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194 Int. J. Entrepreneurship and Innovation Management, Vol. 19, Nos. 3/4, 2015
Copyright © 2015 Inderscience Enterprises Ltd.
The impact of basic conditions on investment in the
venture capital industry. Evidence from European
countries
Bernard Guilhon
SKEMA Business School,
60 rue Dostoïevski,
06902 Sophia Antipolis, France
Email: bernard.guilhon@skema.edu
Sandra Montchaud*
CHERPA – Sciences Po Aix,
25 rue Gaston de Saporta,
13625 Aix-en-Provence Cedex 1, France
Email: sandra.montchaud@sciencespo-aix.fr
*Corresponding author
Abstract: Using an industrial organisation (I/O) approach, this study considers
venture capital (VC) and aims to explain the scale of investments made by fund
management companies by the basic conditions of this industry. Thus, within
the market structure-conduct-performance paradigm, we focus on the
relationship between basic conditions and VC firms’ conduct. The basic
conditions are analysed from the point of view of supply, (corresponding to the
fund management companies that raise capital from investors), and demand,
(referring to the firms in which the capital available can be invested).
Macroeconomic, institutional, exit and entrepreneurial characteristics form the
VC environment, and one and the same element can constitute a basic
condition on both the supply and demand side. The econometric study, based
on a sample of 18 European countries over the period 2002–2009, highlights
the influence of the interest rate, tax and legal framework, exit context and
innovation dynamics.
Keywords: venture capital; VC; investment; IO; basic conditions;
macroeconomic situation; institutional framework; exit context; entrepreneurial
environment; Europe.
Reference to this paper should be made as follows: Guilhon, B. and
Montchaud, S. (2015) ‘The impact of basic conditions on investment in the
venture capital industry. Evidence from European countries’, Int. J.
Entrepreneurship and Innovation Management, Vol. 19, Nos. 3/4, pp.194–214.
Biographical notes: Bernard Guilhon is a Professor at Skema Business School
in France. His main research interests are in the economics of knowledge and
innovation. Among topics covered, the displacement of the risk frontier by VC
financing and the importance of institutional contexts.
Sandra Montchaud is a Senior Lecturer at Sciences Po Aix in France. Her
research mainly concerns the field of corporate finance. The financing of
business creation, firm growth and innovative projects is the subject of special
attention from the standpoint of private equity and VC.
The impact of basic conditions on investment in the venture capital industry 195
1 Introduction
Venture capital (VC) plays a central role in financing innovative enterprises. Its
emergence is specifically tied to the need to develop ways of financing innovation in
order to explore the promising technological pathways that proliferate in high tech
activities. Concomitantly, the deregulation of financial systems favours market
configurations (market-based systems) and threatens the stability of those based on banks
(bank-based systems). This has profound implications for the behaviour of corporate
finance as well as for private saving. VC funds are increasing in number: as
professionally managed organisations, they collect funding resources and invest in new
ventures for a limited time period in order to support their launch and/or expansion. They
have substantially longer investment horizons than other investors and their managers are
personally involved in the success or failure of the investee companies (Strömberg,
2009).
According to the literature, VC represents an activity whose positive influence is
visible on several levels: support of R&D and innovation (Kortum and Lerner, 2000;
Popov and Roosenboom, 2008; Lerner et al., 2008), diffusion of ideas both inside and
outside VC activity (Gonzales-Uribe, 2013), restructuring of the industrial fabric due to
the creation of small agile enterprises able to exploit technological opportunities (Mollica
and Zingales, 2007; Lerner, 2011); it also affects the employment and productivity of
investee companies (VICO Project, 2011), not to mention improving the allocation of
capital and benefits when access to capital is scarce (Strömberg, 2009).
Given the many positive effects expected from VC financing, this paper aims to
investigate the determinants of VC activity. To answer this research question, we have
recourse to the industrial organisation (I/O) approach that includes economic,
institutional and organisational variables that influence actors’ behaviour, and we
consider market adjustments as an important variable (Scherer, 1980). The framework
provided by I/O is meso-economic: firms are not studied for themselves but as part of an
industry whose behaviour and performance has to be explained. All these elements lead
us to think of VC activity in terms of the industry category established by Gompers and
Lerner (2001), Avnimelech and Teubal (2006), De Clercq and Dimov (2008), etc. More
precisely, we refer to the market structure-conduct-performance paradigm (Scherer,
1980). These three dimensions are linked to basic conditions in the industry. Thus, if we
reason backwards, performances are the result of firms’ conduct, which is in turn
conditioned by the industry’s structure and basic conditions. In accordance with our
research question, we focus on the relationships between basic conditions and VC firms’
conduct within this pattern.
The type of conduct in the VC industry we favour in this article concerns the
investments realised, that is to say the amounts invested by VC funds in companies. The
basic conditions of an industry are traditionally viewed from the point of view of supply
and demand. In the VC case, supply corresponds to the fund management companies that
raise capital from various investors, and demand refers to firms seeking money to finance
projects in which available capital can be invested. The basic conditions encompass the
macroeconomic, institutional, exit and entrepreneurial characteristics that form this
activity’s environment. They determine the functioning of the VC industry and, in
particular, its agents’ activity; these conditions are more or less favourable to the
development of this financing mode. The approach thus provides an accurate and
196 B. Guilhon and S. Montchaud
comprehensive analytical framework of VC firms’ environment, allowing to identify the
determinants of VC investments.
In order to highlight the main factors on which VC activity is based, an econometric
study is performed in order to explain VC investment (early and expansion stages) from a
set of variables reflecting the macroeconomic, institutional, exit and entrepreneurial
environment. This study is based on a sample of 18 European countries, all European
Union (EU) members, over the period 2002–2009. The sample size depends on the
information available and the selected period corresponds to an economic cycle from the
end of the Internet boom to the outbreak of the global crisis felt in Europe in late 2009.
Indeed, economic downturns successively associated with the financial and real sector
profoundly affect investment projects. Early stage financing becomes riskier and exit via
initial public offerings (IPOs) or mergers and acquisitions (M&A) appears unfavourable
(Paik and Woo, 2014).
Our contribution to the existing literature may be highlighted at several levels. Above
all, there exist only a few comprehensive econometric studies on what drives VC activity.
Those of Gompers and Lerner (1998), Jeng and Wells (2000), Armour and Cumming
(2004)1, Bonini and Alkan (2012) and Félix et al. (2013) are the most closely related to
our analysis because they are interested in the determinants of VC investment considered
in a broad perspective, that is to say including the early and expansion stages. The main
contribution of our research lies in the fact that we analyse a more recent period. For
Gompers and Lerner’s (1998) and Jeng and Wells’ (2000) studies cover a period ending
in the mid-1990s and those of Armour and Cumming’s (2004), Bonini and Alkan’s
(2012) and Félix et al.’s (2013) end in the early 2000s. Our research thus helps fill the
literature gap by focusing on the post-boom years.
Secondly, among the studies cited, only that of Felix et al. (2013) relates exclusively
to European countries. Others are based on the USA (Gompers and Lerner, 1998) and a
set of developed countries worldwide (Jeng and Wells, 2000; Armour and Cumming,
2004; Bonini and Alkan, 2012). Our research focuses on a sample of exclusively
European countries so it helps to complete the previous analysis based on this
geographical area for a prior period. In addition, our sample covers only EU member
countries, which is not the case in Félix et al.’s (2013) study.
Thirdly, our research proposes a synthetic approach by retaining macroeconomic,
institutional, exit and entrepreneurial variables like those of Gompers and Lerner (1998),
Armour and Cumming (2004) and Bonini and Alkan (2012). Jeng and Wells (2000) do
not take account of the entrepreneurial dimension and Félix et al. (2013) ignore the
institutional framework. Moreover, it is noted that Félix et al.’s study (2013) considers
the exit context for the first time by examining both IPOs and M&A. Our research does
the same and thus appears more comprehensive than previous studies.
Fourthly, our research is firmly rooted theoretically by using I/O through the
structure-conduct-performance model that leads us to analyse VC as an industry. We thus
contribute to the VC literature by showing that the I/O pattern is instrumental in
understanding the development of the European VC industry. Our paper highlights the
important role of basic conditions on both the demand and the supply side. Market
adjustments take place within a setting characterised by macroeconomic, institutional,
exit and entrepreneurial conditions that influence VC funds’ behaviour.
The rest of the paper is structured as follows. In a second section, we analyse the VC
industry’s basic conditions and their impact on agents’ activity by referring to the
existing literature. An econometric model is developed in a third section in order to
The impact of basic conditions on investment in the venture capital industry 197
highlight the main determinants of VC investment for 18 European countries over the
period 2002–2009. The fourth section concludes our paper.
2 Literature review: the analysis of the VC industry’s basic conditions
The basic conditions of an industry are traditionally viewed from the point of view of
supply and demand. In the VC case, supply corresponds to the fund management
companies that raise capital from various kinds of investors and demand refers to the
firms seeking money to finance projects in which available capital can be invested. The
basic conditions encompass various characteristics of the activity’s environment and one
and the same element can constitute a basic condition from the point of view of both
supply and demand. The literature existing on the subject will be used to identify key
dimensions and support the analysis. In particular, we refer to five major econometric
studies on the determinants of VC investment, including the early and expansion stages,
mentioned above: that of Gompers and Lerner (1998) based on the USA, those of Jeng
and Wells (2000), Armour and Cumming (2004) and Bonini and Alkan (2012) on a set of
developed countries worldwide and that of Félix et al. (2013) on a sample of European
countries. The main characteristics and results of these studies are reported in
Appendix 12. In what follows, we focus on the dimensions that seem most relevant.
2.1 Basic conditions on the supply side
First, we consider the macroeconomic environment. The growth rate of the gross
domestic product (GDP) is likely to impact fund-raising from investors (banks, pension
funds, insurance companies, individuals, etc.); the funds collected constitute the
prerequisite of VC investment. They are expected to be higher if these agents have a great
deal of money to invest. This depends largely on the health of the economy. The
influence of the overall economic situation on VC investment seems to be confirmed by
Gompers and Lerner’s (1998) and Félix et al.’s (2013) econometric studies while, on the
other hand, those of Jeng and Wells (2000), Armour and Cumming (2004) and Bonini
and Alkan (2012) demonstrate no significant impact of GDP growth on funds invested.
The interest rate is also an economic indicator to take into account. As Gompers and
Lerner (1998) indicate, it can be interpreted by considering alternatives to VC investment
for holders of capital, that is to say investments remunerated by an interest rate. It can
hence constitute an element of arbitration. According to this logic, if the interest rate
rises, the attractiveness of investing in VC funds may deteriorate, affecting in turn the
amounts allocated to companies. This expected negative impact of the interest rate on VC
investment was demonstrated by Gompers and Lerner (1998) and Bonini and Alkan
(2012). Of course, the trade-off question does not arise for all holders of capital, to the
extent that some of them will immediately disregard investments in VC funds because of
the considerable uncertainty about the success of investee companies and its corollaries in
terms of future returns on investment.
In addition, we need to consider the institutional environment. Among the variety of
institutional forces – regulatory, normative and cognitive (Scott, 1995), the regulatory
ones, corresponding to the intervention of political power and the rules that regulate an
activity and its agents’ behaviour, seem of paramount interest for VC. On the supply side,
198 B. Guilhon and S. Montchaud
we must consider the tax and legal framework that govern fund management companies
and investors. This dimension is part of a composite index of the tax and legal
environment favouring the development of private equity, VC and entrepreneurship,
proposed by the EVCA (2008) for European countries. Its exact composition will be
specified further in this article. Armour and Cumming (2004) retain this index in their
supply regression and conclude that it has a significant impact on VC investment.
If the regulatory framework can be assessed from a multi-criteria indicator, it can also
be considered using individual variables. For example, Poterba (1989) questions the role
of capital gains taxes. Logically, we can expect a reduction in the corresponding rate to
increase the ex post return on equity for venture capitalists and their investors, and thus
the ex ante fund-raising from investors which depends on perceived earnings prospects.
However, Poterba underlines a small supply effect for the USA because most investors
have been tax-exempt institutions since 1980. Gomper and Lerner’s econometric study
(1998) shows that this variable impacts VC activity but does not operate through the
supply side. We will see the interpretation in terms of demand later.
Jeng and Wells (2000), for their part, consider the possible influence of financial
reporting standards3 because investors are reluctant to invest in companies with a lack of
information, and venture capitalists prefer to avoid spending a lot of time on monitoring
activities to reduce asymmetric information. However, the influence of this variable on
VC investment is not verified by these authors econometric study which uses the measure
of public firms’ level of accounting standards as a proxy for that concerning private
firms.
In addition, Gompers and Lerner (1998) emphasise the important role of pension fund
legislation for VC activity in the USA. The constraint tied to the Employee Retirement
Income Security Act (ERISA) of 1974 was lifted in 1979. The decision was of major
importance for the development of VC that immediately began to benefit from greater
financial resources. This is confirmed by the result of their econometric study. More
generally, this underlines the importance of the presence of patient investors prepared to
involve themselves in such long-term projects as pension funds, banks, etc. (Amable et
al., 1999).
Armour and Cumming (2004) also consider political intervention through the
allocation of public money to VC and envisage two scenarios. Logically, a positive
impact on fund-raising and investment is expected in so far as government-sponsored
funds can encourage private investment. This is confirmed by Leleux and Surlemount’s
study (2003) based on 15 European countries during the period 1990–1996. However, a
reduction of fund-raising and investment levels can be envisaged due to the fact that
government-sponsored funds can crowd out private investment. Such a crowding out
effect is highlighted by Cumming and MacIntosh (2003a) for Canada following the
introduction of legislation establishing subsidised Labour-Sponsored Venture Capital
Corporations (LSVCCs). Armour and Cumming’s econometric study (2004) confirms its
crowding out effect. Consequently, this raises the question of how governments can
efficiently support VC activity.
Additionally, we can refer to the fundamental nature of a financial system that,
according to Bruton et al. (2005), constitutes a component of regulatory institutions. A
market-based system corresponding to deep, liquid stock markets provides exit
possibilities to fund management companies via the IPO of investee companies and
should thus favour VC activity (Gompers, 1998; Gompers and Lerner, 1998, 1999, 2001;
Black and Gilson, 1998; Amable et al., 1999; Jeng and Wells, 2000; Armour and
The impact of basic conditions on investment in the venture capital industry 199
Cumming, 2004; Bonini and Alkan, 2012; Félix et al., 2013; etc.); this is less the case for
a bank-centred system. This is important because the main risk faced by VC firms and
their investors is that they will not retrieve their money or not obtain sufficient capital
gains (Jeng and Wells, 2000). Hence a viable exit mechanism is decisive in the
development of a VC industry. This implies that policy makers focus on the development
of stock markets to support VC activity. However, the positive relationship between stock
markets and VC widely established in the literature is not always demonstrated
empirically. Gompers and Lerner’s econometric study (1998) reveals no significant
influence of the real value-weighted stock market return on VC investment and even
shows a surprising negative impact of the value of firms brought publicly by venture
capitalists. For their part, Armour and Cumming (2004) note the absence of influence of
public market return. The same findings are made by Bonini and Alkan (2012) with the
totality of IPOs in all domestic markets and the stock turnover rate corresponding to the
market value of traded shares over total average market capitalisation and by Jeng and
Wells (2000) concerning market capitalisation growth. It should be noted that, for this
last, Félix et al. (2013) even found a negative impact. They explain it by the fact that the
stock market capitalisation growth may also reflect an increase in capital gains impacting
VC attractiveness for investors compared to the stock market. On the other hand, Jeng
and Wells (2000) and Félix et al.’s (2013) econometric studies reveal that IPOs are an
important determinant of VC investment; the study of Bonini and Alkan (2012)
underlines the favourable influence of the total value of stocks traded, and that of Armour
and Cumming (2004) finds a significant, positive impact of the 1999–2000 bubble period.
These contrasted results invite us to stress that exit opportunities are not limited to
those provided by stock markets, even in countries which have a market-oriented
financial system. For trade sales, that is to say sales to industrial corporations, constitute a
viable exit mechanism that is also important for the development of the VC industry.
According to the EVCA, divestments by trade sales represent 28.4% of total amounts
divested in 2009 in Europe and those by public offering only 11.9%. This exit channel
was only taken into account in the study of Félix et al. (2013) that concluded there was a
positive influence.
2.2 Basic conditions on the demand side
Firstly, if the macroeconomic situation is a basic condition of the VC industry on the
supply side, the same is also true on the demand side. In fact, the economic situation
impacts entrepreneurial dynamism by generating more attractive opportunities for
creating and developing firms that need VC financing. Acs and Audretsch (1991)
particularly stress the influence of macroeconomic fluctuations on the activity of
start-ups, the latter represent a substantial part of the demand for VC. Gompers and
Lerner (1998) and Félix et al.’s (2013) econometric studies confirm the positive impact
on investment due to demand effects. In contrast, those of Jeng and Wells (2000),
Armour and Cumming (2004) and Bonini and Alkan (2012) indicate no significant
impact of GDP growth on VC investment on the demand side.
Similarly, the interest rate appears to be a basic condition of the VC industry from
both the supply and demand side. In this second perspective, VC can be viewed as an
alternative to the banking system for financing business. Thus, since a low interest rate
makes bank financing more attractive, VC bodies may be penalised by a lower demand
200 B. Guilhon and S. Montchaud
for them (Bonini and Alkan, 2012). However, econometric studies on the subject reveal
no positive impact of the interest rate on VC activity. Of course, there are other elements
that firms consider when choosing financing channels. For example, some companies,
like family businesses, may be reluctant to resort to VC, fearing the entry of outside
shareholders in their capital; they prefer to expand through bank financing or even limit
their expansion.
It is also interesting to consider the institutional forces at play, this time at the demand
level. Concerning regulatory forces, we can look at the tax and legal environment related
to enterprises in search of financing. Anything that encourages entrepreneurship, namely
advantageous corporate taxation, attractive stock options devices, etc., creates favourable
conditions for VC activity. That is why the tax and legal environment of investee
companies is taken into consideration in the previously mentioned EVCA’s (2008)
composite index of the tax and legal environment favouring the development of private
equity, VC and entrepreneurship. This index incorporates dimensions affecting both the
supply and demand of VC financing. However, in their analysis, Armour and Cumming
(2004) neglect the demand dimension of this index, considering only that of supply.
Poterba (1989) emphasises the role of capital gains taxes on the demand side in so far
as a lower rate encourages individuals to become entrepreneurs. According to him, this
variable is likely to impact the demand for VC more strongly than its supply in the USA.
This appears to be confirmed by Gompers and Lerner’s econometric study (1998) that
highlights a negative impact of this variable on VC investment from the demand side.
Bonini and Alkan (2012) retain the corporate income tax rate. Logically, the higher
the tax burden, the lower the propensity for entrepreneurship, particularly for starting up
a venture (Gordon, 1998; Gentry and Hubbard, 2000). This then should affect the demand
for VC. The expected negative impact on VC investment is verified by Bonini and Alkan
(2012).
Regarding the exit context, it is also possible to consider stock markets and M&A in
the perspective of VC demand. This is the case for Jeng and Wells (2000) who mention
the importance of IPOs, not only at the supply level but also at demand level because it
gives “entrepreneurs an additional incentive to start a company”. As mentioned earlier,
they find a positive impact of this variable on VC investment. Félix et al. (2013) find the
same result for the latter and also for the M&A variable. Jeng and Wells (2000) further
consider market capitalisation growth but this proves not to be significant. Following the
same logic, Armour and Cumming (2004) consider that public market returns and the
existence of a financial bubble also constitute potential demand factors. The results of
their demand-side regression reveal no significant impact of public market returns on VC
investment, but a significant, positive impact in the 1999–2000 bubble period.
At the entrepreneurial level, the basic conditions on the demand side directly concern
a country’s business dynamics. The latter is likely to influence VC to the extent of
resulting in funding needs. These can be assessed in various ways: companies’ creation
and survival rate, their economic and financial performances, etc. For Gompers and
Lerner (1998), a rise in the number of high-quality start-ups constitutes an important
factor of increased demand addressed to VC organisations. In this perspective, the
authors underline the role in VC investment of policies that improve the attractiveness of
becoming an entrepreneur. However the authors do not test these assumptions
econometrically. Bonini and Alkan (2012) and Félix et al. (2013) use the total
entrepreneurial activity index computed from the proportion of the working-age
population involved in a nascent business or young firm.A positive impact on VC
The impact of basic conditions on investment in the venture capital industry 201
investment is found by Bonini and Alkan (2012) and a surprising negative impact by
Félix et al. (2013)4. For their part, Armour and Cumming (2004) retain the proportion of
self-employment in the population as a measure of entrepreneurial activity, but this
variable turns out not to be significant.
Beyond these general aspects related to entrepreneurial dynamics, a more specific
dimension requires attention: firms’ innovation capacity, because companies that develop
innovative projects are a priority target for most VC bodies. This aspect can be examined
from the resources employed and indicators of results. For resources, we traditionally
refer to R&D expenditure. This enlarges the range of technological opportunities and, for
Gompers and Lerner (1998), potentially captures the demand effects of high technology
firms. A higher R&D level can mean more entrepreneurs with an extremely good idea,
requiring financing to develop it and therefore requesting VC support. Félix et al. (2013)5
found a positive impact of R&D expenditure on VC investment. Bonini and Alkan (2012)
highlight the influence of R&D business expenditure (BERD). Gompers and Lerner
(1998) indicate an effective impact of both industrial and academic R&D. The authors
highlight the importance of policies promoting technological innovation for the
development of VC activity. For indicators of results, we can retain the number of patent
applications. Armour and Cumming’s econometric study (2004) demonstrates a positive
impact of this variable on VC investment.
Finally, we can note that Félix et al. (2013)6 also assess the entrepreneurial context by
using the market-to-book ratio. In line with the work of Cumming and MacIntosh
(2003b), the latter is considered as a proxy of the degree of informational asymmetry
characterising the relationships between an entrepreneur and a venture capitalist. As
strong informational asymmetries are associated with high-growth companies, a positive
influence of the market-to-book ratio on the demand for VC is expected because venture
capitalists are deemed able to overcome and manage such asymmetries. The results of the
authors’ econometric study confirm this hypothesis.
3 An econometric study of the determinants of VC investment in
European countries
The investment made in each country constitutes an aggregate measure of the main
behaviour of the VC industry’s actors. In line with the I/O pattern, this behaviour can be
explained by considering the industry’s basic conditions. While most empirical studies on
the subject concern the USA and a set of developed countries, we have chosen to focus
on European countries. We first present our sample, the variables selected and the
method chosen. We then give the results and our discussion.
3.1 Sample, variables and method
Our econometrical study is based on a sample of 18 European countries: Austria,
Belgium, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary,
Ireland, Italy, the Netherlands, Poland, Portugal, Slovakia, Spain, Sweden and the UK.
Due to the availability constraint of certain data, the period of the study is 2002–2009.
We identify the main determinants of VC investment by distinguishing factors of
supply and demand (Figure 1).
202 B. Guilhon and S. Montchaud
Figure 1 The main determinants of VC investment in the I/O framework
Supply factors
●Macroeconomic situation
●Institutional framework
●Exit context
Demand factors
●Macroeconomic situation
●Institutional framework
●Exit context
●Entrepreneurial environment
VC
investment
Note: In order to identify more precisely the relevant sets of determinants, exit conditions
have been removed from the section entitled ‘institutional environment’ although
they can be considered as a part of it.
The structure of our model is in line with these factors (Figure 2). For we select
explanatory variables according to the basic conditions at the levels of supply and
demand. The same variable can be a factor of both supply and demand.
Figure 2 The structure of the model
VC
investment
Macroeconomic variables
GDP
Interest
Entrepreneurial
varia bles
R&D
P
aten
t
Institutional variable
Inst
Exit variables
SMcapital
M&A
Our dependent variable is the total VC investment divided by GDP. The intensity of VC
investment characterises the share of this mode of financing in the economy. As defined
by Eurostat7, VC investment encompasses four financing stages: seed, start-up, expansion
and replacement.
Among the macroeconomic explanatory variables, the real GDP growth rate (lagged
by one year) is a basic condition of both supply and demand. On the supply side, a
dynamic economy can have a positive effect on commitments in VC activity, and it is
fund-raising that determines the investment scale. On the demand side, if the economy is
growing quickly, there may be more attractive opportunities for entrepreneurs to start or
expand their firm. Therefore we may observe increases in the demand for VC funds.
Thus, be it in terms of supply or demand, the expected impact of economic growth on our
dependent variable is positive.
The impact of basic conditions on investment in the venture capital industry 203
The second macroeconomic variable is the interest rate corresponding to real ten year
government bond yields (lagged by one year) that “are often used as a measure for
long-term interest rates” (Eurostat7). The interest rate is a factor of both supply and
demand. From the investors’ viewpoint, it is seen as a criterion of trade-off between
investment in VC funds and alternative investments remunerated by an interest rate. Thus
a high interest rate could prove unfavourable to VC activity, penalising fund-raising
because of the increased attractiveness of alternative investments. From the viewpoint of
enterprises, the interest rate can also constitute a trade-off element, but this time between
private equity financing from VC organisations and debt financing from banks. Thus a
high interest rate will probably lead to many requests for funding by VC bodies because
of the rise in the cost of borrowing. Consequently, the impact our econometric study
reveals will highlight the prevalence of a supply effect or demand effect. If it is negative,
the supply effect dominates but if it is positive, the demand effect prevails.
At the institutional level, we use a composite indicator, the EVCA’s index of the tax
and legal environment favouring the development of VC and entrepreneurship in
European countries; this “provides an indication of competitive private equity and VC
performance per country” (EVCA, 2008). It relates both to the supply side (investors and
fund management companies) and the demand side (entrepreneurs) of the VC industry.
More precisely, it is divided into three subsets: the tax and legal environment for limited
partners and fund management companies, that for investee companies and that for
retaining talent in investee and fund management companies. The first subset is part of
the basic conditions of the supply side, the second is linked to those of the demand side
and the third straddles the two. To be more precise, the tax and legal environment for
limited partners and fund management companies considers criteria related to investors,
such as pension funds and insurance companies, fund structures and tax incentives. The
tax and legal environment for investee companies refers to company incentivisation and
fiscal R&D incentives while that for retaining talent in investee and fund management
companies takes into account the taxation of stock options, of carried interest, etc. Thus
several criteria make up these three categories whose evaluation is based on a scale from
1, (corresponding to the most favourable environment for the development of private
equity and the VC industry), to 3, (corresponding to the least favourable environment).
An average of the scores awarded per issue produces a composite score for each country.
Therefore, we expect a negative relationship between this variable and our dependent
variable, because a favourable tax and legal environment (weak index) encourages VC
activity.
Concerning the exit context, we consider the stock markets that reflect exit
opportunities for venture capitalists via divestments by public offerings. This dimension
is represented by the stock market capitalisation divided by GDP (lagged one year) in
each country. “Stock market capitalisation is calculated by multiplying the volume of
shares issued by companies and quoted on the stock market by their market value”
(Eurostat7). The choice of a variable related to stock markets is in line with the
mainstream literature that attaches great importance to this exit mode. In addition, using
the EVCA’s dataset, we also retain the value of M&A divided by GDP (lagged by one
year) that represents exit opportunities in terms of divestments by trade sale. This exit
204 B. Guilhon and S. Montchaud
channel has been tested only once as a determinant of VC in the empirical studies
presented, but it deserves to be taken into consideration because, as mentioned earlier, it
represents a large proportion of the total divestments. A positive impact of these two
variables on VC investment is expected, especially from the supply viewpoint.
Finally, in order to take into account the innovation context, we choose the BERD
divided by GDP (lagged by one year) representing R&D intensity and corresponding to
an indicator of resources committed. We also use patent applications to the European
Patent Office (EPO) per inhabitant (lagged one year), corresponding to an outcome
indicator. We expect a positive impact of these two innovation variables on VC
investment.
As mentioned above and in accordance with most of the previous econometric studies
cited, all our explanatory variables are lagged by one year except that referring to the
global institutional framework. Table 1 summarises the variables used in our model. The
descriptive statistics are available in Appendix 2.
Table 1 Presentation of the explanatory variables
Variable Definition Role Predicted
sign
Macroeconomic variables
GDP_1 Real GDP growth
rate (lagged one
year) (Eurostat).
To measure the influence of economic dynamics. +
Interest_1 Real ten year
government bond
yields (lagged one
year) (Eurostat).
To underline if the interest rate appears as a
trade-off criterion between investment in VC funds
and alternative investments remunerated by an
interest rate from the investors’ point of view or as
a trade-off element between private equity
financing from VC organisations and debt
financing from banks from enterprises’ point of
view.
-/+
Institutional variable
Inst Index of tax and
legal environment
favouring the
development of
private equity and
VC and
entrepreneurship (a
weak index
represents a more
favourable
environment)
(EVCA).
To assess the influence of the institutional context. -
The impact of basic conditions on investment in the venture capital industry 205
Table 1 Presentation of the explanatory variables (continued)
Variable Definition Role Predicted
sign
Exit variables
SMcapital_1 Stock market
capitalisation
divided by GDP
(lagged one year)
(Eurostat).
To evaluate the impact of the stock market
environment viewed as an exit opportunity.
+
M&A_1 Value of M&A
divided by GDP
(lagged one year)
(EVCA).
To assess the impact of the M&A context viewed
as an exit opportunity.
+
Innovation variables
R&D_1 BERD divided by
GDP (lagged one
year) (Eurostat).
To capture the impact of resources invested in
innovation.
+
Patent_1 Patent applications
to the EPO per
inhabitant (lagged
one year)
(Eurostat).
To assess the impact of the results of innovative
activity in terms of patent applications.
+
The influence of these variables on VC investment will be studied through a multiple
linear analysis. The method of the ordinary least squares (OLS), which involves
minimising the sum of squared residuals, is used.
3.2 Results and comments
Table 2 presents the results of the four regressions (Reg. A1, A2, B1 and B2), taking into
account the constraint of the correlation of variables (Appendix 3). As SMcapital_1 and
M&A_1 are correlated, they cannot be integrated into the same regressions. The same
applies to for R&D_1 and Patent_1. For more information, we provide the complete
regression (Reg. C). The number of observations varies according to the availability
constraint of certain variables. All regressions have good R2 and adjusted R2, those of the
complete model are particularly high.
Firstly, the GDP_1 variable has no significant impact on VC intensity. This is not the
expected result. It confirms the conclusions of Jeng and Wells (2000), Armour and
Cumming (2004) and Bonini and Alkan (2012) concerning a set of developed countries.
Gompers and Lerner (1998) find a positive relation between VC investment and GDP
growth concerning the USA. It is the same for Félix et al. (2013) for European countries.
These different results reflect the difficulty of examining the relationship between VC
activity and economic growth. In our study, the sample is composed of European
countries; in Europe most VC activity focuses on the expansion stage. The fragmentation
of European economies and low returns on investment in the initial stages has resulted in
creating an “early-stage European equity gap”, according to Veugelers (2011). Over the
1985-2009 period, the author notes that the seed and start-up investments of 13 major
European countries are equivalent to only 38% and 22% of US investments in the same
206 B. Guilhon and S. Montchaud
period. And, if we follow the analysis of Jeng and Wells (2000), the seed and start-up
stages are more influenced by macroeconomic dynamics than the expansion stage when
the company has already launched its product on the market, is beginning to make profits
and funding is focused on the increase of production capacity and R&D support. The
relationship between VC investment and GDP growth has also been studied by Meyer
(2006). Although there is a bi-directional movement between the two variables – from
GDP to VC and from VC to GDP – countries with high VC activity experience stronger
growth but the reverse is not true. The Granger tests to determine the direction of
causality indicate that “VC investments in the United States […] cause real GDP growth”
(Meyer, 2006). Estimates indicate that an increase of 0.1% of GDP in VC investment
is associated with an increase of 0.30 pp in real GDP growth. Seed and
start-up investments lead to a stronger increase of 0.96 pp in real GDP growth.
Table 2 Results
Reg. A1 Reg. A2 Reg. B1 Reg. B2 Reg. C
–0.0045 –0.0063 –0.0039 –0.0033 –0.0020 GDP_1
(0.393) (0.230) (0.412) (0.499) (0.701)
0.0104* 0.0116* 0.0132* 0.0161** 0.0135* Interest_1
(0.093) (0.053) (0.081) (0.036) (0.055)
0.0001 0.0003 –0.0006** –0.0005* 0.0001 Inst
(0.772) (0.403) (0.044) (0.085) (0.652)
0.0019*** 0.0021*** - - 0.0012*** SMcapital_1
(0.000) (0.000) (0.000)
0.0102*** 0.0112*** 0.0117*** M&A_1 - -
(0.000) (0.000) (0.000)
0.0096 0.0386*** 0.0470* R&D_1
(0.514)
-
(0.001)
-
(0.057)
–0.4624 1.7456** –3.1117* Patent_1 -
(0.667)
-
(0.045) (0.090)
–0.0006 –0.0008 0.0010* 0.0009 –0.0010 Constant
(0.425) (0.254) (0.085) (0.108) (0.157)
Number of observations 91 94 110 113 89
R-squared 0.4996 0.4995 0.4073 0.3601 0.6014
Adjusted R-squared 0.4702 0.4711 0.3788 0.3302 0.5670
Notes: Standard errors in brackets.
*: significant at 10%, **: significant at 5%, ***: significant at 1%.
The significant, positive impact of the Interest_1 variable leads to an interpretation in
terms of demand. Indeed, from the viewpoint of entrepreneurs, an increase in the interest
rate makes debt financing more expensive so VC financing is more attractive. This
analysis is based on the assumption that bank credit and VC do not fall under the same
logic. Moreover, this does not mean that the interest rate has no effect on the supply side
as evidenced by Gompers and Lerner (1998) and Bonini and Alkan (2012) – a rise in
The impact of basic conditions on investment in the venture capital industry 207
interest rate can lead investors to alternative assets and depress VC – it simply means that
the demand effect prevails over that of supply in our case. Thus our result is particularly
interesting because it highlights the fact that the interest rate constitutes a trade-off
element between different financing channels and, consequently, is a factor of VC
demand.
The Inst variable appears significant in two regressions with the expected negative
impact. This confirms the result of Armour and Cumming’s research (2004) using the
same variable. To be more precise, a one-point decrease in the index, corresponding to an
improvement of the tax and legal environment, generates an increase of 0.055% and
0.047% in VC intensity, in regressions B1 and B2 respectively. Given the composition of
the index, in our view this impact reflects both supply (VC companies and investors) and
demand (entrepreneurs) effects, although we are not able to quantify these. In this sense,
our analysis of the result differs somewhat from that of Armour and Cumming (2004)
who consider that this index is only a supply factor.
The two exit variables – SMcapital_1 and M&A_1 – appear highly significant (at the
level of 1%) and their impact is positive. An increase in market capitalisation and the
value of M&A mean that the risk of not having exit possibilities and obtaining adequate
returns is considerably reduced; this creates a more attractive environment for fund
management companies and investors. Thus, favourable exit conditions generate strong
incentives for investment.
Regarding our stock market variable, we can make some additional comments. Our
econometric study clearly demonstrates the impact of market capitalisation on VC
investment, while Jeng and Wells (2000) do not prove the influence of a variable very
close to ours, that of market capitalisation growth. Moreover, we assume that market
capitalisation sends a positive signal, not only to VC companies and investors but also to
entrepreneurs regarding venture capitalists’ exit and therefore the company’s future
ownership and further development. Indeed, Hege (2001) underlines the preference of
both venture capitalists and entrepreneurs for exit by public offering. On the one hand,
venture capitalists are motivated by the desire for profitability and reputation building.
On the other, entrepreneurs are preoccupied with preserving their independence as they
want to remain in control. We should add to this the announcement effect an IPO
produces. In addition, Stoughton et al. (2001) specified a model in which firms use their
IPO to stress the quality of their products. Thus our variable reflecting stock market size
can be viewed as a proxy for the conditions of both supply and demand. More generally,
we recall that the econometric studies cited have led to mixed results regarding the
impact of different variables referring to stock markets (IPOs, returns, etc.) on VC
activity. The result we obtain for European countries is clear and in line with the
mainstream literature that emphasises the role of stock markets in the development of the
VC industry.
The result concerning M&A is particularly interesting. Such a variable has only been
tested by Félix et al. (2013) that conclude to a positive impact; other authors focus on exit
by public offering and therefore prefer variables related to stock markets. Yet M&A
deserves to be considered, especially as our study shows that the impact of the M&A_1
variable (divided by GDP) is particularly strong and even stronger than that of the
SMcapital_1 variable. This can be explained by the fact that some economies are not
particularly oriented toward stock markets and, as mentioned earlier, trade sales
constitute a major exit channel for venture capitalists in Europe. We believe that an
208 B. Guilhon and S. Montchaud
increase in the total value of M&A produces mainly a supply effect. In other words, the
existence of a large market between companies for their capital shares increases exit
possibilities for venture capitalists and encourages investors. In our opinion, the demand
effect is probably quite limited because, as Hege (2001) has pointed out, entrepreneurs
are often reluctant to accept venture capitalists’ exit by trade sale for fear of losing (at
least partly) control of the company to industrial shareholders; they consequently prefer
exit by public offering, which corresponds to diluted capital on the stock exchange.
However, some entrepreneurs might be tempted by the M&A context if they want to sell
their business, earn money and start a new venture.
Finally, the innovation variables have a significant, positive impact on VC intensity in
several regressions, which confirms the fact that innovation and VC are closely related.
VC is a form of funding especially oriented towards innovative firms and projects. Thus
VC financing strengthens firms’ innovation and innovation projects offer investment
opportunities for venture capitalists.
The R&D_1 variable is significant at the level of 1% in regression B1. This result
confirms those of Gompers and Lerner (1998), Bonini and Alkan (2012), and Félix
et al. (2013). Increasing R&D expenditure (in relation to GDP) expands investment
opportunities. As mentioned by Gompers and Lerner, the growth of these expenditures
captures the effects of demand for financing, especially entrepreneurs’ demand for VC.
Moreover, the demand effect can express the fact that high R&D expenditure is
associated with the existence of a greater number of entrepreneurs leading projects that
implement new ideas (Kraeussl and Krause, 2011). Consequently, a large number of
entrepreneurs may approach venture capitalists.
The Patent_1 variable is significant at the level of 5% in regression B2. An increase
in patent activity leads to an increase in the demand for VC and therefore impacts
investment positively. Indeed, holding patents launches a new phase of business
development that leads to the commercialisation of a new product requiring financial
resources. This confirms the result obtained by Armour and Cumming (2004).
4 Conclusions
The econometric model developed to assess the determinants of VC investment for 18
European countries over the period 2002–2009 shows that the behaviour of fund
management companies is fairly well explained by variables representing the
macroeconomic and institutional situation as well as by those specifically related to VC
activity (exit and innovation). This means that, over the period considered, the European
VC industry is driven by the same major determinants identified in the previous studies
cited in the paper. Moreover, our research confirms the interest of a comprehensive
analysis, in terms of industry with reference to the I/O pattern, which highlights the
important role of basic conditions on the demand and supply side. These basic conditions
do not exist per se, by chance. They are the result of economic, technological,
institutional and organisational developments that appear to shape the VC industry by
guiding agents’ behaviour in terms of amounts invested. Thus our research contributes to
knowledge about this type of financing and, in particular, the factors influencing the latter
within the academic community.
Understanding how macroeconomic, institutional, exit and innovation contexts shape
VC firms’ behaviour has substantial implications. On the managerial level, this question
The impact of basic conditions on investment in the venture capital industry 209
is important for VC firms wanting to develop their activity and for innovative
entrepreneurial firms seeking market entry through VC financing. A better understanding
of the environment in which they operate is essential. On the political level, we help to
provide decision makers with actionable insights allowing them to promote the European
VC industry. However, we must remember that the behaviour of European fund
management companies is based on the existence of specific constraints. There are
significant differences in terms of the size of countries, their economic and institutional
contexts, profitability performances, public policies for R&D and innovation and market
fragmentation along national lines. The limits of our research lie in the fact that it is
difficult to speak of a single VC industry in Europe. Further research should be
undertaken to reveal groups of European countries with quite similar characteristics in
order to highlight the forms of specialisation that are developing between the Euro Area
and the rest of the EU (more oriented towards other categories of private equity).
Acknowledgements
The authors thank the anonymous reviewers for their constructive comments that helped
to improve the article.
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Notes
1 A similar study was published by Armour and Cumming in 2006 but it does not provide
regressions with the total VC (including early and expansion stages) as a dependent variable,
only specific regressions for the early stage on one side and the expansion stage on the other.
2 We invite the reader to consult the corresponding articles to obtain the results not presented in
the Appendix.
3 Jeng and Wells (2000) consider that accounting standards are also potential factors of VC on
the demand side without justifying it. For our part, we mention this variable only in the basic
conditions on the supply side.
4 Félix et al. (2013) consider that the total entrepreneurial activity index is a factor that may also
affect the supply of VC, negatively. In our opinion this is debatable. Moreover, according to
the authors’ reasoning, the effect of this variable on supply would prevail over that affecting
demand. We refer the reader to the authors’ justifications of this in their article. In our
presentation, we consider the entrepreneurial climate only as a factor of VC demand, in
accordance with most studies on the subject.
5 For Félix et al. (2013), R&D expenditure is also likely to positively impact VC activity on the
supply side. In our presentation, we consider R&D expenditure only as a factor of VC demand
in accordance with most studies on the subject.
6 Although Félix et al. (2013) consider the degree of informational asymmetry as a factor
affecting both VC supply and demand, we chose to limit its mention to the demand dimension
as with all other variables of an entrepreneurial nature.
7 The definitions of variables are taken from Eurostat’s website
(http://epp.eurostat.ec.europa.eu).
212 B. Guilhon and S. Montchaud
Appendix 1
Main results of major econometrical studies on the determinants of VC
investment
Gompers and Lerner
(1998) Jeng and Wells (2000) Armour and Cumming (2006) Bonini and Alkan (2012)a Félix et al. (2013)
Samples USA
1976–1994.
21 countriesb (Austria,
Australia, Belgium,
Canada, Denmark,
Finland, France,
Germany, Ireland, Israel,
Italy, Japan, The
Netherlands, New
Zealand, Norway,
Portugal, Spain, Sweden,
Switzerland, UK and
USA).
1986–1995.
15 countries (Austria, Belgium, Canada, Denmark,
Finland, France, Germany, Ireland, Italy, The
Netherlands, Portugal, Spain, Sweden, UK and
USA).
1990–2002.
16 countries (Australia,
Canada, Denmark,
Finland, France,
Germany, Ireland, Italy,
Japan, New Zealand,
Norway, Poland, Spain,
Sweden, UK and USA).
1995-2002.
23 countries (Austria,
Belgium, Czech
Republic, Denmark,
Finland, France,
Germany, Greece,
Hungary, Iceland,
Ireland, Italy, The
Netherlands, Norway,
Poland, Portugal,
Slovakia, Spain, Sweden,
Switzerland, UK,
Romania and Latvia).
1998-2003.
Methods Panel. Panel. Panel. Panel. Panel.
Dependent
variables
Logarithm of real VC
investment in the state
per million residents.
VC investment divided
by GDP.
VC investment divided
by GDP (supply
equation).
VC investment divided
by GDP (demand
equation).
Logarithm of VC
investment.
VC investment divided
by GDP.
Explanatory variables
Economic situation
Significant, positive
impact of the previous
year’s real gross state
product growth.
Significant, positive
impact of the logarithm
of the previous year’s
real gross state product
per capita.
Significant, negative
impact of the previous
year’s real return on
Treasury bills.
No significant impact of
GDP growth.
No significant impact of
the prior year’s real GDP
growth.
No significant impact of
the prior year’s real GDP
growth.
No significant impact of
GDP growth.
Significant, negative
impact of the real yield
of corporate bonds.
Significant, negative
impact of the inflation
rate.
Significant, positive
impact of GDP growth.
No significant impact of
the long-term real
interest rate.
Significant, negative
impact of the
unemployment rate.
Notes: a In addition to the variables presented in the table, Bonini and Alkan (2012) also test variables related to political risk.
b The results of the regression reported are based on 15 countries among the 21 of the total sample.
c Jeng and Wells (2000) consider that this variable has a significant, negative impact at the level of 20%.
Retaining the traditional levels up to 10%, we prefer to indicate that this variable is not significant,
especially since the negative sign of its coefficient is incomprehensible.
The impact of basic conditions on investment in the venture capital industry 213
Main results of major econometrical studies on the determinants of VC
investment (continued)
Gompers and Lerner
(1998) Jeng and Wells (2000) Armour and Cumming (2006) Bonini and Alkan (2012)
a
Félix et al. (2013)
Institutional framework
Significant, negative
impact of the federal
capital gains tax rate.
No significant impact of
the state capital gains tax
rate.
Significant, positive
impact of the dummy
variable for the
clarification of ERISA’s
prudent man rule (1 from
1979).
No significant impact of
accounting standards
c
.
No significant impact of
market rigidities for
skilled labour.
Significant, negative
impact of the EVCA tax
and legal index.
Significant, negative
impact of the dummy
variable for government
VC programs (1 if
superior to 20% of the
total private equity
market).
Significant, negative
impact of the discharge
time in bankruptcy.
Significant, negative
impact of the corporate
income tax rate.
No significant impact of
the employment
protection legislation
(multiplied by GDP).
-
Exit context
Significant, negative
impact of the logarithm
of the market value of
VC-backed IPOs in the
previous year.
No significant impact of
the previous year’s real
return of CRSP value-
weighted index.
Significant, positive
impact of the market
value of IPOs divided by
GDP.
No significant impact of
market capitalisation
growth.
No significant impact of
the MSCI public market
return in the prior year.
Significant, positive
impact of the dummy
variable for the bubble
period (1 for the years
1999 and 2000).
No significant impact of
the MSCI public market
return in the prior year.
Significant, positive
impact of the dummy
variable for the bubble
period (1 for the years
1999 and 2000).
No significant impact of
the number of IPOs in all
domestic markets.
Significant, positive
impact of the total value
of stocks traded divided
by GDP.
No significant impact of
the stock turnover rate as
market value of traded
shares divided by market
capitalisation.
Significant, positive
impact of the total
offering proceeds raised
by IPO companies
divided by GDP.
Significant, negative
impact of the stock
market capitalisation
growth.
Significant, positive
impact of the total deal
values of M&A
transactions divided by
GDP.
Explanatory variables
Entrepreneurial envir onment
Significant, positive
impact of the logarithm
of the previous year’s
real expenditure on
academic R&D per
capita in the state.
Significant, positive
impact of the logarithm
of the previous year’s
real expenditure on
industrial R&D per
capita in the state.
- -
No significant impact of
the proportion of self-
employment in the
population in prior year.
Significant, positive
impact of patent
applications in prior
year.
Significant, positive
impact of BERD.
Significant, positive
impact of the total
entrepreneurial activity
index (multiplied by
BERD).
Significant, positive
impact of the R&D
expenditure divided by
GDP.
Significant, negative
impact of the total
entrepreneurial activity
index
Significant, positive
impact of the market-to-
book ratio.
Notes:
a
In addition to the variables presented in the table, Bonini and Alkan (2012) also test variables related to political risk.
b
The results of the regression reported are ba sed on 15 countries among the 21 of the tota l sample.
c
Jeng and Wells (2000) consider that this variable has a significant, negative impact at the level of 20%.
Retaining the traditional levels up to 10%, we prefer to indicate that this variable is not significant,
especially since the negative sign of its coefficient is incomprehensible.
214 B. Guilhon and S. Montchaud
Appendix 2
Table of descriptive statistics
Observation Mean Standard deviation Minimum Maximum
VC 140 0.0009339 0.0008986 0.00001 0.00613
GDP_1 144 0.0272083 0.02042 –0.03 0.105
Interest_1 124 0.0195165 0.0125981 –0.0314576 0.0531894
Inst 140 1.87925 0.3423354 1.2 2.53
SMcapital_1 114 0.5492886 0.3486017 0.0607 1.5357
M&A_1 136 0.0480534 0.358567 0.0062359 0.2612379
R&D_1 140 0.01064 0.007418 0.0011 0.032
Patent_1 144 0.0001097 0.0000979 1.52e-06 0.0003006
Appendix 3
Correlation matrix
GDP_1 Interest_1 Inst SMcapital_1 M&A_1 R&D_1 Patent_1
GDP_1 1.0000
Interest_1 –0.1223 1.0000
Inst –0.3818 0.3696 1.0000
SMcapital_1 0.0277 –0.0703 –0.4359 1.0000
M&A_1 –0.1746 0.0292 –0.3084 0.6470 1.0000
R&D_1 –0.3802 0.2496 0.3069 0.3662 0.2548 1.0000
Patent_1 –0.4163 0.1979 0.3668 0.2766 0.1957 0.8997 1.0000
