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The economic impact of venture capital

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6. The economic impact of venture capital
Annaleena Parhankangas
INTRODUCTION
A widely held consensus exists among business leaders, policymakers and economists
that a vibrant venture capital market is the cornerstone of America’s leadership in the
commercialization of technological innovation (European Commission, 1994; 1995;
Global Insight /NVCA, 2004; NVCA, 2011). This belief is reinforced by the fact that
many of today’s most iconic and successful American companies received venture
capital at early stages of their lives. These firms include Amazon, Apple, Cisco, eBay,
Genentech, Intel, Microsoft and Netscape (Gompers and Lerner, 2001; IHS Global
Impact, 2009). The success of the American venture capital industry led many
governments to look for ways to nurture a national venture capital industry (Sallard,
1998). It is somewhat more recently that attention has shifted to business angels as a
panacea for economic sluggishness and high unemployment (see for instance Mason,
2009a).
This optimism over the economic benefits induced by venture capital
investments and business angel investments is also shared by the majority of
entrepreneurship scholars. It is noteworthy that pioneers in venture capital research have
already emphasized the crucial role of venture capitalists in promoting innovation and
growth in early-stage companies (Bygrave and Timmons, 1986; Gorman and Sahlman,
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1989). More recently, a wealth of ad hoc and more scholarly evidence has emerged to
suggest that firms grow faster and overcome the problem of underinvestment in
innovative activities if they are backed by venture capitalists (Ueda and Hirukawa,
2003; EVCA, 2002; BVCA, 2008; IVCA, 2005; SAVCA, 2009). In a similar vein, in
one of the first studies on informal venture capital markets in the United States, Wetzel
(1983) suggests that business angels are the most likely source of funding for small,
growth-oriented technology-based firms. This overtly positive view on the economic
impact of equity financing has not gone without criticism. There are some scholars
suggesting that venture capitalist investments are few in number and benefit only a
handful of companies, regions and industries (Aldrich, 2008) and thus have hardly
earned their reputation for being a recipe for sustainable and inclusive economic growth
and wealth creation. In a similar vein, some voices of concern have been raised to warn
us that unsophisticated business angels may do more harm than good in their portfolio
companies (Freear et al., 1994).
As research on the economic impact of venture capital and business angel
investments continues to grow and proliferate, it is important to look back and evaluate
the progress made and to identify gaps in the existing knowledge. This chapter is based
on a review of peer-reviewed articles and other relevant publications focusing on the
economic impact of venture capital and business angel investments. Even though great
effort was taken to provide a reasonable overview of the existing knowledge, the size
and scope of the research field makes it impossible to provide a detailed description of
every article reviewed or an exhaustive listing of all studies published on the topic thus
far. Instead, the focus of this literature review is primarily on scholarly research. It is
also important to note that the studies focusing on the growing significance of public
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and corporate venture capital as well as the studies analyzing the determinants of returns
to venture capital and business angel investments are beyond the scope of this study, as
these topics will be covered in other parts of this book. In a similar vein, the economic
impact of later stage investments was excluded from this study.
Evaluating, let alone measuring, the economic impact of formal and
informal equity investments is a demanding task. I approach this problem by
investigating the existing evidence related to key measures introduced by the classic
economic impact methodology (Hood, 2000). The macro-level measures include job
creation, economic growth and innovation induced by venture capitalist and business
angel investments. The micro-level measures focus on investment portfolio performance
and the performance of individual portfolio companies. This chapter organizes the
literature on the economic impact of venture capital and business angel financing by
first giving an overview of the size of the venture capital and business angel markets.
Thereafter, I continue with a review of the literature on venture capital’s role in
boosting firm performance and innovation and promoting new technologies and
industries. A similar literature review will be conducted on the economic impact of
business angels. Institutional differences in the economic impact of venture capital and
business angel funding will also be explored. Finally, this chapter concludes with a
synthesis and analysis of prior knowledge and suggestions for future research.
SIZE AND PERFORMANCE OF VENTURE CAPITAL MARKET
When evaluating the economic impact of venture capitalists and angel investors, I first
assess the size and performance of venture capital market all over the world. As shown
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in Figure 6.1, global venture capital investment is highly concentrated in a few key
regions, the United States accounting for 71 per cent of global venture capital
investment. The rest of the investment is divided into Europe (15 per cent), China (7 per
cent), Israel (3 per cent), India (2.4 per cent) and Canada (1.6 per cent) (Ernst and
Young, 2011). Because of the dominant role of North America in venture capital
financing, the primary focus of this section will be on the fundraising, investments and
performance of US venture capitalists and business angels.
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Insert Figure 6.1 about here
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Size and performance of formal venture capitalist market
Figure 6.2 shows the volume of venture capital investment in the United States between
1995 and 2009. During those years, US venture capitalists invested an average of $426
billion annually. The highest level of venture capital activity occurred during the dot
com boom of the late 1990s and early 2000s, after which investments sharply declined.
It is noteworthy that the venture capital market had not recovered back to the average
level in terms of fundraising or investment volume by 2009 (NVCA/Thomson Reuters,
2011, 2004; Mason, 2009b, Block and Sandner, 2009). Many of the institutions that had
traditionally allocated significant amounts to venture capital are now scaling back
because of the low returns on their prior investments or their own deteriorating financial
positions (Mason, 2009b).
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Insert Figure 6.2 about here
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In 2010, the vast majority (68 per cent) of US venture capital funding went
to expansion and later stage investments. Only 32 per cent was invested in start-up, seed
or early-stage ventures, as shown in Figure 6.3. The industry breakdown of US venture
capital investment in 2010 is presented in Figure 6.4, with the largest inflows of capital
to the biotechnology, computer and peripherals, energy, medical devices and software
sectors.
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Insert Figure 6.3 about here
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Insert Figure 6.4 about here
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Fundraising and investment trends in Europe show a similar pattern, albeit
being more modest in size than in the United States. Figure 6.5 depicts the amount of
private equity invested in European companies between 2000 and 2009. During those
years, approximately 42.5 billion ($51.9 billion) was invested annually. It should be
noted that the European figures also include rescue/turnaround, replacement and buyout
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capital, which are not included in the US venture capital statistics. In 2009, buyout and
growth deals added up to 83 per cent of the total European private equity investment
value, venture capital deals accounting for the remainder. Venture capital was mainly
driven by investments in the life sciences sector (28 per cent of the total by amount and
21 per cent by number of companies) (EVCA, 2011).
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Insert Figure 6.5 in here
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Prior to the early 2000s, venture capital generated higher risk-adjusted
returns relative to public market investments (Koh and Koh, 2002; Kedrosky, 2009;
Figure 6.6). The average internal rate of return (IRR) for US venture capital investment
between 1981 and 2009 was 21 per cent. However, this figure was highly variable, as
shown in Figure 6.7. The peak performance was achieved during the 1990s, with an
IRR as high as 103.28 per cent. The highest returns were generated by investments in
the information technology and software sectors (Cambridge Associates LLC, 2011).
However, after the burst of the tech boom in the late 1990s and early 2000s, US returns
drastically declined (Cambridge Associates LLC, 2011). The reasons for this declining
performance include among other things the maturing of the main venture capital
investment sectors and the emergence of new sectors that were less competitive, a
decline in the number of initial public offerings (IPOs) and too much venture capital
investment chasing too few high quality deals (Kedrosky, 2009; Mason, 2009b). In
Europe, venture capital funds have generally generated an IRR of 15.5 per cent, but
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only 4.5 per cent and 5.5 per cent for early- and development-stage investments (Wright
et al., 1998; Burgel, 2000; EVCA/Thomson Reuters, 2009).
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Insert Figure 6.6 about here
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Insert Figure 6.7 about here
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Since the early 1970s, approximately $456 billion of venture capital has
backed 27,000 US companies. In 2008, those companies employed more than 12
million people, or 11 per cent of private sector employment, generating revenues of $2.9
trillion, or 21 per cent of the US GDP. While similar figures are not readily available for
other geographic areas, more short-term comparisons can be made based on prior
studies. In recent years, around $25 billion of venture capital, or 0.2 per cent of GDP,
has been annually invested in US companies; about 7 billion in European companies or
approximately 0.05 per cent of Europe’s GDP; and about ¥250 billion in Japanese
companies, or 0.06 per cent of Japan’s GDP (Bosma and Levie, 2009).
Size and performance of business angel market
The Center of Venture Research at the University of New Hampshire conducts an
annual survey on the size of the angel investor market in the United States. According to
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these surveys, angel investors invested an average of $21 billion to approximately
50,000 ventures over the period 20022009 (Figure 6.8). In 2009, only 35 per cent of
angel investments went to seed and start-up ventures. The software, healthcare,
industrial and energy sectors attracted the vast majority of angel investment in the
United States.
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Insert Figure 6.8 about here
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We can also assess the size of the business angel markets all over the world
by taking the Global Entrepreneurship Monitor (GEM) Population Survey as a point of
departure (Bygrave et al., 2003). The results of this survey show that informal
investment activity seems to be relatively high in countries such as Guatemala,
Venezuela, Algeria and Peru, with more than 10 per cent of the population acting as
business angels. Among innovation-driven economies, the United Arab Emirates,
Iceland and Norway have the highest informal investor prevalence rates, scoring from
six to eight percent of the working age population. The lowest informal investor
prevalence rates (below one per cent) can be found in Morocco, Yemen, Japan,
Romania, Romania and the United Kingdom (Bosma and Levie, 2009).1
Some studies have evaluated the economic impact of business angel
investments by analyzing their financial performance. One of the most comprehensive
studies in this area analyzed the financial returns generated by 539 North American
group affiliated angels between 1990 and 2007 (Wiltbank and Boeker, 2007). The
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average return of angel investments in this study was 2.6 times the investment in 3.5
years approximately 27 per cent Internal Rate of Return (IRR). The distribution of
returns was highly variable: while 52 per cent of all exits returned less than the capital
invested, seven percent of the exits achieved the returns more than ten times the money
invested.
Other studies seem to confirm these findings. Center for Venture Research
in the United States reports that the average return to business angel investments is 22
per cent. Studying a sample of Finnish business angel investments, Lumme and Mason
(1996) report that one third provided a significant or moderate return to their investor,
and one in five generated significant financial returns (IRR in excess of 20 per cent).
The rest of the investments resulted in partial or full loss. Based on a UK sample,
Mason and Harrison (2002b) found that the distribution of returns for business angels in
highly skewed, with 34 per cent of exits at a total loss, 13 per cent at a partial loss or
break-even, but with 23 per cent showing an IRR of 50 per cent or above. In a similar
vein, based on his study of 158 UK angel investors Wiltbank (2009) reports 56 per cent
of exits failing to return capital, while 9 per cent generate more than ten times the
capital invested. However, although negatively skewed, the returns to business angel
deals are less skewed than those of early stage venture capital deals. Business angels
have fewer investments in which they lose money but a significantly higher proportion
of their investments either break even or generate modest returns. This is consistent with
the argument that business angels are more concerned with avoiding bad investments
than finding winners (Mason and Harrison, 2002b). Finally, it seems that angel
investors with spending more time interacting with their portfolio companies and on due
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diligence, as well as angels with more business experience enjoy greater returns to their
investment (Wiltbank and Boeker, 2007; Wiltbank, 2009).
VENTURE CAPITAL AND FIRM PERFORMANCE
In addition to relying on the size of the venture capital markets as a proxy for its
economic importance, it is also possible to evaluate venture capital’s impact on the
performance of the portfolio companies. In this section, I will first review the evidence
provided by public policy makers and practitioners on the topic of interest. Then I
proceed to scholarly studies comparing the survival, growth and stock market
performance of venture-backed and other firms. I end this paragraph by discussing the
reasons for the superior performance of venture-backed firms and providing some
words of caution for the interpretation of these results.
One of the very first studies on the performance of venture capital backed
firms was conducted by the Venture Economics Incorporation for the US General
Accounting Office in 1982. The results of this study were promising: venture-backed
firms performed better in terms of aggregated sales growth, payment of taxes and job
creation than the other firms. Since then, studies on the economic impact of venture
capital carried out by venture capital organizations and public policy makers have
multiplied in the United States and elsewhere. For instance, the 2004 study by National
Venture Capital Association in the United States confirmed that venture capital-backed
companies grew faster than their national industry counterparts in terms of their
employment, sales, and wages. Similar results were obtained in Europe (EVCA 2003,
1996; BVCA, 1999), where the venture-backed companies achieved a yearly sales
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growth of 35 per cent as compared to a mere 14 per cent associated with non-venture
backed European public firms. The employment generated by the venture-backed firms
grew by an annual rate of 30.5 per cent, nearly eighty times the annual growth rate of
total employment in 25 European Union countries (Achleitner and Klockner, 2005).
Interestingly enough, venture capitalists seemed to focus their investments in high
growth industries, which might indicate their crucial role in industrial renewal (Global
Insight/ NVCA, 2004; EVCA, 2002). In a similar vein, most of the jobs created by the
venture-backed firms are research-intensive, pay a higher gross-wage and offer more
training opportunities than other firms, indicating that venture-backed firms create high-
quality jobs (Achleitner and Klockner, 2005).
The scholarly studies on venture capital and firm performance can be
divided into three major categories based on the dependent variable used: those
comparing 1) survival; 2) employment and sales growth; and 3) stock market
performance of venture backed firms as opposed to other comparable firms. The earliest
studies using survival as dependent variable date back to the 1970s. Several studies
report that venture capital backed companies, especially those in high technology
sectors, enjoy a higher survival rate and are more successful than other comparable
firms (Timmons et al., 1983; DeHudy et al., 1981; Huntsman and Hoban, 1980;
Zacharakis and Meyer, 1995; Brown, 2005). Also contradictory evidence exists.
Manigart et al.’s (2002) findings based on a Belgian sample, Burgel et al.’s (2002)
findings from the UK and Germany, and Zhang’s (2007) findings from the United
States do not confirm higher growth or survival rates for venture-backed companies.
These findings as such are not surprising, as the ultimate goal for the venture capitalists
is to maximize the returns to their funds by making a timely exit, rather than securing
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the long-term survival of their portfolio companies. In a similar vein, it is important to
note that a significant number of technology-based firms -independent of whether they
are venture-backed or not - are acquired or merge with other companies (Bruno,1992),
which may misleadingly be labeled as non-survival in the official statistics.
Ample empirical evidence from the United States (Davila et al., 2003;
Hellman and Puri, 2000; Jain and Kini, 1995; Zhang, 2007), Germany (Engel, 2002),
Spain (Alemany and Martin, 2005) and 20 OECD countries (Belke et al., 2001; 2003)
indicates that venture-backed firms outperform others in terms of job creation and sales
growth. However, this optimistic view on the superiority of venture-backed firms has
been challenged by some scholars. Using a sample of 511 firms listed on Europe’s new
stock markets, Bottazzi and Da Rin (2002) show that European venture-backed
companies do not enjoy faster sales or employment growth than do non-venture-backed
companies. Interestingly enough, when Bottazzi and Da Rin restrict their sample to
innovative companies, the sales growth of venture-backed firms seems to be lower than
that of other firms. Unlike their American cousins, European venture capital firms do
not seem to participate in the creation of superstars on European stock markets. Whether
this is owing to the relative immaturity of the European venture capital industry or to a
lack of superstars among European firms remains an open question. Alternatively,
anecdotal evidence suggests that European investors tend to sell their investments
prematurely, as demonstrated in the case of Skype, thus compromising the returns to
European venture funds. There is also a possibility that the findings of Bottazzi and Da
Rin are driven by the peculiarities of their sample, i.e. their focus on IPOs, while a
majority of European venture capitalists exit their investments using other vehicles.
Finally, Engel and Keilbach (2007) suggest that the higher employment growth
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generated by venture-backed firms might be driven by sectoral differences, the most
rapid growth being enjoyed by business-related service sectors.
Another way of analyzing the economic impact of venture capital is to
assess the likelihood of venture-backed companies going public compared with non-
venture capital-backed firms. Zhang (2007) reports that companies receiving venture
capital early on are more likely to complete an IPO and enjoy first-mover advantages.
More importantly, a host of studies compare the performance of venture-backed IPOs
with other IPOs (Megginson and Weiss, 1991; Lin and Smith, 1998; Cherin and
Hergert, 1988; Brav and Gompers, 1997; Gompers; 1996; Barry et al., 1990). All these
studies, with the exception of Cherin and Hergert (1988) and Gompers (1996), suggest
that IPOs funded by venture capitalists outperform other IPOs. Belden et al. (2001), in
turn, report that venture capital-backed IPOs are able to compete with more seasoned
public companies unlike their non-venture capital-backed counterparts.
The general tendency of venture-backed firms to outperform other
comparable firms has been explained by two major factors. First, venture capitalists
seem to be relatively skilled at picking the most successful new ventures in the industry
(Timmons and Bygrave, 1986; Timmons, 1994; Amit et al., 1998). This phenomenon is
sometimes referred to as the selection effect. Second, there exists some empirical
evidence on the indirect mechanisms through which venture capitalists boost the
performance of their portfolio companies, giving rise to the so-called value-adding
effect. The value-adding activities provided by venture capitalists involve evaluating
and recruiting managers after the investment decision, negotiating employment
contracts, contacting potential vendors, evaluating product market opportunities or
contacting potential customers (Timmons and Bygrave, 1986; MacMillan et al., 1988;
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Gorman and Sahlman, 1989; Fried and Hisrich, 1991; Elango et al., 1995; Kaplan and
Strömberg, 2001; Hellman and Puri, 2002). These value-adding activities performed by
venture capitalists are discussed more in depth in other parts of this volume.
The majority of studies, however, fail to distinguish between the selection
effect and the value-adding effect. The study of Peneder (2010) takes one of the first
steps towards this direction by confirming that venture capitalists in general invest in
better performing firms. However, even after controlling for this selection effect,
Peneder (2010) was able to confirm the value-adding effect in terms of a genuine causal
impact of venture capital on firm growth. It is important to note that this effect could not
be extended to the innovation output.
However, some words of caution are in order when drawing any conclusions
from studies on the comparative performance of venture-backed firms. At least five
fundamental flaws can be identified in many of the studies cited above (Alemany and
Marti, 2005; Bottazzi and Da Rin, 2002). First, some of these studies suffer from a
severe survivorship bias by excluding a large number of firms that failed from the
analysis. Second, most studies fail to consider the timing of venture capital financing,
limiting their examinations only to the years following the IPOs. Third, some studies
compare venture-backed firms with large firms, which by nature are less dynamic and
grow more slowly. A correct comparison point would be non-venture-backed small and
medium-sized firms. Fourth, there may also be an acquisition bias, excluding venture-
backed firms that have been acquired by another firm from the analysis. Fifth, in some
sectors, such as in life sciences, it might be difficult to create an accurate matched
sample of non-venture capital-backed firms, as it is challenging if not impossible to start
a company without a substantial amount of external capital.
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VENTURE CAPITAL, INDUSTRIAL RENEWAL AND INNOVATION
This section reviews studies focusing on the interplay of venture capital and innovation.
I first discuss studies analyzing the role of venture capital in the creation of new
industries and technologies. This discussion is followed by a review of studies
examining the impact of venture capital on the innovativeness of individual portfolio
companies. Finally, I present some critical remarks on the direction of causality between
venture capital funding and innovation and on the economic impact of venture capital in
general.
Venture capitalists and the creation of new industries and technologies
In the 1970s, venture capitalists helped found the biotechnology industry through their
pioneering investments in Genentech and Amgen. A decade later, venture capital
funding was growing the software development and semiconductor industries. More
recently, online retailing and clean technology followed suit (IHS, 2009). Even though a
wealth of anecdotal evidence exists on venture capital’s indirect contribution (such as
enhancing critical mass, reputation, networks and collective learning) to a high-tech
cluster’s strength and development (see for instance, Bruno and Tyebjee, 1982; Florida
and Kenney, 1988; Sapienza, 1992; Avnimelech and Teubal, 2008; Romain and
Pottelsberghe, 2004), few academic studies focus directly on the role of venture capital
in the creation of new industries and technologies. For instance, in their study of the
founding rates and performance of biotechnology companies, Stuart and Sorenson
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(2003) found that the availability of venture capital in a region is positively associated
with the number of biotechnology start-ups. In a similar vein, Zook (2002) suggests that
the regional distribution of venture capital played a central role in determining the
location of new internet start-ups by attracting firms from other regions to the area.
Bygrave and Timmons (1992, pp. 95-123), in their turn, give a fascinating description
of the role of venture capital in creating revolutionary products and industries, such as
semiconductors, computers and biotechnology.
However, several studies suggest a reverse causality. After analyzing the
emergence of the entrepreneurial cluster in the US Capitol Region, Feldman (2001)
concludes that venture capitalists are attracted to the region in the wake of its
entrepreneurial success rather than it being a catalyst for this success in the first place.
Much in a similar manner, the technology cluster in Ottawa emerged before a venture
capital industry developed in Ottawa, and that in the early days of the cluster venture
capital was mainly imported (Harrison et al., 2004). In addition, Florida and Kenney
(1988) and Florida and Smith (1990) provide some empirical evidence suggesting that
venture capital firms tend to cluster in areas with high concentrations of technology-
intensive businesses. For instance, the venture capital industry in California developed
in tandem with its technology base. As increasing numbers of technology-intensive
companies became successful, a new space for investment and embryonic technologies
developed. Contrary to this optimistic view, Zucker et al. (1998) report an adverse
relationship between the number of venture capitalist firms in a region and the number
of biotechnology start-ups.
Venture capital and the innovativeness of individual portfolio companies
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Venture capital has been found to play a major role in boosting innovation in individual
portfolio companies. For instance, a report prepared for the National Venture Capital
Association indicates that of the top 50 US firms in R&D, 41 are either venture-backed
or an acquirer of a venture-backed firm (Global Insight / NVCA, 2004). Similar results
were confirmed in the European context (see for instance, Achleitner and Klockner,
2005; IVCA, 2005). According to Romain and Van Pottelsberghe (2004), the
contribution of venture capital to innovation takes place through two main channels.
First, venture capitalists help firms bring new products and processes to market. Second,
they facilitate the development of skills and know-how that induce an effective use of
existing knowledge to improve the production system (absorptive capacity).
In their seminal study, Kortum and Lerner (2000) examine the influence of
venture capital on portfolio companies’ propensities to patent innovations in the United
States. Their study involves 20 industries and 530 firms with and without venture
capital funding during the years 1965 to 1992. They conclude that venture capital
investments significantly increase the propensity to patent, to a much larger extent than
in corporate R&D. In addition, they find that the patents granted to venture capital-
backed companies are cited more often than are other patents, indicating that venture-
backed firms are involved in important innovative activities. Kortum and Lerner (2000)
also suggest that venture capital may account for 8 percent of the industrial innovations
in the United States. Similar results confirming venture capital’s positive impact on
innovation have been presented by Tykvova (2000), Popov and Rosenboom (2009) and
Bertoni et al. (2010). However, Ueda and Hirukawa (2006) argue that venture capital
investments may only increase the propensity to patent, but have no impact on industrial
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innovation when productivity growth is used as a proxy for innovation. Finally,
Audretsch and Lehman (2004) find no relationship between the number of patents a
firm holds and venture capital investment.
The relationship among R&D, innovation and venture capital might be more
complex than the studies cited above suggest. In addition to assuming that venture
capital spurs innovation (the ‘venture capital first hypothesis), we must consider the
possibility of the opposite causality. According to the ‘innovation first’ hypothesis, the
arrival of a substantial innovation creates abundant opportunities for new firms to grow
(Gompers and Lerner, 2001). These new firms demand venture capital investments and,
consequently, venture capital markets will grow (Ueda and Hirukawa, 2003; Schroder,
2009). This possibility was explored by Engel and Keilbach (2007) comparing 142
venture-funded firms with more than 20,000 non-venture-funded firms in Germany.
They conclude that the higher innovation output of venture-backed firms can be
explained by the selection process, i.e. venture capitalists preferring more innovative
ventures, or alternatively, innovative firms applying more often venture capital funding
(Romain and Pottelsberghe, 2004). Ueda and Hirukawa (2003) also find that, in general,
innovation measured as multi-factor productivity growth is significantly and positively
associated with subsequent venture capital investments. Relying on European data,
Schertler (2007) finds evidence that venture capital investments depend strongly on the
country’s number of patents, the number of R&D researchers and gross-domestic
expenditures in R&D.2 In the United States, Gompers and Lerner (1999b) were able to
establish a link between venture capital investments and industrial and academic R&D
expenditures per capita, thus supporting the ‘innovation first’ hypothesis.
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The impact of venture capital on innovation has been found to be context-
specific, depending on the type of venture capital and portfolio companies, the source of
innovation and the phase of the business cycle. First, Timmons and Bygrave (1986)
suggest that the venture capital industry is far from homogeneous when it comes to
financing innovation. It seems that a small subset of venture capital firms actively
generate such investment opportunities and play a critical role in their development.
Ueda and Hirukawa (2003), in turn, were able to detect some sector-specific differences
in the relationship between venture capital investments and innovation. While venture
capital was found to be both the antecedent and consequence of innovation in the
computer and communication industries, the drug and scientific instrument industries
exhibit an adverse relationship between innovation and venture capital investment.
Second, Bhide (2008) suggests that it is important to distinguish between internal and
external sources of innovation for venture-backed firms. To be more specific, he finds
that venture-backed firms are more likely to acquire patents from outside sources after
the infusion of venture capital than engage themselves in patenting or science projects.
Third, Lerner (2002) offers a more critical view on venture capital’s impact on
innovation: while the overall relationship between venture capital and innovation might
be positive, the impact may vary depending on the phase of the business cycle. In
particular, boom periods of venture capital activity may lead to an overflow of
investment to particular sectors (Sahlman and Stevenson, 1985; Lerner et al., 2005). The
consequences of this excessive concentration of funding include highly duplicative
research agendas, intense bidding wars for scientific and technical talent, costly
litigation concerning intellectual property rights and the misappropriation of ideas
across firms. Furthermore, a dramatic fall in venture capital financing during bust
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periods is likely to lead good companies to go unfunded, and eventually to a sharp
decline in innovation.
Some critical observations on the economic impact of venture capital
A handful of scholars suggest that the economic impact of venture capital investments
might be exaggerated. For instance, Lerner at al. (2005) report that for most of the
period 19701995, the investments made by the entire US venture capital industry
totaled less than the R&D and capital expenditure budgets of large corporations, such as
IBM, General Motors or Merck. It also goes without saying that venture capitalists
invest in a small number of firms (Engel, 2002), corresponding to only 0.2 per cent of
all start-ups (Aldrich, 2008; Kaplan and Lerner, 2010) or 1.9 per cent of small business
finance. It is well documented that the distribution of returns to venture capital
investments is highly skewed, with few successes supporting a large number of
modestly profitable or unprofitable investments (Bygrave and Timmons, 1992;
Gompers and Lerner, 1999a). Finally, even though the venture capital industry has been
thought to facilitate the creation of vibrant economic regions, many studies show that
venture capital activity is strongly concentrated in few key regions (Florida and Kenney,
1988; IHS, 2009; Global Insight / NVCA, 2004; Leinbach and Amrheim, 1987), such as
Northern California, the Boston Metropolitan area and the San Diego County in the
United States (Powell et al., 2002; Gompers and Lerner, 2001), or the South East of
England in the UK (Mason and Harrison, 2002a; Martin, 1989).3 Thus, it remains an
open question whether venture capital creates successful industrial regions or whether
venture capital is simply attracted to such regions.
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In light of the facts presented above, it is probably safe to say that venture
capital benefits primarily selected companies, industries and regions. Venture capital’s
role is most evident in the formation and commercialization of new industries (Bygrave
and Timmons, 1992; Kortum and Lerner, 2000) and the formation of technology
clusters (Feldman, 2001; Mason et al., 2002; Mason and Harrison, 2004). However, it is
important to note that venture capitalists’ tendencies to overinvest in certain sectors
sometimes referred to as venture capital myopia (Sahlman and Stevenson, 1985;
Valliere and Peterson, 2004) has negative implications for their portfolio companies
and their peers. Venture capital also has a reputation for incubating superstars’ rather
than supporting the mainstream of start-ups. Since its formative years in the early
1970s, the US venture capital industry has invested approximately $456 billion in more
than 27,000 companies. While many of these companies have ultimately failed,
successes such as Genentech, eBay and Intel went on to create entire new industries and
ways of doing business (IHS, 2009). However, it is important to note that a venture
capitalist’s definition of ‘failure may be that the firm simply does not generate the high
rate of return sought, but in all other respects performs well in terms of creating jobs,
generating tax revenues and developing important technologies.
Does this exclusiveness make venture capital’s contribution less significant?
If we approach this question purely from the economic perspective, we have to admit
that even though venture capital accounts for only a tiny fraction of all corporate
investment in the United States, it has a dramatic impact on economic growth and the
creation of new jobs. For instance, Kaplan and Lerner (2010) argue that over 60 per cent
of IPOs received venture capital funding in the United States from 1999 to 2009.
According to Barry et al. (1990), venture-backed companies created 30 per cent of the
22
market value generated by all firms going public between 1978 and 1987. The most
significant impact was felt in highly innovative industries. For instance, in the software
sector, venture-backed public firms created 75 per cent of the industry’s total value. It is
also noteworthy that most of the new jobs, innovations and profits attributable to small
firms are created by relatively few firms that start small and grow fast (Mitchell, 1980;
Storey, 1980; Birch et al., 1993), thus explaining the policymakers’ keen interest in
generating gazelles. If venture capitalists are able to identify and support such firms,
their economic impact is unquestionable. If we evaluate the impact of venture capital
more from the perspective of social justice, equity and diversity, our conclusion might
be different.
In the panorama of entrepreneurship, angel investments might be far more
important than is venture capital. In the 54 countries included in the GEM study,4 only
15,000 companies were funded with venture capital compared with tens of millions of
firms that received funding from business angels. In the words of Bosma and Levie
(2009), ‘in the United States a person has a higher chance of winning a million dollars
in a state lottery than getting venture capital to launch a new venture’. Thus, even
though its economic impact is much less studied, angel financing is likely to have a
greater short-term impact on entrepreneurial activity. If all informal investment dried
up, the consequences for the economy would be disastrous. By contrast, a drop in
venture capital investing would have little if any impact on the nation economy.
However, the economic impact of venture capital is likely to be more of a long-term
nature, facilitating the transformation of existing industries and creating new ones
(Bosma and Levie, 2009).
23
ECONOMIC IMPACT OF BUSINESS ANGELS
This section focuses on the economic impact of business angels. I start with the history
and context of studies approaching this topic. Then, I analyze the importance of angel
funding in entrepreneurial finance, the complementary role played by angel investors
relative to venture capitalists and the geographical aspects of angel finance.
It is well known that numerous successful companies and the inventors
behind them received angel funding. These include Alexander Graham Bell, Henry
Ford, Anita Roddick of The Body Shop and Jeff Bezos of Amazon.com. Angel
investments have remained relatively invisible to academics and public policymakers,
mostly because there are no directories of business angels and no public records of their
transactions (Sohl, 1999). In fact, it was not until 1983 when William Wetzel published
his seminal paper on angel investors that the prominent role of business angels in
entrepreneurial finance became known to academic audiences (Sohl, 2003). Soon after,
Wetzel’s work was replicated in California by Tynes and Krasner (1983) and in the UK
by Harrison and Mason (1988). Since then, much of the research on business angels has
been based on mostly convenience samples and focused mostly on the attitudes,
behaviors and characteristics (the ABCs) of business angels (Freear et al., 2002) or the
investment process (see for instance, Mason and Harrison, 2000a). Thus, the economic
impact of business angels has largely been left unstudied.
Three aspects of the informal venture capital (business angel) market are
significant from an economic development perspective (Mason, 2006). First, the size of
the business angel market is impressive. Business angels are the primary source of
equity financing for start-up and early-stage technology-based ventures (Freear et al.,
24
2002; Aernoudt and Erikson, 2002; Wetzel and Freear, 1994; Bygrave and Hunt, 2005;
Berger and Udell, 1998; van Osnabrugge, 1999; Mason and Harrison, 1996; Bygrave et
al., 2003), far exceeding the role of the venture capital community. Empirical evidence
from 40 countries indicates that business angels comprise 3.4 per cent of the adult
population and invest 1.1 per cent of the GDP to new and growing companies (Bygrave
et al., 2003). According to some estimates, business angels invest in 2 per cent of all
new firms (Aldrich, 2008), and angel finance accounts for an estimated 3.6 per cent of
small business finance (Berger and Udell, 1998).
Many studies estimate that the size of the angel market might be as much as
twice (Venture Economics, 2000 in Wong 2002), four or five times (Wetzel, 1983;
Mason and Harrison, 1992; Bygrave and Reynolds, 2004), 10 times (Freear et al., 1992;
Sahlman, 1990; Sohl, 2003) or 40 times (Gaston, 1989) as large as is the venture capital
market. Furthermore, business angels have an even greater unutilized potential than
these figures suggest (Mason and Harrison, 1993). Research shows that business angels
could potentially have up to three times more capital for investment, but they are held
back by the unavailability of good investment opportunities and less than optimal policy
incentives (Mason and Harrison, 1993; Freear et al., 1997; van Osnabrugge, 1999).
Business angels play a highly complementary role to the one played by
venture capitalists (Mason and Harrison, 1995; Freear and Wetzel, 1990). They invest in
exactly those areas that venture capitalists are reluctant to invest. These include seed
and start-up stages and smaller deals (Freear and Wetzel, 1990; Sohl, 2003; Gaston,
1989; Harrison and Mason, 1992; Landstrom, 1993). A fair share of angel capital goes
to technology and manufacturing sectors (for an excellent review see Farrell, 1998).
Angel investors are also said to be more accommodating to the needs of small
25
businesses by having a lower rejection rate, longer exit horizons and lower investment
fees (Harrison and Mason, 1992). Thus, a significant number of surveys (Freear et al.,
1995; Avery and Elliehousen, 1986; Wetzel, 1987; Sullivan and Miller, 1990; Goldfarb
et al., 2007) report that entrepreneurs prefer angel financing to formal venture capital. In
addition, what makes the business of angel funding even more critical is the fact that
venture capitalists are shying away from small high-tech deals because of growing fund
sizes and high fixed costs of due diligence (Dimov and Murray, 2006; Jensen, 2002).
The second factor that underpins the economic significance of business angels is their
hands-on involvement in their portfolio companies. Such involvement early on is likely
to have a large influence not only on the success of the firm but also on its management,
governance and operations (Sohl, 1999). The value-adding activities of business angels
are discussed more in detail in other parts of this volume.
The third contribution of informal venture capital to economic development
arises from its geographical characteristics. Like venture capitalists, business angels
tend to invest close to home, and thus their economic impact tends to be regional
(Coopers and Lybrand, 1996). However, business angels are much more geographically
dispersed than are venture capitalists (Mason and Harrison, 1995; Gaston, 1989; Feeney
et al., 1999; Farrell, 1998; Sohl, 2003; Landstrom, 1998). As Gaston (1990, p. 273) puts
it: ‘angels are everywhere’. Thus, business angel investments help retain and recirculate
wealth within a region and contribute to the emergence of technology clusters. Notable
examples include the Ottawa, Silicon Valley and Cambridge (UK) technology clusters
(Mason et al., 2002). However, opposing empirical evidence also exists, prompting us
to reconsider the role of angel financing in closing the regional equity gap. In her study
on Swedish business angels, Avdeitchikova (2009) reports that there is a considerable
26
concentration of angel financing in metropolitan areas and university cities. Further,
investments conducted in these places are allocated in proportion to the new business
formation rate and concentration of technology-based firms.
Even though a wealth of studies have focused on the size and characteristics
of business angel markets, the studies that directly tie business angel investments to
specific macro-economic outcomes are few in number. Significant exceptions include
the studies by Autio (2003), Bygrave et al., (2003) and Ho and Wong (2007) based on
GEM data, which confirm a positive relationship between business angel prevalence
and new firm formation rates. In a similar vein, the Center for Venture Research (2003
2009) report that for each business angel investment, four new jobs are created in the
United States, counting up to approximately 200,000 new jobs each year.
INSTITUTIONAL DIFFERENCES IN THE IMPACT OF VENTURE CAPITAL AND
BUSINESS ANGEL INVESTMENTS: A CROSS-COUNTRY COMPARISON
In this section, I discuss the impact of the institutional environment on the value
creation capability of venture capitalists and angel investors. I start with a comparison
of the sizes of the venture capital and business angel markets all over the world and then
proceed to economic impact generated by venture capital in different institutional
environments.
Institutional differences in the economic impact generated by venture capitalists
27
Figure 6.9 shows how venture capital investments in various stages are linked to GDP
levels all over the world. The highest venture capital activity can be found in Israel,
South Africa and the United States, where approximately 0.2 per cent of GDP is spent
on venture capital investments. The countries with the lowest venture capital investment
rates include Serbia, Croatia, Slovenia and Greece, spending less than 0.01 per cent of
their GDPs on venture capital investments. If we focus on only early-stage venture
capital investments, investment activity is highest in Israel (0.20 per cent), Sweden
(0.06 per cent) and the United States (0.05 per cent).
-----
Insert Figure 6.9 about here
-----
Systematic cross-country studies comparing the value-added generated by
venture capitalists in different parts of the world are rare. However, we have some
evidence suggesting that the performance of venture capital funds and venture capital-
backed companies may vary regionally. It seems that venture capitalists in the United
States are more selective in picking portfolio companies than are their colleagues in
other countries, but they also invest far more money per deal and per company. In
addition, European venture capital investments often go to manufacturing sectors,
whereas US venture capitalists invest more heavily in high-tech sectors (Bottazzi and
Da Rin, 2002). This may explain why the impact of venture capital is less significant in
Europe and why US venture-backed companies, such as eBay, Amazon and Google,
dominate global markets (Bosma and Levie, 2009).
28
We also know that European venture capitalist investments perform poorly
compared with their US counterparts (EVCA/Thomson Venture Economics, 2004).
According to Hege et al. (2003) and Brouwer and Hendrix (1998), the higher
performance rates enjoyed by US venture capitalists can be explained by differences in
the contractual relationships and their better capacity to screen projects compared with
European venture capitalists. In addition, Chahine et al. (2007) suggest that venture
capitalists in the United Kingdom decrease the underpricing of newly listed companies,
whereas French venture capitalists increase it, hinting to the possibility that the
certification effect of venture capital and business angel involvement is more significant
in the UK than it is in France.
Historically, venture capital-backed entrepreneurship has not been
responsible for the creation of Asia’s most successful companies, which tend to be spin-
offs from established companies or set up by governments as part of their economic
development programs (Koh and Koh, 2002). Venture capital in Asia has traditionally
focused more on later stage extension financing and investment in mature companies,
rather than early-stage financing in start-ups (Koh and Koh, 2002). The modest impact
of venture capital in Asia can be explained by the less than optimal regulatory
framework, fragmented markets, relatively underdeveloped infrastructure, shortage of
experienced managers, fewer exit options and the cultural resistance of Asian
entrepreneurs to share control with venture capital firms. However, today’s venture
capitalists in China seem to be following closely the US example in terms of deal size
and industry focus. When adjusted for purchasing power, the amount invested in China
in 2008 had nearly caught up with the amount invested in Europe (Bosma and Levie,
2009).
29
In addition to comparing various venture capital markets in terms of their
economic impact, it is possible to assess the effect of various institutional factors on the
value generated by venture capitalists. First, factors promoting fundraising and venture
capital investments include GDP growth and the growth rate of R&D (Gompers et al.,
1998; Jeng and Wells, 2000; Romain and Pottelsberghe, 2004), favorable tax, regulatory
and legal environments (La Porta et al., 1997; Gompers et al., 1998; Marti and Balboa,
2000; Da Rin et al., 2006; Armour and Cumming, 2006; Leleux and Surlemont, 2003;
Guo, 2008), the presence of well-functioning stock markets (Schroder, 2009) and
government programs facilitating investments in young ventures (Lerner, 2002; Leleux
and Surlemont, 2003; Cumming, 2007). Commitments to early-stage ventures are
negatively affected by labor market rigidities (Black and Gilson, 1998; Jeng and Wells,
2000; Romain and Pottelsberghe, 2004) and high capital tax gains (Gompers et al.,
1998). Variations in corporate and tax law environments may have implications on the
financing structure of venture capital investments (Wright et al., 2005), and thus the
performance of venture capital funds and portfolio companies. For instance, the most
lucrative exit vehicles (i.e. IPOs) are reported to be more common in countries where
legal investor protections are strong, whereas buy-outs gain importance in countries
with weaker legal frameworks that protect the interests of investors (Cumming and
MacIntosh, 2003; Armour and Cumming, 2006; La Porta et al., 1997). In a similar vein,
regulations allowing pension funds to invest in private equity increase the supply of
venture capital, thus amplifying its impact (Megginson, 2004).
Second, institutional factors may also impact the ability of venture
capitalists to generate value indirectly by creating conditions that are either beneficial or
detrimental to the supply of lucrative investment targets. As discussed earlier in this
30
section, venture capital tends to thrive in regions and nations characterized by high
levels of entrepreneurship, risk-taking and innovation (see for instance, Zook, 2002;
Schertler, 2007; Feldman, 2001; Gompers and Lerner, 1999a, b; Ueda and Hirukawa,
2003). It seems that the economic impact of venture capitalists can be best captured
when investments are made in local companies (Cumming and Dai, 2010) in the
presence of geographic concentrations of interconnected companies, specialized
suppliers, service providers and firms in related industries (Cooke, 2001). For instance,
Martin et al. (2002) explain that the inferior performance of European venture capital
markets relative to their US counterparts stem from a lack of geographical clustering.
Third, institutional environments also vary in terms of investors’ skills
relative to selecting and adding value to portfolio companies. Relative to deal
generation, deal screening and valuation, several researchers conclude that venture
capitalists in the United States apply a more comprehensive set of criteria for evaluating
the risks associated with new ventures than do their colleagues in other parts of the
world (Ray, 1991; Ray and Turpin, 1993; Knight, 1994; Hege et al., 2003). In a similar
vein, many US senior partners have become legendary for their skills in finding,
nurturing and bringing to market high-tech companies (Megginson, 2004). Likewise,
the availability of professional business intermediaries, such as accounting, auditing and
finance professionals are likely to boost venture capital investments (Guo, 2008). All
these factors may partly explain the fact why the economic impact of venture capital
seems to be the most profound in the United States.
Institutional differences in the economic impact generated by angel investors
31
Figure 6.10 shows informal investment as a percentage of GDP. In countries such as
China, Bosnia-Herzegovina, Syria, Algeria and Latvia, 4 per cent or more of GDP goes
to informal investments. Somewhat surprisingly, countries known as entrepreneurial
hotbeds, such as the United States and Israel, invest an amount equivalent to less than 2
per cent of GDP in business angel deals. However, this finding might be explained by
the fact that unlike many other studies (see for instance, Mason and Harrison, 2000b;
Avdeitchikova et al., 2008) the GEM results were calculated by including the so-called
‘love money’ invested by family and friends in angel finance. It is important to note that
the vast majority (88 per cent) of GEM informal investments are micro-investments by
friends, family and neighbors and that this tendency seems to be stronger in markets
where other types of angel investments are less prevalent (Avdeitchikova et al., 2008).
Finally, the European Business Angel Network (EBAN, 2007) reports that in the US
250,000 angels invested $24 billion in 2005 in comparison to 75,000 angels who
invested only €2–3 billion in Europe (Bosma and Levie, 2009).
-----
Insert Figure 6.10 about here
-----
Apart from cross-country comparisons of the prevalence of angel funding
(thus indicating the mere size not the efficiency of a business angel market), virtually no
study has set out to explore whether the value-added generated by one business angel
dollar varies in different institutional settings. There exists, however, plenty of indirect
evidence suggesting that cognitive, normative, regulatory and legislative institutions
32
may affect the supply of angel funding, and thus indirectly its economic impact. First,
the ability to perceive business opportunities (De Clercq et al., forthcoming; Maula et
al., 2005), general entrepreneurial experience, the skills to evaluate, start and manage
new businesses and favorable cultural attributes, such as affinity to risk taking (Maula et
al., 2005; Landstrom, 1993), have been found to increase the impact of business angel
funding by increasing its supply to nascent entrepreneurs. For instances, studies from
Norway (Reitan and Sorheim, 2000), Japan (Tsukagoshi, 2008; Tashiro, 1999) and
Scotland (Paul et al., 2003) imply that angel investors’ lack of start-up experience and
lack of involvement in their portfolio companies may compromise the value creation of
their investments. Second, the supply of angel funding depends on the quality of
information channels between angel investors and entrepreneurs (Mason, 1992), and the
embeddedness of a country’s culture defined as the extent to which its members value
the development and maintenance of close relationships to one another (De Clercq et
al., forthcoming; Kwon and Arenius, 2010). Third, favorable personal tax regimes
(Landstrom, 1993; Mason and Harrison, 1992), institutions favoring individual wealth
accumulation (Maula et al., 2005; Landstrom, 1993; Harrison and Mason, 1992) and the
presence of effective legal protection and regulatory systems (De Clercq et al.,
forthcoming; Ho and Wong, 2007; Harrison and Mason, 1992) tend to favor business
angel investments.
CONCLUSION AND DISCUSSION
In the following, I present a summary of the key findings, discuss the theoretical and
empirical aspects of the studies reviewed and suggest avenues for future research.
33
Summary of key findings: What do we know about the economic impact of venture
capital and angel financing?
Scholars interested in the economic impact of informal and formal venture capital have
focused on questions such as ‘do venture capitalists and business angels add value to
their portfolio companies?’; ‘does venture capital spur innovation and regional
development?’; and ‘does venture capital and business angel investments spur
entrepreneurship by increasing start-up rates?. The key findings are listed and
discussed more in depth below:
Venture-backed firms are more successful than are other firms in terms of sales
growth, tax revenue generation and job creation.
Venture-backed firms are more innovative than are other firms. It is unclear,
however, whether venture capitalists promote innovation or whether they only
invest in innovative ventures. The same controversy surrounds the impact of
venture capital on regional development.
The economic impact of venture capital is highly limited to selected companies,
industries and regions.
Angel finance is the single most important source of funding for early-stage
innovative ventures.
Prior research seems to be rather unanimous about venture-backed firms
being more successful in terms of aggregated sales growth, payment of taxes and job
34
creation compared with other firms. This superior performance of venture capital-
backed firms can be traced back to the selection and value-added effects. The selection
effect maintains that venture capitalists are highly skilled at picking the most successful
firms in the most promising industries. The value-added effect stems from the activities
undertaken by venture capitalists to boost the performance of their portfolio companies.
Research on business angels confirms their value-adding role, but systematic studies
comparing the performance of angel-backed companies with other firms are still largely
missing.
Studies informing us on the linkage between innovation and venture capital
funding can be divided into two broad categories. The first category of studies supports
the ‘venture capital first’ hypothesis, stating that venture capital promotes the
innovativeness of single firms, countries and regions. The second category promotes the
innovation first’ hypothesis, according to which venture capitalists simply pick the
most innovative firms as their investment targets. The same dichotomy can be found in
studies exploring the relationship between venture capital funding and regional
development. There are studies highlighting the central role of venture capital in the
development of high-tech hot beds, such as Silicon Valley, and the promotion of start-
up entrepreneurship. However, others argue that venture capitalists are simply attracted
to flourishing regions and industries. Again, less academic research exists on the impact
of angel investments on regional development, industrial renewal and innovation.
Based on the studies reviewed above, it is safe to say that venture capital has
played a key role in launching new technologies and industries and creating many of the
most iconic companies of our times. However, the economic impact of venture capital is
limited to selected companies, industries and regions. The economic impact of business
35
angels is likely to be more inclusive in light of the sheer number of investments, the
amount invested and the range of regions. However, this topic is yet to attract the full
attention of the academic community.
Theoretical and methodological considerations
Research on the economic impact of venture capitalist and business angel investments is
surprisingly atheoretical, with a large number of studies failing to refer to any existing
theoretical framework. This applies to research on business angels in particular. In
addition, even those studies that echo the ideas put forward by well-known management
and economic theories often fail to state their theoretical foundations. However, it is
possible to divide the studies included in this literature review into two major categories
based on their research focuses and their implicit or explicit theoretical orientations.
First, the studies investigating the relationship among venture capital
investment, innovation and firm performance are often informed by the resource-based
(Brown, 2005; Peneder, 2010; Hege et al., 2003), resource-dependence (Ho and Wong,
2007), signaling (Davila et al., 2003; Megginson and Weiss, 1991) and agency theories
(Bertoni et al., 2010; Belden et al., 2001; Peneder, 2010; Schertler, 2007). The main
tenet of these studies is that venture capital involvement provides companies with
valuable resources and improved governance structures, thereby boosting their
performance. Second, studies investigating regional variation in the impact of venture
capital investments usually build on the institutional theory (Chahine et al., 2007;
Schertler, 2007) and the literature on regional clusters (Zhang, 2007; Stuart and
Sorenson, 2003; Zook, 2002; Powell et al., 2002; Feldman, 2001; Florida and Kenney,
36
1988; Martin, 1989; Zucker et al., 1998). These streams of literature assume that
national cognitive, normative, political and legal institutions as well as local
agglomeration economies create conditions under which venture capital investments can
flourish and create value.
From a methodological point of view, research on the economic impact of
venture capital can be divided into four major categories based on the dependent
variable used. These include studies focusing on 1) employment generation, 2) wealth
creation, 3) the promotion of innovation and 4) regional development. First, the studies
analyzing the employment generation impact are relatively few in number and
characterized by a European or international focus (Achleitner and Klockner, 2005;
Alemany and Marti, 2005; Belke et al., 2001; 2003; Bottazzi and Da Rin, 2002). Most
of these studies are longitudinal with data collected from the 1990s or early 2000s. It is
noteworthy that the main academic studies have focused on employment generation by
venture capitalists at the expense of angel investors.
Second, the wealth generated by venture capitalists and business angels was
measured using a wide variety of indicators, such as sales growth (Alemany and Marti,
2005; Audretsch and Lehmann, 2004; Belden et al., 2001; Belke et al., 2001; 2003;
Bottazzi and Da Rin, 2002; Brown, 2005; Davila et al., 2003; Engel, 2002; Peneder,
2010; Ueda and Hirukawa, 2003), market performance (Barry et al., 1990; Brav and
Gompers, 1997; Brown, 2005; Burgel et al., 2002; Chahine et al., 2007; Gompers, 1996;
Megginson and Weiss, 1991), profitability (Belden et al., 2001; Brown, 2005; Jain and
Kini, 1995), survival (Manigart et al., 2002; DeHudy et al., 1981) and return on
investment enjoyed by the venture capitalist or angel investor (Burgel, 2000; Mason and
Harrison, 2002b; Wiltbank, 2009). Most of these studies were based on longitudinal
37
data on IPOs in the United States and Europe. It is interesting to note that the studies on
the economic impact of business angels have paid more attention to the return on
investment earned by individual angel investors (Burgel, 2000; Lumme and Mason,
1996; Wiltbank and Boeker, 2007; Wiltbank, 2009) and the value-adding services
provided by angel investors (Sorheim and Landstrom, 2001; Sorheim, 2005; Politis,
2008; Ehrlich et al., 1994), rather than comparing the performance of angel-backed
firms with other firms.
Third, studies investigating the relationship between innovation and venture
capital have mainly used patents as their dependent variable. This research stream is
characterized by quantitative studies from the United States (Kortum and Lerner, 2000;
Ueda and Hirukawa, 2003; 2006; Hellman and Puri, 2000) and, even more extensively,
from Europe (Bertoni et al., 2010; Popov and Rosenboom, 2009; Bottazzi and Da Rin,
2002, Engel and Keilbach, 2007; Peneder; 2010; Tykvova, 2000). Most of these studies
are longitudinal and use data from the 1980s to the 2000s.
Fourth, studies focusing on venture capital’s impact on regional
development can be divided into two categories: quantitative database studies
investigating the geographical dispersion of venture capital within a given country
(Avdeitchikova, 2009; Cumming and Dai, 2010; Florida and Kenney, 1986; Florida and
Smith, 1990; Leinbach and Amrheim, 1987; Martin, 1989; Powell et al., 2002) and
studies mixing quantitative and qualitative approaches analyzing venture capital’s role
in the development of a given geographical or technology cluster (Feldman, 2001;
Harrison et al., 2004; Mason and Harrison, 2004; Stuart and Sorenson, 2003; Zucker et
al., 2004; Zook, 2003). It is worth noting that the studies falling into the second
category focus almost exclusively on formal venture capital.
38
In terms of research methods used, there is relatively little variation in
research on the economic impact of venture capital and business angel investments. A
vast majority of the studies reviewed adopted a quantitative approach and relied on
information derived from database or survey data. Only a fraction of papers used either
a purely theoretical or a qualitative approach. Most of the studies were conducted in the
United States (Brown, 2005; Ehrlich et al., 1994; Zhang, 2007; Stuart and Sorenson,
2003; Belden et al., 2001; Zook, 2002; Wong, 2002; Kortum and Lerner, 2000) or
Europe (Bertoni et al., 2010; Sorheim and Landstrom, 2001; Chahine et al., 2007;
Popov and Rosenboom, 2009; Peneder, 2010; Schertler, 2007). In addition, longitudinal
studies explicitly comparing the economic impact of venture capital and business angel
financing at different time points and cross-country studies comparing the regional
differences in the value added are largely missing.
Suggestions for future research: What would we like to know?
What is the total value-added of venture capital and business angel financing?
Most of the studies on the economic impact of venture capital and business angel
financing provide only a snapshot of the phenomenon at hand and focus only on a
particular aspect of value creation. In other words, a systematic and holistic analysis of
the economic impact of venture capital and business angel funding is missing. Thus,
future studies should borrow tools from the economic impact literature (Kim et al.,
2003; Schumacher et al., 2004; Backhaus and Whiteman, 1994) developed for other
industries. Lubar (1990), for instance, divides economic impact into two categories:
direct and indirect benefits. Direct benefits include tax revenues, job creation, the
39
development of new industries, increased exports and enhanced international
competitiveness. Indirect benefits include enhanced productivity, stimulus to the
regional economy and improved quality of life. It goes without saying that carrying out
such studies would be demanding, requiring access to a wide variety of databases
providing information on the sources of funding for nascent firms, their financials and
product information and official tax statistics, just to mention a few examples.
Future studies should also pay more attention to how the value-added
generated by venture capitalists and angel investors is defined and measured. Firstly,
giving full credit to venture capitalists or business angels for each job or revenue dollar
their portfolio companies create is likely to be unfounded. Merely being a financial
intermediary to a portfolio company is separate from demonstrating that this particular
company could not have obtained financing from other sources (Kedrosky, 2009).
Secondly, the public press and academic research typically convey venture capitalists
and business angels as investors primarily seeking to maximize the economic returns on
their investments. Yet, many venture capitalists (and undoubtedly many angel investors)
have social as well as financial objectives. For instance, American Research and
Development was created not to make money but to finance ‘noble ideas’ (Gompers,
1994, p. 6). The first global venture capital firm, Advent International, stressed the
importance of regional economic development. Today, we experience an emergence of
developmental venture capital funds with the more pronounced objective of serving the
economic development of distressed urban and rural economies, creating high quality
jobs for low income populations, building wealth for minorities and launching products
that benefit society (Rubin, 2009). Thus, future studies should focus on the social as
40
well as economic impact of venture capital and business angel investments and extend
this analysis both to profit-oriented and social-oriented investors.
Are there cross-national and regional differences in the value-added?
Several studies have examined and occasionally compared the characteristics of
business angels (Reitan and Sorheim, 2000; Tsukagoshi, 2008; Tashiro, 1999; Pereiro,
2001; Stedler and Peters, 2003; Hindle and Wenban, 1999; Paul et al., 2003; Hindle and
Lee, 2002; Romani et al., 2009; Wong and Ho, 2007) and venture capitalist markets (see
for instance, Megginson, 2004; Wright et al., 2005; La Porta et al., 1997; Gompers et
al., 1998; Marti and Balboa, 2000; Lerner, 2002; Leleux and Surlemont, 2003) in
various nations. In a similar vein, we know that venture capital funding seems to be
heavily concentrated in a few, high growth regions (Florida and Kenney, 1988; IHS,
2009; Global Insight / NVCA, 2004; Leinbach and Amrheim, 1987) within these
countries. There also exists some evidence suggesting that venture-backed companies
and venture funds perform differently across national borders (Sapienza et al., 1996;
Hege et al., 2003). However, less is known about whether a dollar spent by a venture
capitalist or a business angel produces a different impact in different countries or
regions.
Hence, a fruitful avenue for future research would involve analyzing the
spatial variation in the economic impact of venture capital and business angel funding.
For instance, we may ask whether the economic impact of business angel and venture
capital funding is largely confined to the US, or even specifically to Silicon Valley?
Then, if this seems to be the case, what is hindering Europe and Asia from achieving
similar effects? Here, it should be borne in mind that the impact of business angel and
41
venture capital investments cannot be analyzed in isolation from other factors
influencing the successes and impact of start-ups (Bygrave and Timmons, 2002).
Future studies should also take a more critical look at the economic impact
of entrepreneurial finance. Can there be too much of a good thing, meaning that a heavy
concentration of venture capital and angel investments in a particular region leads to the
overheating of a particular industry sector, cut-throat competition, costly litigation
concerning intellectual property rights and the misappropriation of ideas across firms?
Or does a heavy concentration of venture capital and business angel funding produce a
virtual cycle of prosperity and innovation within a region?
Do different types of players add value differently?
Some empirical evidence has suggested that venture capitalists and business angels are
by no means a homogeneous group in terms of the capability to add value to their
portfolio companies. For instance, Manigart et al. (2002) report that older government-
backed venture capitalists boost the survival rates of their portfolio companies more
than other venture capitalists do. Brander et al. (2010) argue that the right combination
of public and private venture capitalists optimizes the performance of portfolio
companies. Goldfarb et al. (2007), in turn, find that companies financed both by angels
and venture capitalists experience inferior performance outcomes, even though the
participation of either angels or venture capitalists is beneficial. Stein and Bygrave
(1990) suggest that only the best venture capitalists add value to their portfolio
companies. Similar conclusions can be drawn from studies on business angels (Freear et
al., 1994; Sorheim and Landstrom, 2001; Das and Lerner, 1995). Thus, a compelling
topic for future studies would be to investigate whether a particular group of venture
42
capitalists or business angels contributes more than their fair share to economic
development.
How has the value-adding capacity of venture capitalists and business angels evolved
over time?
There is growing concern among the financial and academic communities that the
venture capital industry might have entered a state of crisis (Mason, 2009b; Kedrosky,
2009; Block and Sandner, 2009). This crisis is demonstrating itself in a decrease in the
amounts raised by portfolio companies and the returns they generate to their investors.
Some authors speculate that the problems facing the venture capital industry may not
simply be an outcome of the present economic crisis but reflect longer-term issues
(Block and Sandner, 2009)5 and they have called for a fundamental restructuring of the
industry. In addition, it is possible that the economic impact of venture capital is
dependent on the stage of the business cycle. In boom times, it is easier to raise a
venture capital fund, which potentially attracts poor quality investors less capable of
selecting the optimal investment targets and adding value. In tougher economic times,
only high quality venture capitalists are able to raise funds, which is likely to lead to
greater economic impact.
While some longitudinal data exist on how the number of venture capital
deals and the amounts invested have evolved over time (see for instance, Kaplan and
Lerner, 2010), less is known about whether the economic impact produced by one
venture capital or business angel dollar has changed over the decades or over business
cycles. Thus, future studies should investigate the fluctuations in new jobs, sales
43
generation, technology development, tax revenues, regional development and returns on
investment by venture capital- and angel-backed companies.
NOTES
1. Please note that there was a significant decline in average informal investor prevalence rates in all G7
countries in 2009.
2. It is interesting to note that Schertler (2007) and Da Rin et al. (2006) fail to detect a positive
association between public expenditure in R&D and venture capital.
3. However, some regional hubs of venture capital are emerging beyond the traditional strongholds.
These areas include the Pacific Northwest, the Mid-Atlantic and the South West of the United States.
4. These countries include Morocco, Yemen, Venezuela, West Bank and Gaza, Lebanon, Kingdom of
Tonga, Saudi Arabia, Syria, Algeria, Jamaica, Guatemala, Uganda, Brazil, Russia, Romania, Bosnia and
Herzegovina, South Africa, Malaysia, Jordan, Panama, Uruguay, Ecuador, Croatia, Argentina, Iran,
Colombia, Serbia, Hungary, Dominican Republic, Tunisia, China, Latvia, Peru, Chile, the United
Kingdom, Germany, Japan, Italy, the Netherlands, Denmark, Finland, Belgium, Greece, Hong Kong,
Slovenia, Spain, Republic of Korea, Israel, the United States, France, Switzerland, Norway, Iceland and
the United Arab Emirates.
5. Please note that Kaplan and Lerner (2010) present a contradictory view.
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Source: Modified from Dow Jones Venture Source
Figure 6.1 Global quarterly venture capital investment by geography ($ billion).
1Q'09 2Q'09 3Q'09 4Q'09 1Q'10 2Q'10
US $4.30 $6.10 $5.90 $7.00 $4.70 $7.70
Europe $1.20 $1.00 $1.20 $1.50 $1.20 $1.40
Israel $0.20 $0.21 $0.25 $0.22 $0.22 $0.47
China $0.40 $0.50 $0.40 $0.70 $0.60 $0.70
India $0.10 $0.10 $0.20 $0.30 $0.30 $0.20
Canada $0.10 $0.10 $0.10 $0.20 $0.20 $0.10
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
76
Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree(tm) Report
Figure 6.2 Venture capital investment in the United States 19952010
0
2000
4000
6000
8000
10000
12000
1995 1997 1999 2001 2003 2005 2007 2009
Total Investment (10
Million $)
Total Deals
77
Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree(tm) Report
Figure 6.3 Venture capital investment in the US by investment stage in 2010
Start-Up/Seed
8%
Early Stage
24%
Expansion
39%
Later Stage
29%
Venture Capital Investment 2010
78
Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree(tm) Report
Figure 6.4 Venture capital investment in the US by industry sector in 2010
17%
2%
2%
2%
2%
2%
1%
8%
15%
7%
11%
3%
0%
1%
4%
18%
4%
Venture Capital Investment 2010
Biotech
Business Product & Services
Computers & Peripherals
Consumer Products and
Services
Electronics & Instrumentation
Financial Services
Healthcare Services
IT Services
Industial/energy
Media/Entertainment
Medical Devices
79
Source: EVCA/PEREP_Analytics 20072009; EVCA/Thomson Reuters/PwC for Previous Years
Figure 6.5 European private equity investment 20002009
80
Source: National Venture Capital Association, 2009; Kedrosky, 2009
Figure 6.6 Venture capital performance versus other investments 19902008
81
Source: 2011 Cambridge Associates Benchmark Statistics*
*Vintage funds formed since 2006 are too young to have produced meaningful returns. Analysis and
comparison of partnership returns to benchmark statistics may be irrelevant.
Figure 6.7 US Venture capital funds since inception IRR
0
20
40
60
80
100
120
1975 1980 1985 1990 1995 2000 2005 2010 2015
82
Source: Center for Venture Research 20022009
Figure 6.8 US angel investment 20032008
0
10
20
30
40
50
60
70
2002 2003 2004 2005 2006 2007 2008 2009
Angel Investment ($)
Investments * 1000
83
Figure 6.9 Venture capital investments as a percentage of GDP by the stage of the
company (Bosma and Levie, 2009)
84
Figure 6.10 Amount of angel investment as a percentage of GDP (Bosma and Levie,
2009)
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