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JOSH LERNERHARVARD BUSINESS SCHOOL
The Promise of Venture Capital
Why is venture capital important?
Venture capital is still very young: First fund in 1946.
Venture capital is still very small: In largest market, U.S.:
Only about 4000 professionals. Average of 1,500 companies funded for first time
annually, 2000- 2008. Relative to 1 million businesses started
annually. Considerably less elsewhere.
Venture Capital Investment Worldwide 1992 ~ 2007
0
20
40
60
80
100
120
140
160
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Year
Inve
stm
ent
Am
ou
nt
(in
200
7 U
S$
bill
ion
)
Israel
Canada
Asia
Europe
USA
But importance far beyond its size
The backdrop: Young high-tech and restructuring firms pose
many challenges: Uncertainty. Information gaps. The nature of the firm’s assets. Market conditions.
“I realize, gentlemen, that thirty million dollars is a lot of money to spend. However, it’s not real money and, of
course, it’s not our money either.”
General Doriot’s insight
• Difficult for traditional financiers to fund these firms:– Banks.– Public markets.
• A new organization could address with three key mechanisms:– Sorting: picking the right entrepreneurs.– Controlling: limiting “agency” problems,
through a mixture of incentives and monitoring.
– Certifying: developing a tradition of quality and fair dealings.
9
The evolution of venture capital
Venture capital has developed many tools to address challenges: Intensive scrutiny of business plans. Restrictions in preferred stock agreements. Staged financing. Board service and monitoring. Informal advice.
Not surprising that dominant funding source.
Venture capital has had a profound impact
Between 1972 to 2007, ~2500 venture-backed firms went public in U.S.: 13% of all public firms at end of 2008. 8% of market capitalization ($2.0 trillion). 6% of total employees.
Particularly true in high-technology industries.
Supporting evidence
Hellmann and Puri [2000]: Look at 170 Silicon Valley firms. Venture capital-backed firms seem more innovative on
several measures. Unfortunately, hard to control for causality:
Does VC spur innovation or does innovation spur VC?
Supporting evidence (2)
Kortum and Lerner [2000] look at industry level: VC appears to have a strong positive effect:
Even after controlling for corporate and government R&D spending.
Use 1979 ERISA shift to address causality issues. In 1983-95 period, while VC <3% of corporate R&D,
accounted for 10-12% of innovations.Mollica and Zingales [2007] also
demonstrate strong relationship with different appproach: State pension fund holdings.
Why a government role?
Increasing returns to scale Much easier to do 100th deal than the first:
Knowledge and expectations of entrepreneurs. Familiarity of intermediaries. Sharing of information among peers. Comfort level of institutional investors.
Economists term these “externalities.”In these cases, government can
frequently play a catalytic role.
Also historical precedents
In the U.S.: Critical role of SBIC program. Established in 1958. Many early VC firms started as SBIC
awardees, then opted out. Building critical “infrastructure”: Lawyers,
data providers, etc.Similar insights from Israel, Singapore, etc. Suggests that some of funding should be
directed to growing industries!
Particularly in light of boom in emerging market private equity fundraising ($Bs)
But history also suggests need for care
But many pitfalls from earlier efforts.Three key points from report:
More than money is needed: entrepreneurship is not in a vacuum.
The virtues of market guidance. Getting details right important as well.
Need for patience!
Josh LernerRock Center for Entrepreneurship
Harvard Business SchoolBoston, MA 02163 USA
www.people.hbs.edu/jlerner