The Promise of Venture Capital

1. The Promise of Venture Capital Josh Lerner Harvard Business School

2. 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.

5. 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.

6. “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.”

8. 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.

10. 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.

11. 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.

13. 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?

14. 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.

15. 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.

16. 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!

17. Particularly in light of boom in emerging market private equity fundraising ($Bs)

18. 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!

19. Josh Lerner Rock Center for Entrepreneurship Harvard Business School Boston, MA 02163 USA 617-495-6065 josh@hbs.edu www.people.hbs.edu/jlerner