KNOWLEDGE, INSTITUTIONS, AND THE INTERNATIONALIZATION OF U.S. VENTURE CAPITAL FIRMS

Isin GulerBoston University

guler@bu.edu

Mauro F. GuillénThe Wharton School

University of Pennsylvaniaguillen@wharton.upenn.edu

Very First Draft with Preliminary ResultsComments Welcome

Please Do Not Circulate without Permission

October 2004 Version

Funding from the Mack Center for Technological Innovation at the Wharton School is greatly appreciated. Adrian Tschoegl provided excellent comments and suggestions.

KNOWLEDGE, INSTITUTIONS, AND THE INTERNATIONALIZATION

OF U.S. VENTURE CAPITAL FIRMS

ABSTRACT

This study examines the country-level factors that affect U.S. venture capital firms’

decisions to invest in foreign ventures. Foreign venture capital investment is driven by a

combination of factors different than those accounting for either foreign direct or portfolio

investment: the availability of innovative opportunities, the ability to commercialize these

opportunities, and the extent to which the institutional infrastructure of each country enables the

appropriation of returns. We report preliminary results using a sample of 350 U.S. venture

capital firms potentially investing in 140 countries during the 1990-1999 period. Countries with

more opportunities, as measured by the level of scientific knowledge, and those with better

commercialization institutions, as measured by capital market development, are more likely to

attract U.S. venture capital investments. We find no effect for institutions guaranteeing the

appropriability of returns.

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1. Introduction

Venture capital firms have traditionally raised and invested money within the borders of

their home country. Many a venture capitalist would even take pride in investing in ventures

located within a couple hours’ drive from their offices so as to be able to monitor them closely

(Sorenson and Stuart, 2001). In the last ten years, however, cross-border venture capital

investment has started to rise. This paper investigates the choice of international venture capital

investment location, a question of increasing relevance as the world economy shifts toward

knowledge-intensive activities. The venture capital industry has played an important role in

spurring innovation and entrepreneurship in the United States. In recent years, U.S. venture

capital firms started to look abroad for investment opportunities in other countries. This trend is

important not only in providing new opportunities for venture capital firms, but also in

contributing to the development of local economies through entrepreneurship and innovation.

There is a large body of theoretical and empirical research on the destination of foreign

direct investment (FDI), i.e. when a firm decides to set up operations abroad by managerially

controlling a foreign asset (Caves, 1996). This literature highlights that FDI location decisions

are driven by country-specific as well as firm-specific factors (Dunning, 1998). There also is a

well-established literature on the drivers of international portfolio investment, focusing on

interest rates, taxation, legal barriers, and risk (Dornbusch and Fischer, 1994). However, there

are no studies specifically focusing on the investment choices of venture capital firms, choices

that are different from those faced by either multinational firms or portfolio investors. Unlike

FDI, venture capital investments are not aimed at securing managerial control of the venture.

Compared to portfolio investments, they are far less liquid. Typically, venture capital firms

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identify and invest in relatively high-risk and low-liquidity ventures, provide them with a variety

of financial and technical resources, monitor their progress without directly managing them, and

seek to realize gains from their investments relatively quickly through initial public offerings

(IPOs), acquisitions, stock buybacks or liquidations. We argue that the decision of U.S. venture

capital firms to invest in companies located in foreign countries is driven by the availability of

innovative and entrepreneurial opportunities, the ability to commercialize these opportunities,

and the extent to which the institutional infrastructure of each country enables the appropriation

of returns.

2. Foreign Investments and Location Choice

The international investment decisions of venture capital firms have not yet been

addressed theoretically or empirically. Location choice by multinational firms, however, has

been the subject of a large number of theoretical and empirical studies on foreign direct

investment or FDI (Caves, 1996). This voluminous literature suggests that firms choose to invest

in countries where location-specific benefits outweigh transaction costs (Dunning, 1998). The

benefits have to do with the possibility of improving efficiency, accessing markets or acquiring

strategic assets such as brands or technology. The costs of foreign expansion have to do with

several variables. First, the level of political hazards and corruption in the host country, which

research has shown to be related to the level of foreign direct investment (Wei, 2000; Henisz and

Delios, 2001). Government policies that affect business conditions (regulation, taxes) or trade

also affect the level of foreign direct investment. Second, the similarity between the home and

the host countries in terms of business environment reduces transaction and coordination costs,

thus helping firms overcome the “liability of foreignness” (Zaheer, 1995), and inducing FDI.

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Empirical findings show higher FDI activity between countries of similar size (Markusen, et al.,

1996), language, and culture (Kogut and Singh, 1988; Agarwal and Ramaswami, 1992;

Barkema, et al., 1996), and prior network linkages. Third, the presence of other multinationals in

the host country attracts new investments because it not only reduces perceived uncertainty for

investing firms (Martin, et al., 1998; Henisz and Delios, 2001), but also provides agglomeration

benefits (Caves, 1996). In order to minimize the impact of these costs, the foreign direct

investing firm seeks managerial control. In sum, foreign direct investment occurs because of

market imperfections and is all about the control of resources (Hymer, 1960/1976: 25;

Kindleberger, 1969).

At first blush, it may be tempting to classify venture capital investments as a special case

of FDI, and generalize the findings from this literature to venture capital. However, a closer look

at the motives for foreign direct investment activity reveals a crucial difference between FDI and

venture capital investments. FDI is typically motivated by a search for natural, human, or

knowledge-based resources, new markets for existing products, or ways and means of improving

efficiency (Dunning, 1998). By contrast, venture capital investments are not motivated by any

one of these. Venture capital firms make capital investments in “opportunities” that typically

entail high risk, and a potential of high returns. These opportunities are not single resources or

means of production, but individual companies that compile a unique “bundle of resources”

(Penrose, 1959). Although venture capital firms undertake ownership in these companies for

monitoring purposes, they do not internalize the companies with the intention of managing them

(Gompers and Lerner, 2000). Therefore, while the literature on foreign entry location choice

sheds some light on the factors that might affect venture capital investments, the question of

location choice in international venture capital remains a distinct and interesting one.

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Venture capital investment also bears some similarity to international portfolio

investment. The literature on international capital movements contends that the determinants of

capital flows are changes in interest rates as well as taxes, regulations, political risk, and

information asymmetries (Brennan and Cao, 1997). Thus, capital moves from better to less well

endowed countries, looking for a higher marginal productivity. At first sight, venture capital

movements seem to follow a similar pattern of arbitrage. However, the resemblance is also

limited, since there are fundamental differences between foreign venture capital investments and

international portfolio investments. The most important has to do with the irreversibility of

venture capital investments for longer periods of time. Since venture capital firms invest with

longer time horizons, and typically exit investments through IPOs or acquisitions, they face

much lower liquidity and higher risk compared to the typical portfolio investor. The question of

location choice in venture capital investments, then, still remains a distinct one.

In sum, venture capital investments bear resemblances to foreign portfolio investments

and to FDI; yet they exhibit distinct features that distinguish them from both portfolio and direct

investments. Therefore, a study of international venture capital investment is a worthwhile and

interesting question that has not been previously addressed in the literature on foreign

investment. Before developing our theoretical approach, we summarize the venture capital

industry’s modus operandi.

3. The Venture Capital Industry in the U.S. and around the World

The venture capital industry has been one of the major driving forces behind innovative

activity and growth of high-technology industries in the U.S. economy. In 2002 over half of the

venture capital investments were technology-related (Global Private Equity 2002). Although

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venture capital outlays represented only 3 percent of total corporate investment between 1983

and 1992, they resulted in 8 percent of all U.S. industrial innovations (Kortum and Lerner, 2000).

As a result, venture capital has been a significant driver of the U.S. economy through spurring

entrepreneurial activity. Venture capital invested during the period 1970-2000 created 7.6

million jobs and over $1.3 trillion in revenue. In 2000, venture capital-backed companies

represented 5.9 percent of total U.S. jobs and 13.1 percent of GDP.1

Venture capital firms2 act as intermediaries between investors in search of investment

opportunities and entrepreneurs in need of capital. The majority of U.S. venture capital firms are

structured as limited partnerships, whereby limited partners provide the capital to be invested and

general partners provide expertise in selection and management of investment opportunities.

Typically, limited partners include institutional investors and wealthy individuals. Among

institutional investors, corporate and public pension funds comprise the largest investor group,

followed by endowments and foundations, bank holding companies, insurance companies,

investment banks, non-financial corporations, and foreign investors (Fenn, et al., 1997). Venture

capital firms vary substantially in size. A typical venture capital firm has anywhere between two

and over thirty general partners. The amount of capital can range from 10 million to several

billion dollars (Fenn, et al., 1997).

Venture capital firms go through a “cycle” of activities that involve selection,

management, and liquidation of investments in portfolio companies over a period of 5-7 years

(Gompers and Lerner, 2000; Guler, 2003). First, venture capitalists need to generate a steady

flow of investment proposals from which to select. Second, they select companies for investment

1 Oct. 22, 2001. ‘Three Decades of Venture Capital Investment Yields 7.6 million Jobs and $1.3 Trillion in Revenue.’ URL: www.nvca.com2 In the discussion pertinent to the venture capital industry we use the term “firm” solely to refer to venture capital firms and “company” to refer to portfolio companies (entrepreneurial ventures).

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through a rigorous process of screening. The average venture capital firm invests in only one per

cent of the proposals that it receives (Fenn, et al., 1997). Venture capital firms typically invest in

their portfolio companies in exchange for equity. Although they do not directly assume full

ownership or management of the companies, they monitor them during the life of the investment

through advisory functions, board memberships, and the provision of financial and non-financial

resources. Finally, they manage the exit process, after which the proceeds are returned to the

limited partners. Venture capitalists may exit investments in several ways, including initial

public offerings (IPOs), acquisitions, liquidations, or stock buybacks (Gompers and Lerner,

2000). The returns from the investments accrue to the limited partners after liquidation.

The success of the U.S. venture capital industry in financing innovation and contributing

to growth has encouraged venture capital activity in other countries. Although private equity and

venture capital investment around the world are comparatively smaller, many countries report

large growth rates. For instance, during 2001 private equity investments grew by 72 percent in

India, and 38 percent in Israel (Global Private Equity 2002). The early experiments with venture

capital in countries like Germany and Japan failed in spite of government or corporate backing

(Kenney, et al., 2002; Becker and Hellmann, 2003). Later developments gave rise to venture

capital activity that differed in structure and operation from their U.S. counterparts, always in

response to unique institutional demands (Bottazzi, et al., 2004). Some of the factors that have

been argued to affect the growth of venture capital activity include appropriate structures to

protect investor returns (Becker and Hellmann, 2003), the level of economic development, the

availability of exit options (Kenney, et al., 2002) as well as the quality of the national system of

innovation and levels of entrepreneurship (Kenney, et al., 2002; Becker and Hellmann, 2003). A

small number of studies has examined the growth of the domestic venture capital industry in a

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number of countries, and linked it to the institutional environment of the country. A comparative

study of German and U.S. venture capital markets suggests that the existence and strength of the

stock market is a key determinant of venture capital financing (Black and Gilson, 1998). A cross-

country study of venture capital investing in 21 countries finds support for the importance of

IPOs and government policies (Jeng and Wells, 2000).3

Entrepreneurial ventures in other countries also present U.S. venture capital firms with

new pools of investment opportunities, and potentially high returns. At the same time, U.S.

venture capital investments can benefit local economies by supporting entrepreneurial and

innovative activity. Moreover, entry of U.S. venture capital firms into other countries creates

opportunities for the diffusion of practices to local firms (Kenney, et al., 2002). While U.S.

venture capitalists may be less subject to some institutional idiosyncrasies of the portfolio

company’s country (e.g. they do not need to raise funds in the host country), they are still subject

to many institutional constraints in their operations and in their ability to repatriate returns.

4. The Institutional Environment and the Internationalization of Venture Capital

The main argument of this paper is that the institutional environment of each country

affects the levels of expected returns for U.S. venture capital firms, and in turn, their propensity

to invest in those countries. In particular, three broad sets of factors can affect U.S. venture

capital firms’ propensity to invest in a given country. The first relates to knowledge of the

availability of investment opportunities, the second to local conditions conducive to

commercialization, and the third has to do with the extent to which the institutional infrastructure

of the country facilitates the appropriation of returns from the investment.

3 Other studies have focused on differences in decision making (Manigart, et al., 2000) or on the willingness to invest abroad (Hall and Tu, 2003).

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Entrepreneurial Opportunities

The likelihood of venture capitalists’ investing in a foreign country is a function of

entrepreneurial opportunities available for investment. As explained above, venture capital firms

constantly seek investment opportunities that can potentially yield high returns. In countries

where innovative and entrepreneurial activity is already vibrant, venture capital firms have a

higher likelihood of finding lucrative opportunities. Countries differ significantly in the intensity

of their innovative activity, even with the increasing possibility of accessing knowledge at a

global level (Kogut and Zander, 1993; Furman, et al., 2002). The number and innovativeness of

entrepreneurial ideas in a country, in turn, is a function of the level of scientific and technical

knowledge, for two reasons. First, the rate at which new ideas are produced in an economy

increases with the number of idea workers and the stock of ideas already available (Romer, 1990;

Furman, et al., 2002). The availability of a highly trained labor pool, and the extent of resources

available for R&D increases the likelihood of innovations in a country. Moreover, the production

of new and innovative ideas is facilitated by the availability of other ideas that researchers can

build on. Therefore, the presence of innovative clusters, as well as research institutions such as

universities, facilitates the level of innovation (Furman, et al., 2002). Indeed, the U.S. venture

capital industry has historically developed and operated in clusters comprising entrepreneurial

ventures and research universities (Florida and Kenney, 1988; Kenney, et al., 2002; Stuart and

Sorenson, 2003). Similarly, anecdotal evidence suggests that venture capital industries in

countries such as Israel and the United Kingdom benefited from the existence and quality of

higher education institutions (Kenney, et al., 2002). We therefore predict:

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Hypothesis 1 (H1). The probability of foreign venture capital investment in a

given country increases with the level of scientific knowledge in that country.

Commercialization

Even when the level of scientific knowledge in a country is high, venture capital firms

may be reluctant to invest because their ability to commercialize these investments is hindered

by the lack of an appropriate infrastructure. The national innovative capacity of a country is

defined as a combination of capabilities to produce and commercialize technologies (Furman, et

al., 2002). While the existence of innovative ideas is necessary for a venture capital firm to find

attractive investment opportunities in a country, it may not be sufficient to convert these ideas

into profitable investments. The ability to extract returns from these ideas requires

complementary assets, as well as stable or growing demand conditions. While some

complementary assets are firm-specific (e.g. capabilities in marketing), some rely on the physical

infrastructure available in the country. For instance, many high-technology industries—e.g.

Internet-based services, or wireless telecommunications—critically rely on the physical

infrastructure, including energy, transportation and other services. Availability and quality of the

infrastructure enables entrepreneurial ventures to provide higher quality services to a wider

market, decreasing costs of providing services and increasing potential profitability. Since

venture capital firms typically invest in ventures that operate in high-technology industries,

countries with better physical infrastructure will be better able to attract U.S. venture capital.

Therefore, we formulate

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Hypothesis 2 (H2): The probability of foreign venture capital investment in a

given country increases with the availability of a physical infrastructure in that

country.

A second aspect of the ability to extract commercial benefits out of innovative ideas is

the availability and size of stock markets. Unlike foreign direct investors, who tend to have a

long-term interest in exercising managerial control over the invested company, venture capital

firms typically exit investments through public offerings. The existence of developed stock

markets signals greater prospects for such successful exits, and provides incentives for venture

capital investors (Black and Gilson, 1998; Leachman, et al., 2002). Moreover, the availability of

exit options through well-developed stock markets helps venture capital firms to capitalize on

earlier investments within a shorter time and to recycle capital towards new opportunities. Well

developed stock markets also provide a means to show performance and profitability to potential

investors (Black and Gilson, 1998). Thus, we expect that

Hypothesis 3 (H3): The probability of foreign venture capital investment in a

given country increases with the size of the stock market in that country.

Appropriability

The attractiveness of a county for venture capital investment is likely to be affected by

appropriability conditions. Venture capital firms are more likely to invest in countries where

their returns are protected by stable local institutions (Henisz and Delios, 2001). We examine

two factors that might affect appropriability, and in turn, the probability of venture capital

investment. First, venture capital investments are likely to increase with the existence of stable or

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growing demand conditions. In countries where economic conditions are volatile, demand for a

product or service can shrink abruptly, leaving investors exposed to large risks on sunk

investments. This is referred to as economic uncertainty. Since firms seek to avoid uncertainty in

decision making (Cyert and March, 1963), venture capital firms are likely to bypass investments

in countries where political or economic conditions jeopardize future returns. Hence,

Hypothesis 4 (H4): The probability of foreign venture capital investment in a

given country decreases with economic uncertainty in that country.

Second, political uncertainty in a country might affect conditions of appropriability and

deter investment. Political uncertainty refers to unforeseeable changes in future policies and

regulations. Uncertainty about future regulations, tax rates, or government policies can

discourage capital investment. Research on foreign direct investment shows that firms tend to

avoid countries where political uncertainty is high (Henisz and Delios, 2001). In particular, if

policymakers have unilateral power to change the policy regime in a country, the likelihood of an

unanticipated future change is higher, and likewise the policy uncertainty. Countries where

policy changes are not constrained by multiple political institutions present a higher political

hazard (Henisz and Delios, 2001). Thus, we predict that

Hypothesis 5 (H5): The probability of foreign venture capital investment in a

given country decreases with the level of political uncertainty in that country.

It is important to note that the five predictors of foreign venture capital investment

considered in this paper affect foreign direct and portfolio investment decisions to varying

degrees. A country’s technological and scientific knowledge stock is only relevant for a small

proportion of foreign direct investment decisions—those having to do with strategic assets—

while it tends not to be a consideration in the cases of the much more frequent efficiency or

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market-seeking direct investments (Dunning, 1998). Similarly, international portfolio investors

do not look for opportunities exclusively in the technology area, while venture capital investors

overwhelmingly do. The physical infrastructure is certainly important to foreign direct investors,

though not to portfolio ones. By contrast, the size of local stock markets is much more important

to the portfolio than to the direct investor. Economic and political uncertainty affect direct

investors seeking market access to a greater extent than those seeking efficiency or strategic

assets. Both types of uncertainty are relevant to the portfolio investor. Thus, while the five

predictors are pertinent to foreign venture capital investments, their relevance to direct or

portfolio investments varies from case to case, reflecting the fact that venture capital investing

shares some features of direct and portfolio investing, while exhibiting key peculiarities.

5. Data and Methods

In order to test our hypotheses we examine the international investment decisions by U.S.

venture capital firms between 1990 and 1999. The U.S. venture capital industry grew

significantly during this period, in terms of both capital available for investment and the number

and amount of actual investment. Involvement of U.S. venture capital firms in foreign markets

also rose as a result of increases in the amount of available capital and the search for new,

innovative opportunities.

We compiled the venture capital investment data from the VentureXpert database

provided by Venture Economics,4 which collects information through an annual survey of over

1000 private equity partnerships in the U.S. This database has been used extensively in venture

4 The data from Venture Economics’ VentureXpert database includes “standard U.S. venture investing” in portfolio companies, as long as the company is domiciled in the U.S., at least one of the investors is a venture capital firm, venture investment is a primary investment, and it entails an equity transaction.

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capital research (Barry, et al., 1990; Sahlman, 1990; Megginson and Weiss, 1991; Gompers and

Lerner, 2000; Shane and Stuart, 2001). The country-level data on economic, political, and

demographic characteristics of potential investment locations were compiled from the World

Bank’s World Development Indicators, and World Telecommunications Indicators. Data on the

level of scientific knowledge were compiled from the NBER patent database and the ISI

scientific citations index. We used data compiled by Beck, Demirguc-Kunt, and Levine (2001)

for the size of capital markets, and Henisz’s political hazards index to measure the level of

political uncertainty (Henisz and Delios, 2001).

We included in our database for analysis venture capital investments undertaken by 350

U.S. venture capital firms (VCFs) over a period of ten years (1990-1999). Taken together, these

firms made 336 investments in foreign countries. After casewise deletion of missing data, the

sample includes 244,999 unique combinations of VCF-country-years.

Dependent Variable. The dependent variable is a non-negative integer count of venture

capital investments in each country. The usual approach in estimating models with such

dependent variables is to assume that the error structure follows a Poisson distribution (Cameron

and Trivedi, 1998). However, the dependent variable exhibits a large number of zero counts

since the dataset includes all possible VCF-country-year combinations. In such cases, where

overdispersion may occur as a result of excess zeros, a zero-inflated Poisson (ZIP) model can be

used. The ZIP model assumes that the process generating the excess zeros is qualitatively

different from the process that generates the non-zeros (Greene, 1997; Tu, 2002). We therefore

estimated the number of investments by venture capital firm i in country j during year t with

zero-inflated Poisson models, nested within a logit model estimating the likelihood of zero

investments for the venture capital firm-country pair during year t. In estimating the probability

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of zero investments, we used two predictor variables as well as a year control. The first variable

is the number of other U.S. venture capital firms that have invested in the focal country as of the

previous year. This measure accounts for venture capital firms following one another in location

choices under high uncertainty (DiMaggio and Powell, 1983; Sahlman and Stevenson, 1985;

Henisz and Delios, 2001). The second variable is the prior international investment experience of

the venture capital firm, which accounts for firm heterogeneity concerning the pursuit of foreign

opportunities. Prior international investment experience indicates a greater propensity to go

abroad, and can provide firms with operational capabilities and decision rules that help manage

idiosyncratic institutional environments (Henisz, 2003). The results of the first-stage logit

analysis show that both variables significantly reduce the probability of zero investments,

confirming earlier empirical studies (e.g. Henisz and Delios, 2001). We conducted a Vuong test

in order to compare the estimates of the ZIP and non-nested Poisson models. The test statistic is

significantly larger than zero (8.33, p < 0.001), confirming that at least some of the unobserved

heterogeneity is due to an excess zero count. Multiple observations for the same country may

create correlations between the error structure and the independent variables. To partially

account for this we estimate all models with the Huber-White-sandwich estimator of variance

yielding robust standard errors.

Independent Variables. We use two separate measures to approximate the availability of

innovative opportunities in country j. The first is the number of patents granted by the U.S.

Patent Office to establishments in country j and year t. Numbers of patents have traditionally

been used as a measure of innovative output. Since venture capital firms typically invest in high

technology companies, patenting is a relevant measure of opportunities for commercially viable

ideas in a country (Furman, et al., 2002). These data were compiled from the NBER patent

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database (Hall, et al., 2001). We used the number of patents in the U.S. patent system, since this

represents a standardized process of registering innovations, as opposed to possible differences

in national systems. We normalized the number of patents by the GDP of each country, and took

the logarithm of the measure in order to make it normally distributed.

The second measure of the availability of scientific knowledge is the number of scientific

publications by residents of a country. The number of articles published in academic, technical,

and trade journals is an indicator of knowledge exchange and exposure among members of a

community (Guler, et al., 2002). This measure was compiled annually from Science Citation

Index (SCI), and normalized by the GDP of each country.

We measure the role that the physical infrastructure plays in enhancing the ability to

commercialize technology with the number of telephone mainlines per 1000 people. The

telecommunications infrastructure is very important not only to the diffusion of many high-

technology innovations, such as internet-enabled services, but also to the smooth operation of all

kinds of businesses, especially knowledge-intensive ones. The data were compiled from the

International Telecommunication Union’s World Telecommunications Indicators database. The

second factor we hypothesized as affecting the ability to commercialize technology was the size

of capital markets in the country. We use the measure of capital market size compiled by Beck et

al. (Beck, et al., 2001), calculated as the value of listed domestic shares on domestic exchanges,

normalized by the GDP of each country.

We test the ability to appropriate returns with the real conditional variation in the GDP

growth rate as a measure of economic uncertainty (Serven, 1998), and with the index of political

constraints (Henisz and Delios 2001). The latter measure captures the lack of constraints on

policymakers to unilaterally change the policy regime (Henisz, 2000). Accordingly, a higher

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number of independent government branches that have veto power over a policy change in a

country reduces the political hazard. This indicator is rescaled to range from 0 (minimal hazards)

to 1 (extreme hazards).

Control Variables. We include controls for the size of the economy (GDP in constant

1995 U.S. dollars), and for time.

6. (Preliminary) Results

Table 1 presents the descriptive statistics. The number of investments for each venture

capital firm-country-year varies between 0 and 15. The correlations between the explanatory

variables and the dependent variable are in the expected direction. Results of the zero-inflated

Poisson analysis are presented in Table 2. The first model is the baseline with control variables

only. The first stage is the logit model estimating the likelihood of zero investments by VCF i in

country j during year t. Other VC investments in country j significantly reduce the likelihood of

zero investments, consistent with the literature on international expansion. Similarly, the VCF’s

prior international experience significantly reduces the likelihood of zero investments.

The second stage shows the effects of the hypothesized variables. We obtain support for

the prediction that the availability of investment opportunities increases venture capital

investment that is robust to the indicator used (patents or scientific publications) and to the

inclusion or exclusion of other variables (hypothesis 1). We obtain partial support for the

prediction that the availability of a commercialization infrastructure increases venture capital

investment in that the physical infrastructure (telephone lines) does not exert a significant effect

(hypothesis 2) while the size of capital markets does (hypothesis 3). This finding confirms the

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importance of IPOs as the main exit strategy being sought by VCFs. We fail to find evidence to

the effect that appropriability regime increases foreign venture capital investment: neither

economic uncertainty nor political uncertainty. Thus, our preliminary results confirm two of our

five predictions, and lend support to both the availability of opportunities and the possibilities of

commercialization as drivers of foreign venture capital investment.

7. Discussion and Conclusion

The most robust finding of this study is that foreign venture capital investment is driven

by the availability of innovative ideas. This is consistent with the idea that intensity of innovation

is location-dependent, and is affected by the local institutions and agglomeration that exists in a

particular country (Kogut and Zander, 1993; Furman, et al., 2002). It is important to note,

however, that while U.S. venture capital firms seek out local innovative opportunities to invest

and support with a view to making a profit, in so doing they contribute to the development of an

institutional infrastructure for further innovation and growth.

Although we did not find a significant effect for the presence of a well-developed

physical infrastructure, we confirmed the importance of capital markets to the attraction of

foreign venture capital investment. This combination of results may be due to the fact that

venture capital firms look for opportunities that can attract demand in international markets, as

opposed to local markets only. As such, weaknesses in the physical infrastructure do not

discourage investment in innovative ideas, as long as they have potential beyond the specific

country. In contrast, the size of the capital markets significantly affects the likelihood of venture

capital investment, suggesting that venture capital firms seek opportunities with discernible exit

options. This is consistent with prior research showing that venture capital funding in domestic

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industries is highly related with the strength of the IPO market (Black and Gilson, 1998; Jeng

and Wells, 2000). Although countries like Israel host opportunities that are commercialized in

other countries through IPOs, this seems to be the exception rather than the rule (Megginson, et

al., 2004). Future extensions of this study can examine how the availability of exit opportunities

in foreign markets affects the likelihood of venture capital investment, and the relationship

between venture capital investment and the size of the capital market.

The ability to appropriate returns from the investment was not related with the likelihood

of venture capital investment. The results showed that neither economic uncertainty, in terms of

variation in GDP growth levels, nor the level of political uncertainty in the country had a

significant effect on the likelihood of venture capital investment. This contrasts with studies

finding that political uncertainty is a significant determinant of foreign direct investments, and

infrastructure investment decisions (Henisz, 2000; Henisz and Delios, 2001). This result could be

due to the different nature of venture capital investments. While foreign direct investment

requires a significant commitment on the part of the foreign multinational over a presumed long

period of time, venture capital investments are typically smaller in scale, involve limited

ownership, and have a definite timeline. Since venture capital firms keep a portfolio of uncertain

investments, and look to exit investments within 5 to 7 years, they may have more limited

exposure to political hazards than multinational corporations. Moreover, venture capital firms

look for opportunities that promise potential for high returns, but cannot secure funding

elsewhere. Therefore venture capital firms may be more willing to take risks that other investors

may not. They may be more tolerant toward economic and political uncertainty in a particular

country in choosing locations to invest.

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This study represents a first attempt at understanding the factors that might affect patterns

of U.S. venture capital investments in other countries. As such, it suffers from certain limitations

which we hope to address in further research. First, we would like to test the robustness of our

results with other alternative measures that may more specifically address our theoretical

arguments. For instance, the number of patents awarded in the U.S. is a measure of the

innovative output of a country, but it does not allow us to understand what drives the level of

innovative output. Other alternative measures such as the level of R&D investments, and the

number of scientists and engineers in a country, may allow us to examine what countries might

do to increase innovative opportunity and attract foreign risk capital.

Second, we would like to examine some of the more specific relationships between our

variables. For instance, our results suggested that the likelihood of venture capital investment

was higher in countries where the capital markets are larger. However, we did not examine

whether the strength of the capital markets or the level of scientific knowledge can compensate

for other institutional shortcomings such as higher levels of economic uncertainty. Another

interesting question is whether there are alternative mechanisms for commercialization of

opportunities (such as the level of high-technology exports) that can explain the likelihood of

venture capital investment in countries where the physical infrastructure is insufficient, and the

economic growth is volatile. A closer look at the relationships between variables can yield a

more precise understanding of necessary and sufficient conditions determining the likelihood of

U.S. venture capital firms to invest in other locations.

Despite these limitations, we believe that this study provides an understanding of the

country-level factors that affect international venture capital investment decisions. Venture

capital has been a significant driver of innovation and growth in the U.S. economy. The ability of

21

countries to attract foreign capital can also spur economic growth, and contribute to local

economies. At the same time, venture capital investment is sufficiently different from foreign

direct investment to warrant specific attention to its determinants. This study hopes to provide an

initial attempt in understanding the growth of venture capital in a global context.

22

Table 1. Descriptive Statistics (N=244,999)

Variable Mean Std. Dev. Min Max 1 2 3 4 5 6 7 8 9 101 Number of

investments0.002 0.084 0 15 1

2 Sci. knowledge – patents (log)

-4.200 6.230 -16.118 2.270 0.021 1.000

3 Sci. knowledge - publications

0.025 0.023 0.000 0.139 0.015 0.230 1.000

4 Physical infrastructure

24.329 21.594 0.190 72.150 0.031 0.558 0.311 1.000

5 Capital market size

-7.441 1.646 -19.570 -3.470 0.023 0.344 0.059 0.408 1.000

6 Economic uncertainty

0.355 0.426 0.000 2.804 -0.010 0.051 -0.059 -0.144 0.048 1.000

7 Political uncertainty

0.558 0.291 0.000 0.890 0.017 0.415 0.146 0.595 -0.025 0.297 1.000

8 GDP (*10-8) 3.672 1.054 0.914 8292 0.016 0.264 0.005 0.348 -0.099 0.204 0.212 1.0009 Year 1994.874 2.747 1990 1999 0.018 -0.006 0.182 0.077 -0.155 0.088 0.113 -0.026 1.000

10 Prior VC investments in country j

1.687 6.539 0 65 0.064 0.201 0.098 0.310 -0.100 0.189 0.166 0.281 0.232 1.00

11 VC’s prior international experience

0.503 3.901 0 87 0.140 0.001 0.021 0.010 -0.020 0.009 0.011 -0.003 0.112 0.03

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Table 2. Results of Zero-Inflated Poisson ModelsStage 2: Poisson model predicting the count of entries

(1) (2) (3) (4) (5) (6) (7) (8) (9)

Patents (log) 0.437** 0.445** 0.350** 0.370** 0.368** 0.370**(0.114) (0.122) (0.083) (0.085) (0.085) (0.086)

Scientific publications 16.188** -1.26 11.414*(5.065) (5.241) (5.356)

Physical infrastructure 0.009 0.002 0.002 0.002 0.021(0.009) (0.011) (0.011) (0.012) (0.013)

Capital market size 0.547* 0.574* 0.574* 0.649*(0.261) (0.251) (0.251) (0.274)

Economic uncertainty -0.026 -0.026 -0.023(0.045) (0.045) (0.048)

Political uncertainty -0.079 0.479(0.473) (0.454)

GDP 0.034** 0.029** 0.049** 0.027** 0.029** 0.032** 0.032** 0.032** 0.046**(0.008) (0.008) (0.010) (0.010) (0.009) (0.008) (0.008) (0.007) (0.009)

Year 0.172* 0.103 0.146 0.104 0.102 0.082 0.078 0.078 0.078(0.078) (0.066) (0.078) (0.068) (0.064) (0.062) (0.062) (0.062) (0.062)

Constant -344.4* -206.9 -292.3 -209.1 -204.6 -164.3 -157.4 -156.8 -159.3(155.8) (131.7) (154.7) (135.4) (128.6) (124.8) (123.3) (123.5) (123.5)

Log likelihood -2500.6 -2396.7 -2479.2 -2396.6 -2394.9 -2383.5 -2383.2 -2383.2 -2415.7Wald chi-square 27.99 25.81 38.63 28.05 66.15 90.46 109.11 160.66 150Stage 1: Logit model predicting zero countsOther VC investments -0.055** -0.037** -0.051** -0.037** -0.036** -0.035** -0.035** -0.034** -0.038** in the same country (0.004) (0.005) (0.004) (0.005) (0.005) (0.005) (0.005) (0.005) (0.005)VC firm’s int’l 0.077** -0.085** -0.079** -0.085** -0.085** -0.086** -0.086** -0.086** -0.085** Experience (0.007) (0.013) (0.008) (0.013) (0.013) (0.014) (0.014) (0.014) (0.013)Year 0.122 0.054 0.120 0.054 0.056) 0.047 0.045 0.045 0.075

(0.057) (0.053) (0.032) (0.053) (0.053) (0.052) (0.052) (0.052) (0.050)Constant -236.21 -103.60 -234.12 -101.63 -106.8 -87.76 -85.84 -85.48 -144.33Observations 244999 244999 244999 244999 244999 244999 244999 244999 244999Robust standard errors reported in parentheses+ p<0.1, *p<0.05, **p<0.01

24

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