CHAPTER 3

WHY SHOULD POLICYMAKERS CARE?

At this point we are familiar with the argument that government has no role in promoting venture capital and entrepreneurship. In the last chapter, we looked at some historical evidence that planted seeds of doubt about this argument. Now we’ll turn to more systematic evidence, as articulated in recent research.

The case that policymakers should indeed care about new ventures and venture capitalists—and do have a role to play in facilitating their activity—rests on three foundations. The bulk of this chapter reviews the first two critical rationales: that innovation is critical to growth, and that new ventures can stimulate innovation. As we’ll see, both rationales are quite compelling. We’ll discuss the third critical link in the argument in chapter 4.

INNOVATION IS LINKED TO GROWTH

Since the 1950s, economists have understood that innovation is critical to economic growth. Our lives are more comfortable and longer than those of our great-grandparents on many dimensions. To cite just three improvements: antibiotics cure once-fatal infections, long-distance communications cost far less, and the burden of household chores is greatly reduced. At the heart of these changes has been the progress of technology and business.

Economists have documented the strong connection between technological progress and economic prosperity, both across nations and over time. This insight grew out of studies done by the pioneering student of technological change, Morris Abramowitz.¹ He realized that there are ultimately only two ways of increasing the output of the economy: (1) increasing the number of inputs that go into the productive process (e.g., by having workers stay employed until the age of sixty-seven, instead of retiring at sixty-two), or (2) developing new ways to get more output from the same inputs. Abramowitz measured the growth in the output of the American economy between 1870 and 1950—the amount of material goods and services produced—and then computed the increase in inputs (especially labor and financial capital) over the same time period. To be sure, this was an imprecise exercise: he needed to make assumptions about the growth in the economic impact of these input measures. After undertaking this analysis, he discovered that growth of inputs between 1870 and 1950 could account only for about 15 percent of the actual growth in the output of the economy. The remaining 85 percent could not be explained through the growth of inputs. Instead, the increased economic activity stemmed from innovations in getting more stuff from the same inputs.

Other economists in the late 1950s and 1960s undertook similar exercises. These studies differed in methodologies, economic sectors, and time periods, but the results were similar. Most notably, Robert Solow, who later won a Nobel Prize for this work, identified an almost identical “residual” of about 85 percent.² The results were so striking because most economists for the previous 200 years had been building models in which economic growth was treated as if it was primarily a matter of adding more inputs: if you just had more people and dollars, more output would invariably result.

Instead, these studies suggested, the crucial driver of growth was changes in the ways inputs were used. The magnitude of this unexplained growth, and the fact that it was exposed by researchers using widely divergent methodologies, persuaded most economists that innovation was a major force in the growth of output.

In the decades since the 1950s, economists and policymakers have documented the relationship between innovation—whether new scientific discoveries or incremental changes in the way that factories and service businesses work—and increases in economic prosperity. Not just identifying an unexplained “residual,” studies have documented the positive effects of technological progress in areas such as information technology. Thus, an essential question for the economic future of a country is not only what it produces, but how it goes about producing it.

This relationship between innovation and growth has been recognized by many governments. From the European Union—which has targeted increasing research spending as a key goal in the next few years—to emerging economies such as China, leaders have embraced the notion that innovation is critical to growth.

NEW VENTURES SPUR INNOVATION

The second underpinning of the argument for government support of entrepreneurship stems from the insight that new firms are particularly innovative.

The Size, Age, and Innovation of Firms

Initially, economists generally overlooked the creative power of new firms: they suspected that the bulk of innovations would stem from large industrialized concerns. For instance, Joseph Schumpeter, one of the pioneers of the serious study of entrepreneurship, posited that large firms had an inherent advantage in innovation relative to smaller enterprises.

But these initial beliefs have not stood the test of time: indeed, today, such suggestions look like the intellectual by-product of an era that saw large firms and their industrial laboratories (such as IBM and AT&T) replace the independent inventors who accounted for a large part of innovative activity in the late nineteenth and early twentieth centuries.

In today’s world, Schumpeter’s hypothesis of large-firm superiority does not accord with casual observation. In numerous industries, such as medical devices, communication technologies, semiconductors, and software, leadership is in the hands of relatively young firms whose growth was largely financed by venture capitalists and public equity markets. (Think, for example, of Boston Scientific, Cisco, Intel, and Microsoft.) Even in industries where established firms have retained dominant positions, such as finance, small firms have developed an increasing share of the new ideas, and then licensed or sold them to larger concerns.

This pattern, new ventures playing a key role in stimulating innovation, has been particularly pronounced in the past decade. The two arenas that have seen perhaps the most potentially revolutionary technological innovation—biotechnology and the Internet—were driven by smaller entrants. Neither established drug companies nor computer software manufacturers were pioneers in developing these technologies. On the whole, small firms did not invent the key genetic engineering techniques or Internet protocols. Rather, the enabling technologies were developed with government funds at academic institutions and research laboratories. It was the small entrants, however, who first seized upon the commercial opportunities. Even in areas where large firms have traditionally dominated, such as energy research, start-up firms appear to be playing an increasing role.

Not only do Schumpeter’s arguments fail the test of experience, but systematic studies have generated little support for his belief in the innovative advantage of large firms. Over the years, economists have tried repeatedly to measure the relationship between firm size and innovation. While this literature is substantial, it is remarkably inconclusive. In part, its uncertain conclusions reflect the difficulty of doing such studies. Not only is it hard to measure innovative outputs and spending on research across a large number of firms, but often researchers struggle with what may be termed “selection biases.” Consider, for instance, that it is very hard to get thorough information on firms that are not publicly traded. Thus, while we can see all of the large firms, which are almost invariably publicly held, we may only see the most successful small firms, since less stellar small firms are unlikely to complete a public offering.

While I will not inflict upon the reader a detailed review of the hundreds, if not thousands, of papers on this subject, it is worth highlighting that they give very little support to the claim that large firms are more innovative.³ Much of this work has related measures of innovative discoveries—for example, R&D expenditures, patents, or inventions—to firm size. Initial studies were undertaken using the largest manufacturing firms; more recent works have employed larger samples and detailed data (e.g., studies employing data on firms’ specific lines of business). Despite the improved methodology of recent studies, the results have remained inconclusive: the studies seem as likely to find a negative as a positive relationship, and even when a positive relationship between firms’ size and innovation has been found, it has had little economic significance. For instance, one study concluded that a doubling of firm size increased the ratio of R&D to sales by only 0.2 percent.⁴

Whatever the relationship between a firm’s size and its innovations, one of the relatively few things that researchers can agree on is the critical role played by new firms, or entrants, in many industries. The role of start-ups in emerging industries has been highlighted not just in many case studies, but also in systematic research. For instance, a study by Zoltan Acs and David Audretsch examined which firms developed some of the most important innovations of the twentieth century.⁵ They documented the central contribution of new and small firms: these firms contributed almost half the innovations they examined. But they found that the contribution of small firms was not central in all industries. Rather, their role was a function of industry conditions: it was greatest in immature industries in which market power was relatively unconcentrated. These findings suggest that entrepreneurs and small firms play a key role in observing where new technologies can meet customers’ needs, and rapidly introducing products.

What explains the apparent advantage of smaller firms? Much of it stems from the difficulty of large firms in fomenting innovation. For instance, one of Schumpeter’s more perceptive contemporaries, John Jewkes, presciently argued:

It is erroneous to suppose that those techniques of large-scale operation and administration which have produced such remarkable results in some branches of industrial manufacture can be applied with equal success to efforts to foster new ideas. The two kinds of organization are subject to quite different laws. In the one case the aim is to achieve smooth, routine, and faultless repetition, in the other to break through the bonds of routine and of accepted ideas. So that large research organizations can perhaps more easily become self-stultifying than any other type of large organization, since in a measure they are trying to organize what is least organizable.⁶

But this observation still begs a question: what explains the difficulties of larger firms in creating true innovations? Answers have been explored in recent work. In particular, there are at least three reasons why entrepreneurial ventures are more innovative:

•  The first has to do with incentives. Normally, firms provide incentives to their employees in many roles, from salespeople to waiters. Yet large firms are notorious for offering employees little more than a gold watch for major discoveries. Why would the design of incentive systems for innovative tasks differ from that appropriate for humdrum tasks? The weak incentives in large firms may reflect the inherent riskiness and unpredictability of innovative projects, their length and complexity, and the number of parties who may make crucial contributions. Whatever the reason, there is a striking contrast between the very limited incentives at large corporate labs and the stock-option-heavy compensation packages at start-ups.

•  Second, large firms may simply become ineffective at innovating. A whole series of authors have argued that incumbent firms frequently have blind spots, which stem from their single-minded focus on existing customers.⁷ As a result, new entrants can identify and exploit market opportunities that the established leaders don’t see.

•  Finally, new firms may choose riskier projects. Economic theorists suggest that new firms are likely to pursue high-risk strategies, while established firms rationally choose more traditional approaches.⁸ Hence, while small firms may fail more frequently, they are also likely to introduce more innovative products. This insight has been corroborated by, for instance, a study of the introduction of new software programs.⁹ Its authors show that new firms are more effective at creating new software categories, while established firms have a comparative advantage in extending existing product lines.

One example of such innovation by a young firm that had a broad social impact was the African cell phone provider Celtel International.¹⁰ The firm, begun in 1998, succeeded by taking advantage of the liberalizing African telecom industry of the 1990s and introducing services quickly absorbed by its customers. Because of the low average income, the African market had little penetration in either wireless or landline phones. Celtel grew by recognizing the large cash-based informal sector, addressing the low income of users by selling prepaid time in small, affordable units. In Tanzania, for instance, Celtel introduced per second instead of per minute calls that were the norm in the market and, by saving the consumer money, increased demand for its own services. Similarly, when Celtel obtained a permit for a microwave link between Congo-Kinshasa and Congo-Brazaville—capital cities on opposite sides of a river that were formerly linked by satellite—thus dropping the price of a call from one dollar per minute to twenty-eight cents, traffic increased by 700 percent.

While the growth process was not easy—the company was consistently short on cash and dependent largely on short-term loans from banks—its success was remarkable. By 2004, the company generated $147 million in earnings. The next year, the firm was acquired by Kuwait’s Mobile Telecommunications Company in an all-cash transaction for $3.4 billion.

These initiatives had broad-reaching social consequences. In many cases, the cell phone has been as an income generator for village entrepreneurs. For instance, Celtel Tanzania sold personal call offices—briefcases with metered phones—to entrepreneurs who then sold the phone services on a per call basis. More generally, entrepreneurs on the continent have become more effective and profitable because of the spread of cell phones. Small-scale farmers and traders in particular have benefited from better knowledge of prices, allowing the market to converge to a point more beneficial to the small player. The cell phone is also used for low-cost banking targeting low-income users underserved by traditional banks. Celpay, Celtel’s mobile commerce company, sees over 3 million transactions a month in the Democratic Republic of the Congo alone. The firm also has shown a preference for hiring locally at the community level for tasks like guarding generators or building towers, thus creating income for grassroots communities. Celtel and other cell phone service providers had a measurable effect on the national economies of the countries they entered. A 2007 report by the London Business School estimates that the average developing nation sees economic growth of 1.2 percent for every 10 percent increase in mobile users.¹¹

The Special Case of Venture-Backed Firms

Recent studies have also highlighted the special advantage in innovation that belongs to certain entrepreneurs: those backed by venture capital firms. Considerable evidence shows that venture capitalists play an important role in encouraging innovation. The types of firms that they finance—whether young start-ups hungry for capital or growing firms that need to restructure—pose numerous risks and uncertainties that discourage other investors.

Where, then, does this advantage come from? The financing of young and restructuring firms is a risky business. Uncertainty and gaps in information often characterize these firms, particularly in high-technology industries. A lack of information makes it difficult to assess these firms, and permits opportunistic behavior by entrepreneurs after financing is received. To address these information problems, venture investors employ a variety of mechanisms that seem to be critical in boosting innovation.

The first of these devices is the screening process that venture capitalists use to select investment opportunities. This process is typically far more efficient than that used by other funders of innovation, such as corporate research and development laboratories and government grant-makers. For instance, most large, mature corporations tend to look at their existing lines of business when choosing projects to fund. Technologies outside the firm’s core market, or projects that raise internal political tensions, often get shelved. In fact, many successful venture-backed start-ups are launched by employees who leave when their companies decline to pursue a promising technology.

Numerous studies have documented that typical venture capitalists use an exhaustive process to assess the large number of business plans they receive each year. One of the pioneering studies described a typical process:

1) Conversations with venture capitalists that ask[ed firm] to look at company; 2) Checked personal references of controller, vice-president, and president; 3) Met with company’s founders and controller; 4) Conversation with loan officer at major insurance company. The insurance company’s loan committee had turned down company’s request for financing even though the loan officer recommended it; 5) Conversation with company’s accountant …; 6) Conversation with local banker who slightly knew the company; 7) Conversation with banker who handles company’s account; 8) Telephone conversation with director of company; 9) Talked to about 30 users; 10) Talked to two suppliers; 11) Talked to two competitors.¹²

One sophisticated individual investor, who follows an approach similar to venture firms, suggests it is likely to take up to 160 hours to properly screen an opportunity.¹³ A leading venture capital group, Bessemer Venture Partners, prepared a “Due Diligence Booklet” for investors to complete for each potential investment. This fifty-page publication asked a large variety of questions about the industry, the company, the people, and the transaction itself.

How do venture capitalists make sense of all the data they gather during this assessment process? Certain measures are more important than others. After interviewing a large number of funds about their investment criteria, T. T. Tyebjee and A. V. Bruno described the most common criteria as follows:

1. Market Attractiveness (size, growth, and access to customers),

2. Product Differentiation (uniqueness, patents, technical edge, profit margin),

3. Managerial Capabilities (skills in marketing, management, finance and the references of the entrepreneur),

4. Environmental Threat Resistance (technology life cycle, barriers to competitive entry, insensitivity to business cycles and downside risk protection),

5. Cash-Out Potential (future opportunities to realize capital gains by merger, acquisition or public offering).¹⁴

Steve Kaplan and Per Strömberg, who examined the analyses that venture capitalists undertake when presenting potential transactions to their investment committees, identified a similar set of findings. They grouped the key decision-making criteria into three overall categories: (1) internal factors (quality of management, performance to date, funds at risk, influence of other investors, fit with the investment firm’s existing portfolio, and monitoring costs and valuation); (2) external factors (market size and growth, competition and barriers to entry, likelihood of customer adoption, and financial market and exit conditions); and (3) difficulty of execution (nature of the product or technology, and the business strategy model).¹⁵

Another way in which venture capitalists screen transactions is through financial analysis. They carefully analyze the prospective returns from investments, conditional on the firm’s success. They invest only if the expected return is suitably large. This requirement of a large return if the firm is successful stems from the high failure rates associated with venture capital investments. Only one-third of firms complete initial public offerings, typically the most attractive route through which to exit investments.¹⁶ While some investments are exited successfully though acquisitions, in most cases they generate far lower returns. Despite all the care and expertise of venture capitalists, disappointment is the rule rather than the exception.

In addition to the careful interviews and financial analysis, venture capitalists usually make investments with other investors. One venture firm will originate the deal and look to bring in other venture capital firms. Involving other firms provides a second opinion on the opportunity. There is usually no clear-cut evidence that an investment will yield attractive returns. Having other investors approve the deal limits the likelihood of funding bad deals. This is particularly true when the company is early-stage or technology-based. Syndication also allows the venture capital firm to diversify. If venture capitalists had to invest alone in all the companies in their portfolio, they could make far fewer investments. By syndicating investments, the venture capitalist can invest in more projects and largely diversify away firm-specific risk.

The result of this detailed analysis is, of course, a lot of rejections: only about 0.5 to 1 percent of business plans are funded.¹⁷ Inevitably, many good ideas are rejected as part of the assessment process. Most venture capitalists are embarrassed to admit these goofs, but Bessemer cheerily posts an “anti-portfolio” of great companies it passed over for various reasons.¹⁸ And, of course, many companies are funded that ultimately prove to be disappointments.

When venture capitalists invest, they hold preferred stock rather than common stock. The significance of this distinction is that if the company is liquidated or otherwise returns money to the shareholders, preferred stock is paid before the common stock that entrepreneurs, as well as other, less privileged investors, hold. Moreover, venture capitalists add numerous restrictive covenants and provisions to the preferred stock. They may be able, for instance, to block future financings if they are dissatisfied with the valuation, to replace the entrepreneur, and to have a set number of representatives on (or even control of) the board of directors. In this way, if something unexpected happens (which is the rule rather than the exception with entrepreneurial firms), the venture investor can assert control. These terms vary with the financing round, with the most onerous terms reserved for the earliest financing rounds.

In addition to the initial selection process, the advice that venture firms provide to entrepreneurs and the postinvestment monitoring and control they exert support top-quality innovation. Venture capitalists also tend to spot more potential future applications of technology than larger, mature companies do, perhaps because older companies focus on narrower markets.

The staging of investments also improves the efficiency of venture capital funding. In large corporations, research and development budgets are typically set at the beginning of a project, with few interim reviews planned. Even if projects do get reviewed midstream, few of them are terminated when signs suggest they’re not working out.

This contrasts with the venture capital process: once they make a decision to invest, venture capitalists frequently disburse funds in stages. The refinancing of these firms, termed “rounds” of financing, is conditional on achieving certain technical or market milestones. Proceeding in this fashion allows the venture capitalist to gather more information before providing additional funding, thus helping investors separate investments that are likely to be successful from those that are likely to fail. Managers of venture-backed firms have to return repeatedly to their financiers for additional capital, which allows venture capitalists to ensure that money is not squandered on unprofitable projects. Thus an innovative idea continues to be funded only if its promoters continue to execute, and as a corollary, projects that prove promising are able to access capital in a timely fashion.

Finally, venture capitalists provide intensive oversight of the firms they invest in. Michael Gorman and Bill Sahlman found that venture capitalists who responded to their survey spent about half their time monitoring an average of nine portfolio investments and serving on the boards for five of those nine companies.¹⁹ They visited their companies relatively frequently, and spent an average of eighty hours a year on site with the company on whose board they served. Frequent telephone conversations amounted to another thirty hours per year for each company. In addition, they worked on the company’s behalf by attracting new investors, evaluating strategy against new conditions, and interviewing and recruiting new management candidates.

Interviews with venture capitalists and entrepreneurs suggest that, as a consequence of these tools, venture capital plays an important role in boosting innovation. This assistance has two dimensions: accelerating growth and ensuring long-run success.

With support from venture capitalists, start-ups can invest in the research, market development, marketing, and strategizing they require to attain the scale necessary to go public. As a result, venture-backed firms tend to be considerably younger at the time that they go public, or first start trading in the market, than other companies. Table 3.1, which shows the age of U.S. venture-capital-backed and non-venture-capital-backed firms at the time they go public, captures this phenomenon.²⁰ The table shows the time in months from company founding to the issuing of equity in an initial public offering, both overall and in various industries. (We look at offerings between 2003 and September 2008, thus avoiding the atypical “bubble” years.) Overall, and across the industries, the venture-backed initial public offerings (IPOs) reached the public market sooner than the non-venture-backed group. Venture capitalists speed the development of companies because they help them pursue effective strategies while providing access to capital, if the companies are meeting their stated goals.

Table 3.1
Age of Firms (in Months) at the Time of Going Public

Note: Based on U.S. IPOs since 2003

The evidence suggests that the early participation of venture firms—including their guidance, monitoring, shaping of management teams and boards, networking, and credibility—helps innovators sustain their success long after their company issues an IPO. By contrast, companies that go public without having had professional investors beforehand often encounter disappointment: they do not have the infrastructure in place, for example, financial reporting, investor communications, and strategic planning, to operate successfully as a public firm.

Two Illustrations

At this point, it’s almost obligatory to illustrate the impact of venture capitalists with one of a few stories of real firms. Rather than discuss how Kleiner Perkins and Sequoia helped Google dominate the market for Internet searches, or how Accel and Greylock facilitated Facebook’s climb into a dominant position in the crowded world of social networking, perhaps it would be more interesting to discuss some less well-known firms.

Consider, for example, the story of Lingtu.²¹ This Beijing company makes digital maps for both individual and corporate applications. While we’re all familiar with the power of mapping software both online and in mobile devices, these services are particularly important in China, where city streets are frequently a maze of winding, tiny lanes and where breakneck growth renders paper maps obsolete soon after they are printed.

By January 2003, Lingtu’s founders—who had begun the firm four years previously—decided they needed help in thinking about strategic choices. Yes, the firm had built an impressive database of information about China’s roadways, developed cutting-edge mapping software, and—important in a nation where maps are still regarded as sensitive information—obtained a license from the China State Bureau of Surveying and Mapping to create, digitize, and edit maps. But the plethora of new options left the founding team, which was dominated by engineers, struggling to decide which option to pursue. Observed Lingtu’s CEO, Nengzhe Tang, “Sometimes I’m working so hard all I can see are … trees [and not the forest].… Maps are like tofu, they can be prepared so many different ways.”²²

Shortly thereafter, Lingtu’s team met Gobi Partners, a fund that from its inception in 2001 has focused single-mindedly on financing early-stage Chinese digital media companies. The three founders of Gobi had expertise in investment banking, the law, and software engineering, and had worked together at one of the pioneering Asian venture funds before launching their own firm. After an exhaustive due diligence process, Gobi invested a little over $2 million in Lingtu.

Gobi assisted the firm in a variety of ways in the next few years. First, it helped the firm prioritize the allocation of resources. As Tang commented, “Gobi gives us the forest view.… After we saw how they planned, we understood what it takes to move into big applications and how that could benefit us.”²³ Second, Gobi introduced Lingtu to a number of corporations that were investors in Gobi’s fund. These partners included IBM, which partnered with Lingtu to develop navigation and web map-search programs and supported the young firm in a winning bid to provide geographic information and software to telecommunications provider China Unicom, and NTT DoCoMo, which also served the lead investor in a subsequent financing round. Finally, the initial and subsequent financing rounds—including a $30 million round that also involved U.S.-based Oak Investment Partners and AllianceBernstein—allowed the firm to invest in technology and marketing to a much greater extent than previously.

The jury is still out on Lingtu, which remains privately held. It hopes to go public soon, though the battering that the Chinese stock market experienced in 2008 means that “soon” may take a while. But whatever its fate, venture capitalists played a critical role in transforming promising technology into a real business.

While venture capitalists often specialize in young technology companies, their reach can extend in other realms as well. To cite one example, Abraaj Capital, the leading private equity group in the Middle East, bought a one-third interest in April 2006 in National Air Services (NAS), a privately held aviation services and management company based in Riyadh, Saudi Arabia.²⁴

To Abraaj, the deal was attractive for several reasons. The investment would allow the Dubai-based fund to gain access to the largest economy in the region and to a fast-growing sector that was typically closed to outside investors. But most importantly, Abraaj believed that the four-year-old firm’s existing management was stumbling amid ambitious expansion plans, and that Abraaj could materially assist in the firm’s growth.

After the deal closed, Abraaj assembled a team of fourteen specialists from its own ranks and outside the firm, who stayed for almost a year in Saudi Arabia. Shortly after its investment, the Abraaj team helped reorganize the company into three new business units, NAS Air, NetJets Middle East, and Al Khayala. Each of these units experienced substantial growth in the ensuing years, catalyzed in large part by Abraaj:

•  In February 2007, the firm launched NAS Air, Saudi Arabia’s first low-cost airline. Abraaj recruited a new CEO for NAS Air, Ed Winters, the former operating head at the British discount carrier easyJet. By the end of 2007, NAS Air had expanded to add more than 300 weekly flights and over twenty routes carrying nearly half a million passengers, making it Saudi Arabia’s leading carrier in number of passengers. Orders were in place for more than forty planes.

•  In 2007, private aviation service NetJets Middle East (which had held the franchise from Berkshire Hathaway’s NetJets for Saudi Arabia) won the franchise rights to expand into new markets across the region.

•  With Abraaj’s help, the firm also launched Al Khayala, a luxury shuttle and charter service, in 2007.

Abraaj had planned to take the firm public to access further financing, but in June 2008 it sold its stake to a large Saudi investor. The implied valuation of the firm—more than twice that of Abraaj’s initial investment—reflected in large part the value that had been created by the venture team, including the recruitment of new talent, the accomplishment of strategic initiatives, and the overcoming of regulatory and contractual hurdles.

Large-Sample Evidence

Clearly, venture capital exerts a major impact on the fate of individual companies. But does all this fund-raising and investing influence the overall economic landscape? How could such an influence be determined? And if it did exist, how would it be measured?

To assess this question, we can look at studies of the experience of the United States, the market with the most developed and seasoned venture capital industry. Although venture activity is particularly well developed in the United States, the reader might doubt whether this activity noticeably drives innovation: for most of past three decades, investments made by the entire venture capital sector totaled less than the research-and-development and capital-expenditure budgets of large, individual companies such as IBM, General Motors, or Merck. On the face of it, this suggests the business press has exaggerated the importance of the venture capital industry. High-tech start-ups make for interesting reporting, but do they really redefine the U.S. economy?

One way to explore this question is to examine the impact of venture investing on wealth, jobs, and other financial measures across several industries. Though it would be useful to track the fate of every venture-capital-financed company and find out where the innovation or technology ended up, in reality only those companies that have gone public can be tracked. Consistent information on venture-backed firms that were acquired or went out of business simply doesn’t exist. Moreover, investments in companies that eventually go public yield much higher returns than support given to firms that get acquired or remain privately held.

These publicly traded firms have had an unmistakable effect on the U.S. economy. In September 2008, 895 firms were publicly traded on U.S. markets after receiving their private financing from venture capitalists (this figure does not include the firms that went public but were subsequently acquired or delisted). One way to assess the overall impact of the venture capital industry is to look at the economic “weight” of venture-backed companies in the context of the larger economy. Table 3.2, which documents the impact of venture capital in 2008, reveals some startling numbers.²⁵ By late 2008, venture-backed firms that had gone public made up over 13 percent of the total number of public firms in existence in the United States at that time. And of the total market value of public firms ($28 trillion), venture-backed companies came in at $2.4 trillion—8.4 percent.

Venture-funded firms also made up over 4 percent (nearly one trillion dollars) of total sales ($22 trillion) of all U.S. public firms at the time. And contrary to the general perception that venture-supported companies are not profitable, operating income margins for these companies hit an average of 6.8 percent—close to the average public-company profit margin of 7.1 percent. Finally, those public firms supported by venture funding employed 6 percent of the total public-company workforce—most of these jobs high-salaried, skilled positions in the technology sector. Clearly, venture investing fuels a substantial portion of the U.S. economy.

Table 3.2
Relative Status of Venture-Backed and Non-Venture Firms at the End of September 2008

Note: All dollar figures in millions; all employment figures in thousands.

Venture investing not only supports a substantial fraction of the U.S. economy, it also strengthens particular industries. To be sure, it has relatively little impact on those dominated by mature companies—such as the manufacturing industries. That’s because venture investors’ mission is to capitalize on revolutionary changes in an industry, and the well-developed sectors often have a relatively low propensity for radical innovation.

But contrast mature industries with highly innovative ones, and the picture looks completely different. For example, companies in the computer software and hardware industry that received venture backing during their gestation as private firms represented more than 75 percent of the software industry’s value. Venture-financed firms also play a central role in the biotechnology, computer services, and semiconductor industries. All of these industries have experienced tremendous innovation and upheaval in recent years. Venture capital has catalyzed change in these industries, providing the resources for entrepreneurs to generate substantial return from their ideas. In recent years, the scope of venture groups’ activity has been expanding rapidly in the critical energy and environmental field, though the impact of these investments remains to be seen.

As these statistics suggest, venture capitalists create whole new industries and seed fledgling companies that later dominate them. The message is clear: the venture capital revolution drove the transformation of the U.S. economy in recent decades.

It might seem fairly easy to delineate the impact of venture capital on innovation. For instance, one could seek to explain across industries and time whether, controlling for R&D spending, venture capital funding has an impact on measures of innovation. But even a simple model of the relationship between venture capital, R&D, and innovation suggests that this approach is likely to give misleading estimates.

This is because both venture funding and innovation could be positively related to a third unobserved factor, the arrival of technological opportunities. Thus, there could be more innovation when there is more venture capital, not because the venture capital caused the innovation, but rather because venture capitalists reacted to a technological shock that was sure to lead to more innovation. To date, only a handful of studies have attempted to address this challenging interaction.

The first of these papers, by Thomas Hellmann and Manju Puri,²⁶ examines a sample of 170 recently formed firms in Silicon Valley, including both venture-backed and non-venture firms. Using questionnaire responses, they find evidence that venture capital financing is related to product market strategies and outcomes of start-ups. They find that firms that pursue an “innovator strategy” (a classification based on the content analysis of survey responses) are significantly more likely and faster to obtain venture capital. The presence of a venture capitalist is also associated with a significant reduction in the time taken to bring a product to market, especially for innovators (probably because these firms can focus more on innovating and less on raising money). Furthermore, firms are more likely to list obtaining venture capital as a significant milestone in the life cycle of the company than other financing events.

The results suggest significant interrelations between the type of investor and the product market, and a role of venture capital in encouraging innovative companies. But this does not definitively answer the question of whether venture capitalists cause innovation. For instance, we might observe personal injury lawyers at accident sites, handing out business cards in the hopes of drumming up clients. But just because the lawyer is at the scene of the car crash does not mean that he caused the crash. In a similar vein, the possibility remains that more innovative firms choose to finance themselves with venture capital, rather than venture capital causing firms to be more innovative.

In my work with Sam Kortum, I visited the same question.²⁷ Here we looked at the aggregate level: did the participation of venture capitalists in any given industry over the past few decades lead to more or less innovation? Does such an analysis escape the methodological problem illustrated by the personal injury lawyer at the accident scene, that is, mistaking effect for cause? To put the question another way, even if we see an increase in venture funding and a boost in innovation, how can we be sure that one caused the other?

We addressed these concerns about causality by looking back over the industry’s history. In particular, a watershed in the history of venture capital was the U.S. Department of Labor’s clarification of the Employee Retirement Income Security Act in the late 1970s, a change that freed pensions to invest in venture capital. This shift led to a sharp increase in the funds committed to venture capital. This type of external change should allow us to figure out what the impact of venture capital was, because it is unlikely to be related to how many or how few entrepreneurial opportunities there were to be funded.

Once these concerns with causality have been addressed, the results suggest that venture funding does have a strong positive impact on innovation. The estimated coefficients vary according to the techniques employed, but on average a dollar of venture capital appears to be three to four times more potent in stimulating patenting than a dollar of traditional corporate R&D. The estimates therefore suggest that venture capital, even though it on average amounted to less than 3 percent of corporate R&D in the United States from 1983 to 1992, was responsible for a much greater share—perhaps 10 percent—of U.S. industrial innovations in this decade.

A natural worry with this analysis is that it looks at the relationship between venture capital and patenting, not venture capital and innovation. It is possible that venture funding leads entrepreneurs to protect their intellectual property with patents rather than other mechanisms, such as trade secrets. Perhaps entrepreneurs can fool their venture investors by applying for a large number of patents, even if they protect modest advances. If this were true, the patents of venture-backed firms would likely be of lower quality than non-venture-backed patent filings.

How could this question of patent quality be investigated? One possibility is to check the number of patents that cite a particular patent.²⁸ Higher-quality patents, it has been shown, are cited by other innovators more often than lower-quality ones. Similarly, if venture-backed patents are lower quality, then companies receiving venture funding would be less likely to initiate patent-infringement litigation. (It makes no sense to pay money to engage in the costly process of patent litigation to defend low-quality patents.)

So what happens when patent quality is measured with these criteria? As it happens, the patents of venture-backed firms are more frequently cited by other patents and are more aggressively litigated—thus it can be concluded that they are of high quality. Furthermore, venture-backed firms more frequently litigate trade secrets, suggesting that they are not simply patenting frantically in lieu of relying on trade-secret protection. These findings reinforce the notion that venture-supported firms are simply more innovative than their non-venture-supported counterparts.

FINAL THOUGHTS

This chapter examines the first two pillars supporting the case for public intervention to promote venture activity. Both seem quite sturdy.

First, the link between innovation and growth is well established. More economic activity and a better quality of life depend vitally on a steady supply of new technologies and approaches. The need for innovation is widely accepted by governments around the world.

Second, there is a powerful link between innovation and new firms. Whether it is due to the stultifying bureaucracy that inhibits new ideas at large firms, the more powerful incentives new firms offer, or some other factor, entrepreneurs seem better at developing and commercializing new ideas. And no matter how one looks at the numbers, venture capital clearly serves as an important source industry for innovation, reflecting the fact that these investors both provide important guidance to young firms and relieve all-too-common capital constraints. This relationship is one that appears true across the world, though many of the systematic studies have focused on the well-developed American market.

All these arguments suggest that government interventions to boost entrepreneurial and venture capital activity may make sense. But it is not so simple, of course: for public intervention to boost venture capital and entrepreneurship, it has to be effective.

And this is by no means always the case. It is this complicated territory that we explore in the next chapter.