocking rights and large voting rights in key decisions, such as IPO timing (Zider 1998,
Kortum and Lerner 1998). Moreover, they usually include clauses against equity dilution in
case of further rounds of financing at a lower value. If the venture proves successful, investors
can usually obtain equity at below market prices. Usually several VCs invest in the same firm,
to diversify their portfolios and reduce the workload for each VC; generally there is one “lead”
investor, and several “followers”. The presence of several VCs also adds credibility.
Generally, only between 10% and 20% of all investments turn out to be very good. Some turn
out complete losses, some great investments, and most in between. Great and very bad
investments are usually devoted little time, while the ones in between (middle portfolio
companies) take most of the time from VCs. Those deals take time and resources to turn
around, and to evaluate whether or not to continue investing in them. The characteristics of
the deals typically allow VCs to replace management at mediocre companies to turn them
around.
Amit et al. (1990) identify five generally distinguishing features of VC financing contracts: First,
the agreement involves a risky position for both, the entrepreneur and the investor. Second,
the entrepreneur’s profit will depend on the demonstration of skills. Third, if the entrepreneur
is replaced, he will be compensated by a fixed quantity, independently of achievements.
14
Fourth, the entrepreneur must demonstrate a predetermined level of skills (achievement) to
remain in control of the venture in subsequent stages. Lastly, the first-round investor has the
right to first refusal for subsequent financing rounds.
Exiting
VC funds have several exit alternatives. They may sell the company or merge it with another
corporation without going public. Yet, it is generally agreed that the most profitable exit
strategy for VCs is an Initial Public Offering (IPO). In these operations, venture capitalists are
usually required to hold their shares in the company for at least 6 months, although some of
them keep the shares long after it has gone public. Typically, they keep them for up to one
year, and large institutional investors tend to hold them even longer. Studies have shown that
venture-backed shares are less underpriced when the company goes public than other firms,
and the market valuation therefore fluctuates less in the first day on the market (Lerner 2001).
After the required holding period, the fund may sell the shares on the market, paying the
proceeds to investors in cash, or may distribute the shares among investors of the fund (this
last option is largely unregulated and not free of polemic). Gompers and Lerner (1999) find
that investors are right to be worried about an asymmetry in the information. Following the
increase in stock prices before the distribution, there is negative adjustment following the
distribution, which suggests that investors should worry about the incentives for VCs.
Black and Gilson (1997) argue that a healthy and well developed stock market that allows
venture capitalists to sell the company through an IPO is a pre-requisite for the development
of mature venture capital markets. In a comparison between the financial sectors in the US,
Germany and Japan, they conclude that US venture capital market is more developed because
of the institutional setting that allows a successful exit to a vibrant public market. The evidence
of their study shows that there is a clear (lagged) relationship between the number of IPOs and
the amount committed to venture capital funds.
15
Venture Capital, Innovation, Growth and Performance
Innovation
Timmons and Bygrave (1986) find that evidence from 1967 to 1982 shows that VC investment
has a significant effect on innovation. In addition, they argue that the capital provided by
Venture Capitalist is the least important factor in fostering technological innovation. It is the
managerial knowledge, the web of contacts and networks, and the involvement of venture
capitalists what facilitates the emergence and accelerates the commercialization of
innovations. Successful venture capital investment helps entrepreneurs in selecting key
management, provides credibility with suppliers and customers, and assists in designing
strategy when daily tasks postpone this activity. The choice of Venture Capitalist by the
entrepreneur then, is highly relevant: as Timmons and Bygrave (1986) put it, “The message for
technology entrepreneurs is clear: focus on venture-capital firms with reputations for proven
performance in your technology and market, especially with your targeted customers.” (pp.
162).
Kortum and Lerner (1998, 2000) study empirically the relationship between VC and innovation.
They study the influence of venture capital on patented inventions in the US across twenty
industries in a period of three decades. It is probably one of the fist papers to address
empirically the relationship between this particular financial institution (VC) and innovation
performance. On the theoretical side, they build a model to analyze the impact of VC
investment on patenting relative to that of corporate R&D. Even though their approach faces
several methodological and conceptual issues5, it is an ambitious and original research. One of
the original factors in their method is that they use an external shock to the supply of VC
provided by the clarification of the “prudent man” act in 1979 as an instrumental variable. The
explicit interpretation of the act removed the constraints on pension funds to invest in riskcapital such as VC. This setting provides evidence on the effect of a sudden increase in the
availability of funds on the industry without an evident increase in the number of
opportunities to be founded in the short run.
Throughout the paper, they address several key methodological issues, such as the causality
between VC investment and innovation, and the relative propensity of VC-backed companies
5
Notably, they compare R&D expenditure and Venture capital as substitutes in an innovation (or
patenting) variable.
16
to patent and the quality of the patents.6 Perhaps some issues regarding the unobserved
variables could be considered. For example, what other things have changed in the period
preceding 1979 and after that, such as macroeconomic changes and tendencies, and changes
in public markets.
The paper, nevertheless, provides some robust results. They show that there is significant
evidence that venture capital investment is related to more patenting vis-à-vis corporate R&D.
Their most conservative estimates suggest that a dollar invested in VC is up to 5 times more
effective than a dollar of corporate R&D. They also prove that this is not due to the greater
propensity to patent by VC-backed firms (which is also the case), since the quality of the
patents is not lower than that of firms not backed by venture capital. Moreover, the higher
rate of patenting is coupled with a higher level of litigation over both patents and secrecy,
suggesting that the patents are valuable and that they are not the only method for protecting
knowledge chosen by VC-backed firms.
Performance and Growth
During the late 1980s and beginning of 1990s there was a large interest on the valued added
by venture capitalist to new firms. Timmons and Bygrave (1986), MacMillan et al. (1989), Amit
et al. (1990), and Sapienza (1992) are only some of the most prominent studies on the field.
More recently, Barney et al. (1996) investigates the learning of venture backed teams from
investors; Hellmann and Puri (2002) have studied the effects of venture capitalists involvement
and the professionalization of startups; Baum and Silverman (2004) evaluate whether VC
backed firms perform better because they are well selected or because investors add real
value to them; Parks and Steensman (2011) analyze the value added concretely by corporate
venture capital to new ventures. Croce et al. (2010) have investigated the impact of venture
capital financing on productivity growth in European high-tech ventures. Davila et al. (2003)
and Engel (2002) also study the relationship between venture capital financing and startup
growth. Dushnitsky and Lenon (2006) investigate directly when venture capital adds value to
firms. Florin (2005) investigates the effect of venture capital on firm performance and funder
returns.
6
Note perhaps the inconsistency in page 19, when they first assume that vfv(V/λ.H) is increasing, and
fr(V/λ.H) is decreasing, and then in page 21 they arrive to that conclusion.
17
On the evidence about the value added by venture capitalists to their portfolio ventures,
Busenitz et al. (2005) approach the issue from an inter-organizational learning perspective –
that is, they analyze the particularities of the relationship between venture capitalist and the
teams they fund. They present a solid –perhaps the only- longitudinal analysis on the value
added of VCs to the companies they back. Of the firms that responded the questionnaire
between late 1989 and early 1990, data was obtained on 183 of them through the year 2000.
Busenitz et al. conclude that there is a positive relationship between procedural justice and
performance. They also find that there is a negative relationship between performance and
the dismissal of more than one member of the team. Their study finds no significant evidence
that VCs provide strategic information to their portfolio companies that increases
performance.
Perhaps one of the main limitations of this analysis is that it actually treats relationships
among actors as a static phenomenon. The continuous mutation of relationships suggests that
the perception by members of the portfolio companies’ management about the value added
activities of VCs will not necessarily remain constant throughout the whole 10-year period –
especially the concept of “fairness”. Moreover, as the authors mentioned, there is the
possibility of confounding factors that have been unaccounted for, especially in the
relationship between team members’ dismissal and long-term venture performance.
Nevertheless, these drawbacks should not obscure their contribution to the discussion.
Amit et al. (1990) argue that the most promising new firms will not use venture capital as a
source of financing. They argue that we should observe a higher rate of failure among the
firms backed by Venture Capital than among new firms in general, since they are not founded
by the most capable entrepreneurs. Their analysis concludes that VCs are not capable of
accurately assessing the skills of the entrepreneurs, and therefore the most promising
entrepreneurs will not find their offers attractive enough. Only low skilled entrepreneurs will
perceive that the offer is sufficiently good, and thus the performance of VCs portfolios will
tend to be worse than the population of new firms.
The results seem rather counterintuitive since most research shows that venture capital
backed companies operate in highly dynamic environments where the risk of failing is
considerable. If VCs are financing poor firms, it seems surprising that they raise ever larger
funds to invest. Moreover, the analysis of the motives for entrepreneurs that seek financing VC
is highly restrictive. Firstly, there might be a number of other reasons for an entrepreneur to
18
seek the backing of a venture capitalist. For example, the team of entrepreneurs might be
conscious about their ability to develop a given technology or product, but might recognize
their lack of expertise in other fields, such as sales and strategy. Secondly, this analysis is based
on the idea that an entrepreneur knows its ability better than the venture capitalist, and that
its ability determines entirely its ambitions. None of these is necessarily true. Individuals that
consider themselves highly skilled entrepreneurs may not be so, and high potential
entrepreneurs might be unaware of their true talent. Lastly, although it is well recognized that
there is an asymmetry of information between the entrepreneur and the VC, it is not clear
whether a VC is unable to select the highly skilled entrepreneur from the rest. Since less than
1% of applications for VC are actually successful, it is possible that most low skilled
entrepreneurs lay within the unsuccessful 99%. Venture capitalists currently have a set of tools
to identify the best ventures and entrepreneurs, such as scrutinizing exhaustively the
entrepreneur and financing the venture in stages to minimize losses.
Sapienza (1992) conducted a study on the value added by venture capitalists on new ventures
in 1988. Despite the small final sample -51 matched pairs of lead investor-CEO--, his results
show a strong correlation between the involvement of investors in the venture and
performance. He further shows that value can be added at all stages of the venture, and that
CEOs of varying experience can all benefit from investors’ involvement. Moreover, the study
shows that the most innovative ventures are the ones that benefit the most, and that
communication between the investors and the entrepreneur is essential for effective
performance. Lastly, this highlights that it is important for entrepreneurs to choose the right
venture capitalist, much as Timmons and Bygrave (1986) argue.
Hellmann and Puri (2002) provide an empirical assessment on the impact of VC on the
development of new firms. They run a series of probit regressions and Cox regressions with
time-varying covariates on a hand collected data sample of 170 companies in Silicon Valley.
Their findings suggest again that VC investment provides a higher involvement and has higher
reverberations than other financial intermediaries, which is in line with Timmons and Bygrave
(1986). In particular, they study the role of Venture Capitalists in the professionalization of
human resources and the organizational structure of new firms in Silicon Valley. The study
concludes that Venture Capital has a significant positive effect in the professionalization of
new venture in Silicon Valley, particularly in human resources practices and organizational
structures.
19
On an aggregate level, Alemany and Martí (2005) and Romain and van Pottelsberghe de la
Potterie (2003) study the effect of venture capital investment on economic growth. Alemany
and Martí (2005) use an unbiased data sample of 323 venture capital backed companies in
Spain to test the economic impact of venture capital investment. They compare the growth in
employment, sales and assets of venture capital backed firms with a control group of firms
that have not received venture capital financing. Their results show that there is indeed a
strong and positive effect of venture capital investment on those indicators. They further
indicate that there is a strong relationship between the cumulative investment by venture
capitalists and those economic indicators over time.
Romain and van Pottelsberghe de la Potterie (2003) find that VC affects growth through two
channels: by introducing new products and processes to the market –innovation-, and by
enhancing the absorptive capacity of firms. Based on data from 16 OECD countries over the
period 1990-1998, they find evidence that VC contributes to the productivity growth of the
economy at large. Moreover, they find that the social return of investment on VC is twice as
high as the social return on public or private R&D.
Belke et al. (2003) also analyze empirically the effect of venture capital on labor market
performance. Based on the analysis of 20 OECD countries, they find evidence that financial
markets indeed have an effect on the level of unemployment. The capacity of entrepreneurial
firms to obtain financing for new technological ventures is a determinant of new job creation
in the economy. To the degree that a healthy venture capital market enhances the available
options of entrepreneurs to obtain financing for such projects, venture capital markets
contribute to job creation and structural change in the economy.
Bertoni et al. (2006) analyze the value added hypothesis of venture capitalists with evidence
from new firms in Italy. Their findings support the argument that venture capital enhances the
growth performance of new firms. In addition, they find that venture capital provided by
specialized financial intermediaries (venture capitalists) has a stronger effect on growth than
corporate venture capital. This is attributable to differences in both the skills and objectives of
venture capitalists and corporate investment.
Keushnigg (2004) attempts to incorporate venture capital, startup entrepreneurship and
innovation in a general dynamic equilibrium model. His model adds a theoretical framework
for the analysis of venture capital effects in a general equilibrium. Nevertheless, the model
assumes, rather than showing, that venture capitalists add value to their portfolio firms.
Although this is a plausible assumption, the paper does little in itself to demonstrate that VCs
20
enhance performance and growth. This should not undermine the main contribution of the
paper, which is to allow for an understanding of the effect of venture capital and innovation at
a national level.
Engel and Keilbach (2007) use a probit estimation method on a sample of 142 venture capital
funded firms and 21,541 non VC funded firms in Germany for their analysis. They find evidence
that firms in the German market that receive VC are more innovative, measure by the number
of patent applications, than firms that do not receive VC. Nevertheless, they find that the
patent applications were filled before the financing by venture capitalists: after the
investment, there were no significant differences in innovation performance between both
groups of firms. These findings contradict previous evidence by Kortum and Lerner (2000) in
the US: The higher innovative rate of firms that receive VC seems to come from the selection
process, rather than the influence of VCs. However, Engel and Keilbach find that firms that
receive VC grow much faster after the investment that firms which do not receive VC. This
suggests that venture capitalists add value in the commercialization process of existing
innovations and growth of the firm.
Croce et al. (2010) provide one of the most recent studies on the valued added proposition of
venture capitalists. They perform a regression analysis on a sample composed by 564 high-tech
firms, 227 of which had received VC, from six different European countries (Italy, Spain,
Belgium, Finland, France and the U.K.) which received their first VC investment between 1995
and 2004. Their results support the argument that venture capitalists indeed contribute to the
productivity growth of companies in high-tech industries, not simply by the financial support,
but also by other value added activities. They used a control group to evaluate the changes in
productivity before and after the VC investment, and found the increase to be positive and
significant. Moreover, they were able to distinguish the role of increased assets by the
investment and other value added activities by measuring productivity growth instead of
simply sales or employment growth.
In a recent study, Sampsa and Sorenson (2011) use a panel of data on U.S. metropolitan areas
to study empirically the relationship between venture capital, entrepreneurship and economic
growth. Their findings support the notion that venture capital fosters startups, employment
and aggregate income. In fact, they find that it is possible that venture capital stimulates the
establishment of even more firms than it finances. They acknowledge, nevertheless, that the
scale of venture capital investment means that it unlikely to make a major impact in the
economic activity of a region: even in Silicon Valley, less than 4% of firms are financed by VC.
21
Alternatively, Hochberg et al. (2007) study the value added to the portfolio companies and the
performance of the VC fund by the contacts and networks of venture capitalists. They find
evidence that better networked VCs perform better, measured by successful exits, and their
portfolio firms are also more likely to survive and exit successfully. They argue that syndication
of VC investments help venture capitalists screen potential projects, diversify their portfolios,
and add to the pool of resources (such as customers, creditors and headhunters) that portfolio
firms can draw from. Although the syndication of venture capitalists is not a field we will delve
into in this review, it is worth noticing here that Hochberg et al. (2007) find concrete evidence
that syndication adds value both to venture capital funds and to portfolio companies.
Venture Capital Policy
Public policy initiatives to foster entrepreneurship and venture capital are receiving increasing
attention by researchers. Most policies attempt to tackle deficiencies either in the supply of
venture capital or in the demand by entrepreneurs. As a particular case of financing of
entrepreneurial activities, it would unwise –if at all possible- to isolate our understanding of
most public policies directed to entrepreneurs from those directed to venture capital
financing, since they are highly embedded. Yet, one may ask if we need a public policy on
venture capital and entrepreneurship at all.
The answer, clearly, is yes –for several reasons. Lerner (2009) maintains that the state can
create virtuous cycles of entrepreneurship and venture capital: it is harder to find professional
services, qualified staff and so on for the first few startups than for latecomers. Recent
evidence on the effect of VC investment (Sampsa and Sorenson 2011) also points towards the
self-reinforcing mechanisms of this form of financing. Moreover, it appears that venture
capital in early-stage markets are hardly likely to yield high returns, as can be documented
both from developing countries and from the history of venture capital in the U.S. Even AMD,
which had its “home run” with Digital Equipment, yielded a return of just 14.7%; most of the
funds that existed at the time have since been forgotten, which very likely means that they
had even lower returns (Lerner 2009, Gompers 1994).
The second reason for government intervention is to provide certification. Public investment in
firms with high potential increases the likelihood of obtaining add-on capital by private
venture capitalists. An analysis of investment by industries suggests that many promising firms
do not get financed because of the preferences of venture capitalists on “hot” industries.
22
Lerner (2009) documents that, in 2000, 92% of VC investment went to health care and
information technology. By the end of the decade, the flow had shifted and at least 16% went
to the energy sector. These shifts point toward a herd behavior by institutional investors
(Gompers 1994, Lerner 2009). If governments are able to spot the promising firms that are left
aside by this selection bias, they could play a major role in financing young entrepreneurial
firms with high innovative potential.
A third reason for involvement by the government is to increase the knowledge flows in the
economy (Lerner 2009). It is well known that innovators do not always manage to capture the
lion’s share of the profits, which may sometimes go to rivals or providers of complementary
services. Some innovations may indeed prove not profitable, yet extremely beneficial for
society. For those spillover effects, there is a strong rationale for public support schemes.
Now that we have considered some of the main reason for involvement by the public sector,
let us see what some studies say about different types of policies to fosters the demand and
supply for venture capital.
Supply Policies
There have been a number of schemes that attempted to increase the supply of venture
capital funds available to entrepreneurs. Public intervention in this area includes the direct
provision of capital through public venture capital funds, the removal of regulations impeding
investment in venture capital by institutional investors –particularly pension and insurance
funds-, and public participation in venture capital funds. The latter form of participation seems
to be of little interest to the discussion, since such investment seeks only a return on capital
(Fisher 1988). The first two, aimed at increasing the availability of capital for entrepreneurs,
have had substantial effects on the venture capital industry.
One early influential paper in this field is Fisher (1988), who discuses public venture capital
funds as an economic development strategy. In particular, he analyses the Massachusetts
Technology Development Corporation, funded in 1978, to draw broader implications for public
policy. According to Fisher, the basis for state intervention in the market relies on three
assumptions: first, small firms generate a disproportionate number of new jobs; second, small
firms need equity financing (patient capital), since they generally do not make profits in the
first years; and third, there is a shortage of venture capital, particularly since funds are usually
not interested in small investments (up to $300.000). After an analysis based on a financial
23
forecast of the fund, he finds that the scheme can –and is likely to- be profitable in the
medium- to long-term, even after accounting for the opportunity costs of the investment. The
firms financed by the scheme were required to prove lack of access to other means of
financing, and seem to present on average slower growth and lower risk than private venture
capital portfolio companies. Fisher also finds that the cost per job created was $4000,
substantially lower than other public investments initiatives (Murray (1998) finds similar
results for European Seed Capital Fund Scheme). This suggests that public venture capital
funds can be a useful tool to fill the equity financing gap left by private venture capitalists.
In the same line, Murray (1998) documents evidence of the European Seed Capital Fund
Scheme. He finds that the scheme proves to be a resource efficient tool for stimulating job
creation. The low failure rate of portfolio companies also suggests that the fund may be indeed
targeting successful companies. Moreover, the ability of regional funds to find promising deals
suggests that there is indeed a latent demand for venture capital that is not sufficiently
satisfied by the private sector.
Another relevant article on public venture capital initiatives in Europe is Leleux and Surlemont
(2003). They study whether public venture capital funds are seeding the market or crowding
out private venture capital investment in 15 European countries from 1990 to 1996. After
controlling for the characteristics of the legal system of each country, they find no support for
the crowding out hypothesis. If anything, there is a positive correlation between the size of
public intervention and the overall size of the industry. Although they find no evidence either
that public intervention seeds an industry –public venture capital investment seems to be
latecomer in most industries-, this seems to suggest that public initiatives do create a larger VC
sector.
Demand Policies
It is clear, nonetheless, that despite the possible benefits of increasing the supply of venture
capital, this is only part of the story. If the supply of capital was to grow, but the number of
potential deals would remain constant, it would have little overall impact on entrepreneurial
activity, besides possibly reducing the cost of capital. This is why some scholars argue that the
most effective policies are not those to increase the supply of venture capital, but those that
foster the demand by encouraging entrepreneurship and innovation.
24
Florida and Smith (1990), for example, find evidence that the lack of venture capital
investment in some regions is not due to the lack capital itself, but the absence of potential
good deals for investors. Their findings from a two-year study of venture capital across the U.S.
suggest that the financing gap reflects an underlying structural weakness, and as such cannot
be fulfilled with more financing by the government. Policy efforts, thus, should focus on
overcoming these weaknesses and increasing technological capabilities and infrastructure.
Their study shows that VC is extremely concentrated, and investment flows to established
high-tech centers. In their view, venture capital is not sufficient to stimulate innovation and
growth: it only does so in established high-tech areas. Arguably, VC is only one of the factors
behind “an area’s technology base and social structure of innovation”7, and certainly “venture
capital… [is not] the start of entrepreneurial activity.”
Da Rin et al. (2006) study a panel of data on 14 European countries between 1988 and 2001,
and consistently with Florida and Smith (1990) for the U.S., find no evidence of a shortage in
the supply of venture capital in Europe. On the other hand, they find strong evidence for the
stimulation of innovation through “new” stock markets. In line with Black and Gilson (1997),
therefore, they argue for the importance of an appropriate market for a successful exit
strategy as key to foster venture capital investment, particularly in high-tech, innovative
activities. Their findings also suggest that taxation matters significantly, partly supporting
findings by Gompers and Lerner (1999). In addition, labor market flexibility also has a positive
impact on the innovation ratio of the economy. No overall effects were found for R&D
changes. Acording to the authors, the most effective policies focus on increasing the returns
for the entrepreneur and the investors, rather than providing more capital. This study provides
one of the most robust analyses on the effect of public policy in stimulating early stage, hightech venture capital.
A mixed approach
Clearly, both demand and supply venture capital policies have a rationale. There is evidence
(Fisher 1988, Murray 1998) that there is a latent demand for equity financing that is not being
fulfilled by the private sector. Yet, increasing the supply of venture capital alone is unlikely to
foster significantly the entrepreneurial activity. Murray (1998) recognizes that there are
relevant concerns about the future viability of portfolio companies that require follow up large
7
Florida and Smith (1990), pp. 346.
25
investments that often cannot be provided by public schemes aimed at seed-stage financing.
These schemes alone will hardly reduce the regional disparities and foster employment growth
without the development of techno-commercial networks of professionals to assist the growth
of the portfolio ventures.
The need to facilitate entrepreneurship in the economy, therefore, is at least as important as
ensuring the sources of appropriate financing. Gompers and Lerner (1999) found that the main
impact of reductions in capital tax gains, policies intended to increase the supply of venture
capital available, have actually proven effective because they increased the demand for capital
by entrepreneurs. The reduction in the differential between income and capital gains tax rates
encouraged a significant number of corporate employees to start up their own enterprises.
Thus, they argue that the most effective policies to encourage venture capital creation are
probably those that stimulate entrepreneurship and technological innovation in the economy.
Although this is true to a certain extent, evidence for the demand-side approach is also not
overwhelming. Florida and Smith (1998), for example, do not seem to provide irrefutable
prove on their case. It stems from their study –and other more recent papers, such as
Gompers and Lerner (1999)- that high venture capital resources do not necessarily translate
into high venture capital investment, as money flows to areas with high technological basis.
Nevertheless, they only consider the geographical dimension of the capital gap. There is
evidence that VC funds have a bias against small investments, particularly since pension funds
have been allowed to invest in VC after 1979 (Lerner 2002a, Fisher 1988). Thus, while
stimulating the supply of VC might be a poor regional development policy, it does not
necessarily represent an inefficient national policy. Additionally, in the same way as an
increase in the supply of capital alone is unlike to foster high-tech entrepreneurial activity, an
increase in the technology base of a region is equally unlikely to exist in the first place if there
is not appropriate financing –not only in size, but also in kind.
Da Rin et al. (2006), on the other hand, only focus on innovation ratios, as measured by the
relative amount of VC that is invested at seed-stage, and the relative amount of VC invested in
high-tech industries. Thus, they says little about the overall impact of public policy and R&D
spending on overall innovation. Their contribution is showing that public investment in venture
capital does not make the venture capital sector more innovative, which was not necessarily
the primary objective of such policies. Da Rin et al. (2006) also fail to consider that public
policy may have broader social implications and objectives than simply making profits or
increasing the innovation ratios.
26
Effective policies to foster venture capital investment, then, should include a mixed approach.
This is what Josh Lerner, one of the most influential academics in the field of venture capital,
maintains. He documents that most public initiatives to enhance entrepreneurship have been
largely ineffective and even detrimental, with some sound exceptions. These exceptions could
possibly form the basis of effective entrepreneurship policymaking. The most prominent in this
group, has been the success of Singapore in tackling both the supply and the demand for VC
and enhancing entrepreneurial activities in the island-state. The government started by
providing extensive financing for entrepreneurs and venture capital investment, but soon
realized that the issue became the lack of entrepreneurs and human capital. Thus, it aimed at
training entrepreneurs, providing them with adequate professional services, and attracting top
researchers to their institutions, besides increasing the financing for their activities. Lerner
(2009), therefore, argues that policies directed to enhancing VC should not only focus on the
supply of capital for high-growth firms, but also in stimulating the demand by creating the
appropriate conditions for entrepreneurship to thrive. This includes the appropriate legislative
framework (to allow, for instance, the enforcement of preferred stock by VCs), ensuring access
to cutting-edge technologies to entrepreneurs, creating the appropriate tax incentives (or
removing barriers), and training of potential entrepreneurs.
Policy objectives and evaluation
There are some last considerations we should have with regard to public policies. The first one
is that there is always a risk of overrating the benefits of schemes, since we actually do not
know how many of these jobs have actually been created overall, and how many were simply
shifting from one firm to another (Fisher 1988). Moreover, the number of jobs created says
little about an improvement in the quality or stability of jobs, so the actual number is not a
necessarily a very good indicator of development.
The second factor to consider is that public policy is not, in general, primarily concerned with
making profits. In the same way than the actual number of jobs created by a policy initiative
might be a poor indicator of its success, the profits or losses made, for instance, by a public
venture capital fund may say little more in that direction. Private investment is as much
concerned with creating value as with capturing it; public policy is generally more concerned
with creating than capturing. For example, a qualified employee spinning out from a private
firm and forming a competing venture may hinder the firm both by diminishing its stock of
human capital and by increasing competition. The firm clearly ends up worse off: yet society at
27
large may have actually gained. The same applies for ventures backed by public VC schemes.
Even if many of the companies that receive funding stay private for long periods or actually
fail, the funding may help industries gain knowledge and critical mass, aiding the development
of capabilities that may not have been there in the first place. Many employees of these firms
may actually spin-off and form their own ventures, fostering the development of that
particular industry and the venture capital sector.
Let us consider another example. Leleux and Surlemont (2003) find that public venture capital
hardly seeds industries; yet, they also find that larger public intervention is associated with a
larger venture capital market. This might be in itself an interesting objective for public policy:
to attract resources and encourage learning at the market. Experienced venture capitalist with
established social ties and contact networks that add substantial value to firms are not in
abundance; an effect of larger VC markets would be an increase in the number of qualified
venture capitalist. And the same logic applies to entrepreneurs. As Lerner (2009) argues,
entrepreneurship is more of an art than a science, and the best way to improve the quality of
entrepreneurs is through experience. Samila and Sorenson’s (2011) findings also point to
similar stimulation phenomena. Likewise, as the sector grows, institutional investors become
more confident on the ability of actors in the market, and are more likely to increase their
commitment.
Our third consideration is directly linked to the previous one: the trade off between
profitability and social impact. On the one hand, programs that restrict investment to
particular geographical areas, industries or targeted groups narrow down the investment
possibilities and the number of potential good deals that can be targeted. On the other hand, if
the programs place no restriction, then capital is most likely to flow towards those areas that
already have strong technological basis, complementary legal and accounting services, and
established network structures (Florida and Smith 1990). Fisher (1988) proposes that public
financing should target not just any firm, but particular social groups where it is most likely to
make an impact, rather than focusing on self-sustaining, profitable investments. Moreover,
schemes should set conditions for long term establishment and environmental plans that will
actually provide broader, long term benefits for economically depressed regions and society at
large.
Fourthly, when considering the impact of public venture capital policies, we should understand
the scale of the VC industry: even in Silicon Valley, the most developed venture capital market
in the world, fewer than 4% of startups receive venture capital financing (Samila and Sorenson,
28
2011). Fisher (1988) also indicates that the overall impact of these schemes is rather low, since
the investment gap left behind by private venture capitalists includes a relatively small number
of potentially successful investments. Likewise, the number of jobs created is unlike to make a
major impact in the development of a region.
Lastly, we should consider that even though the author has argued that there is a strong
rationale for public venture capital policy, this does not mean that such policies will be
effective in practice. It has been argued in the last section for a mixed policy approach, but
even the perfect policy in theory will have to overcome a series of obstacles. Corruption,
incompetence, and the so called “regulatory capture” (Lerner 2009) are concerns that
permeate most public policy initiatives, and should be at the center of the design and
evaluation of venture capital schemes.
Concluding discussion
Venture capital has attracted much attention in recent years, not least because of the sizeable
increased in magnitude it has experienced: total funds raised by venture capital firms have
increased from $579 million (in 2007 dollars) in 1978 to $35.9 billion in 2007. It is not
surprising, then, than there is an increased interest in the value that venture capital adds to
firms and the economy at large. Most scholars seem to agree that venture capital adds value
to economic activity, though they hardly agree on exactly how. In theory, it appears clear that
venture capital investment provides firms with much more than capital for equity; the
investors offer well established networks of professionals to portfolio firms, assist in strategic
planning, management selection, and other activities that add value to companies. Moreover,
receiving support of a venture capitalist adds a considerable reputational benefit, enhancing
the availability of further sources of financing and access to suppliers and customers. Strong
evidence on the value added activities of venture capitalist has only recently been empirically
documented, however, and to the understanding of this author, remains largely insufficient.
The presumption that a larger venture capital sector is desirable for the economy and society
has permeated public policy initiatives to foster entrepreneurship around the world. Until
recently, however, much of the literature has given for granted the benefits of venture capital
for innovation and economic growth. Some research has begun to shed some light on this
issue, but more careful investigation is needed at macroeconomic level.
The most recurrent limitation for venture capital research is the lack of available
representative data on venture capital, particularly outside the U.S. Most firms backed by
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venture capital never make it to public markets: in fact, a large proportion remain private or
are acquired by or merged with other firms. Data on firms that go public is more broadly
available, making it an easier group to study empirically. Needless to say, these firms do not
compose a representative sample of firms that receive venture capital, which raises some
serious concerns on the validity of some pieces of evidence. New databases and surveys have
contributed to filling the informational gap on those firms that remain private, yet more
advances are needed in the availability of information on those companies.
The field of public support for venture capital has been under-analyzed. Most people seem to
agree that more venture capital is good, yet there is little evidence reported on the actual
benefits for the economy at large. There are a few studies that have considered public
initiatives from regional and local development perspective, analyzing the flows of venture
capital and the centers where the capital is actually raised. But little explicit attention has been
given to the role of venture capital financing as a part of a broader national system of
innovation. Moreover, evaluation of these schemes has been incomplete, since they need to
be considered in light of the objectives that set them up in the first place.
Perhaps one of the strongest limitations of most research done on the effects of venture
capital is the difficulty of finding appropriate control groups for econometric analyses.
Therefore, it is hardly possible to understand what could have happened to firms in the first
place had they not received venture capital. Some authors, for example, claim that many
companies backed by venture capital have become industry leaders. Yet there is little empirical
evidence to prove that they would have not eventually become so by other means of
financing. There have been some recent advances in this direction, for example by Croce et al.
(2010) and Samila and Sorenson (2011). Perhaps the speculation of alternative scenarios may
not seem completely relevant to all researchers, but to this author it should be at the center of
all methodological concerns in future research.
The aim of this paper is to review the most relevant literature on venture capital research. We
have pointed out several phenomena where further understanding and empirical evidence
remains largely insufficient or inadequate. Now it is the task of future research to pick the
challenge and delve into the still unknown fields within venture capital.
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