Boom and Bust in the Venture Capital Industry and the Impact on Innovation

1. Boom and Bust in the Venture Capital Industry and the Impact on Innovation Josh Lerner Harvard University and NBER

2. Extraordinary drop in venture activity…

3. … has triggered worries about consequences “Most venture capitalists are shelving the expensive change-the-world bets of the past few years.. The danger is that cutbacks will go too fast and too deep.” • Business Week, 2001.

4. Agenda • Seeks to understand implications of venture investment collapse for innovation: • Demystifying booms and busts in venture capital. • Understanding implications for public policy. • Exploring public policy consequences.

5. Basic elements • Not different from any other markets: • Supply and demand! • Supply is willingness of investors to provide capital. • Likely to increase with expected rate of return.

6. Supply Curve for Venture Capital Return Quantity

7. Basic elements (2) • Demand is supply of acceptable businesses. • Varies with return demanded by investors: • The higher the return expectation, the fewer firms satisfy the test. • Together supply, demand will determine quantity Q, return R. • Crude but useful! • Can illustrate historical shifts from U.S.

8. Steady-State Level of Venture Capital Return S R D Quantity Q

9. Example 1: 1995-98 • Expansion of opportunity associated with diffusion of the Internet. • Can be seen as shift of demand curve outward. • Increase in VC funding, and rising returns: • Predictions of inevitable decline misguided.

10. R2 R1 Q1 Q2 Impact of Demand Shock Return S D2 D1 Quantity

11. Example 2: 1979 • Prior to 1979, pension funds essentially prohibited from VC investing. • Policy shift allowed these investments, shifted demand curve out. • Led to decline in considerable growth, but decline in returns.

12. R1 R2 Q1 Q2 Impact of a Supply Shock S1 Return S2 D Quantity

13. Example 3: 1957 • Sputnik launch led to two policy shifts: • SBIC program, which made it easier to raise venture pools (supply). • Boost in government high-tech procurement, which increased demand for VC. • Led to substantial increase in quantity, but little impact on returns.

14. R2 R1 Q1 Q2 Impact of a Supply and Demand Shock Return S1 S2 D2 D1 Quantity

15. Painful adjustments • So far, assumed smooth adjustment. • In actuality, may see under- or over-reaction: • Dramatic swings in fundraising levels and returns. • How do these effects come about?

16. Level of fundraising

17. Level of returns

18. Rationales for stickiness • VC funds are raised for extended periods. • Investors shift targets only on occasion. • VC groups often limit rate of growth to avoid adjustment problems. • Even after decision is made, draw-downs and liquidations take many years. • Funds “self-liquidate”: must run faster in hot periods to stay even.

19. Consequences of stickiness • In long run, supply curve may be upward-sloping. • But in short run, may be nearly vertical. • Immediate consequence of demand shocks may be spike in returns, not volume.

20. R2 R1 R3 Q1 Q2 Impact on Quantity of a Demand Shock SS Return SL D2 D1 Quantity

21. Rationales for overshooting • Hard to assess promise of new technologies: • Uncertainty is what created opportunity in first place! • Public markets provide very noisy--but highly visible--signals of industry promised: • “Irrational exuberance.”

22. Consequences of overshooting • Public market, other signals may lead VCs to conclude that major demand shift: • Actual shift may be far more modest. • Supply may swing out to perceived value, leading to: • Surge in funding of investments. • Poor returns.

23. R1 R3 Q1 Q3 Misleading Public Market Signals Return SS3 SS1 SL D3 D2 D1 Quantity

24. Venture capital appears to spur innovation • Venture capital is well suited for funding high-risk innovative projects: • Intensive scrutiny of business plans. • Restrictions in preferred stock agreements. • Staged financing. • Board service and monitoring. • Informal advice. • Not surprising that dominant funding source.

25. 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?

26. 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% of innovation.

27. But is impact of market cycles as bad as it seems? • During “overshooting” periods, too similar companies funded at too high valuations: • Biotech financing surge in early 1990s led to dozens of similar firms pursuing same approach to same disease. • Mean pre-money value of VC-funded biotech firms in mid-1992 was $70MM. • By 12/93, only 42 of 262 public biotechnology companies had a market capitalization above $70MM. • Financial and social returns modest. • Similar stories form Internet boom.

28. But is impact of market cycles as bad as it seems? (2) • Supporting evidence from regression analyses: • Look at impact of venture capital on innovation in boom periods and others. • Coefficient is about 15% lower during the years and industries with venture investments : • Effect is strongly statistically significant. • Effect widens when add controls for causality.

29. But is impact of market cycles as bad as it seems? (3) • Thus, while cycles in activity are dramatic, impact on innovation may be more modest. • Quality of companies funded during booms is often lower. • Caution: if complete melt-down in fundraising, investments, could be very harmful.

30. Policy implications • “Public venture capital” programs have far too often added “fuel to the fire”: • Concentrating on “hot sectors” in boom periods: • May lead to “success stories,” but unlikely to boost innovation much. • Much better strategy is to focus on “out of favor” sectors and technologies: • In-Q-Tel, SBIR provide models.

31. Policy implications (2) • More generally, may be best to focus on boosting demand for funds: • Less emphasis on supply of capital. • Possible efforts: • Easing access to early-stage federally funded research. • Tax incentives. • Less direct efforts likely to enjoy greatest success!