JOSH LERNERHARVARD BUSINESS SCHOOL

The Promise of Venture Capital

Why is venture capital important?

Venture capital is still very young: First fund in 1946.

Venture capital is still very small: In largest market, U.S.:

Only about 4000 professionals. Average of 1,500 companies funded for first time

annually, 2000- 2008. Relative to 1 million businesses started

annually. Considerably less elsewhere.

Venture Capital Investment Worldwide 1992 ~ 2007

0

20

40

60

80

100

120

140

160

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Year

Inve

stm

ent

Am

ou

nt

(in

200

7 U

S$

bill

ion

)

Israel

Canada

Asia

Europe

USA

But importance far beyond its size

The backdrop: Young high-tech and restructuring firms pose

many challenges: Uncertainty. Information gaps. The nature of the firm’s assets. Market conditions.

“I realize, gentlemen, that thirty million dollars is a lot of money to spend. However, it’s not real money and, of

course, it’s not our money either.”

General Doriot’s insight

• Difficult for traditional financiers to fund these firms:– Banks.– Public markets.

• A new organization could address with three key mechanisms:– Sorting: picking the right entrepreneurs.– Controlling: limiting “agency” problems,

through a mixture of incentives and monitoring.

– Certifying: developing a tradition of quality and fair dealings.

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The evolution of venture capital

Venture capital has developed many tools to address challenges: Intensive scrutiny of business plans. Restrictions in preferred stock agreements. Staged financing. Board service and monitoring. Informal advice.

Not surprising that dominant funding source.

Venture capital has had a profound impact

Between 1972 to 2007, ~2500 venture-backed firms went public in U.S.: 13% of all public firms at end of 2008. 8% of market capitalization ($2.0 trillion). 6% of total employees.

Particularly true in high-technology industries.

Supporting evidence

Hellmann and Puri [2000]: Look at 170 Silicon Valley firms. Venture capital-backed firms seem more innovative on

several measures. Unfortunately, hard to control for causality:

Does VC spur innovation or does innovation spur VC?

Supporting evidence (2)

Kortum and Lerner [2000] look at industry level: VC appears to have a strong positive effect:

Even after controlling for corporate and government R&D spending.

Use 1979 ERISA shift to address causality issues. In 1983-95 period, while VC <3% of corporate R&D,

accounted for 10-12% of innovations.Mollica and Zingales [2007] also

demonstrate strong relationship with different appproach: State pension fund holdings.

Why a government role?

Increasing returns to scale Much easier to do 100th deal than the first:

Knowledge and expectations of entrepreneurs. Familiarity of intermediaries. Sharing of information among peers. Comfort level of institutional investors.

Economists term these “externalities.”In these cases, government can

frequently play a catalytic role.

Also historical precedents

In the U.S.: Critical role of SBIC program. Established in 1958. Many early VC firms started as SBIC

awardees, then opted out. Building critical “infrastructure”: Lawyers,

data providers, etc.Similar insights from Israel, Singapore, etc. Suggests that some of funding should be

directed to growing industries!

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

But history also suggests need for care

But many pitfalls from earlier efforts.Three key points from report:

More than money is needed: entrepreneurship is not in a vacuum.

The virtues of market guidance. Getting details right important as well.

Need for patience!

Josh LernerRock Center for Entrepreneurship

Harvard Business SchoolBoston, MA 02163 USA

617-495-6065josh@hbs.edu

www.people.hbs.edu/jlerner