venture capital backed growth.docx

venture capital backed growth.docx

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venturecapitalbackedgrowth

Abstract（DocumentSummary）

Thepaperproposesasimpleequilibriummodelofventurecapital,start-upentrepreneurshipandinnovation.Venturecapitalistsnotonlyfinancebutalsoadvisestart-upentrepreneursandtherebyaddvaluetonewfirms.Thepapershowshowaproductiveandactiveventurecapitalindustryboostsinnovationbasedgrowth.Italsodemonstratesthepotentialoftaxpolicytopromoteinnovationandgrowthbystrengtheningincentivesformoreintensiveventurecapitalsupport.[PUBLICATIONABSTRACT]

FullText （11039 words）

CopyrightKluwerAcademicPublishersJun2004

[Headnote]

Thepaperproposesasimpleequilibriummodelofventurecapital,start-upentrepreneurshipandinnovation.Venturecapitalistsnotonlyfinancebutalsoadvisestart-upentrepreneursandtherebyaddvaluetonewfirms.Thepapershowshowaproductiveandactiveventurecapitalindustryboostsinnovationbasedgrowth.Italsodemonstratesthepotentialoftaxpolicytopromoteinnovationandgrowthbystrengtheningincentivesformoreintensiveventurecapitalsupport.

Keywords:

Venturecapital,doublemoralhazard,innovation,growth

JELclassification:

D82,G32,016,O40

（ProQuestInformationandLearning:

...denotesformulaeomitted.）

1.Introduction

Creationofinnovativeyoungfirmsisanimportantsourceofinnovationandgrowth.ItiswidelyclaimedamongeconomiststhattheexistenceofasophisticatedventurecapitalindustryisamajorfactorbehindAmerica'sabilitytoencourageandsustaintechnologicalinnovationandgrowth.Theargumentisthatventurecapital（VC）makesyoungfirmsgrowfaster,createmorevalueandgeneratemoreemploymentthanotherstart-ups.EmpiricalresearchintheUnitedStateshasshownindeedthatVCcanimportantlyenhancetheabilityofnewfirmstocreatewealthandjobs.1AccordingtoKortumandLerner（2000）,VCbackedfirmsaremoreinnovativeandproducemoreandmorevaluablepatents.HellmannandPuri（2000,2002）showthattheyaimatmoreradicalinnovations,aresignificantlyfasterinintroducingtheirproductstothemarketandpursuemoreaggressivemarketstrategiesthanotherstart-upfirms.Theyarefoundtohaveahigherrateofexecutiveturnoverandtobefasterinhiringaspecializedmarketingdirector.ItseemsthattheexistenceofanactiveVCsectorcanshowupinsuperiormacroeconomicperformance.Recently,WasmerandWeil（2000）econometricallyinvestigatedpaneldataof20OECDcountriesovertheyears1986-1995.TheyfoundthatanincreaseintheGNPshareofVCby0.075wouldreducetheshort-rununemploymentrateby0.25percentagepointswhilethelong-runeffectwouldamounttoareductionof0.9to2.5percentagepoints.2

TheempiricalstudybyBottazziandDaRin（2002）suggeststhatEuropeanVChasgrownvigorouslyintermsofvolumeinvestedbut,incontrasttotheUSevidence,apparentlyhadnotmuchinfluenceongrowthandemploymentofportfoliofirms.ThisraisesthequestionwhattherealcontributionofVCexactlyisandhowincentivesinVCinvestingaredetermined.VentureCapitalists（VCs）carefullyscreenfirms,structurecontractstostrengthenincentives,andmonitorfirms（KaplanandStromberg2001）.Theyaddvaluetonewfirms,promotetheirprofessionalization,andinducethemtobehavemoreaggressively.ItisoftenstatedthattheUnitedStateswithanactiveVCsectorisfasterinadoptingnewtechnologies.KortumandLerner（2000）estimateindeedthatadollarofVCseemsaboutthreetimesmorepotentinstimulatingpatentingthanadollaroftraditionalcorporateR&D.Theyalsoconcludedthatby1998,venturefundingaccountedforabout14percentofUSinnovativeactivity.Yet,thisliteraturehasleftunspecifiedtheprecisetransmissionchannelsthroughwhichVCinvestingaffectstheeconomy'sequilibriumrateofinnovation.

ThemaincontributionofthispaperistomodeltherealeffectsofVCasadeterminantofinnovationdrivengrowth.WeshowhowanactiveVCsectorwithexperiencedandsophisticatedinvestorscanenhancethesuccessofstart-upentrepreneursandcantherebyraisetheequilibriumrateofinnovation.ThemodelexploreshowthejointinputsofbothentrepreneursandVCsinteracttodeterminetheprospectsofstart-upfirms.Whileentrepreneurscontributethekeytechnologicalidea,theytendtobecommerciallyinexperienced.VCssupportthefirmwithmanagerialadvicethatdrawsontheirindustryknowledgeandcommercialexpertise.WestudyanalyticallyhowcertainstructuralparametersdeterminethequalityofVCfinanceandhowthisaffectsentrepreneurshipandinnovationingeneralequilibrium.Forexample,GompersandLerner（1999,p.4）pointedtothefactthattheskillsneededforsuccessfulVCinvestingaredifficultandtimeconsumingtoacquireandarelikelytobeanimportantconstraintinthedevelopmentofanactiveVCindustry.WethusstudyhowanincreaseininvestorsophisticationraisesthequalityofVCfinancingandhowthistranslatesintoahigherrateofinnovationingeneralequilibrium.WealsoexploretheconsequencesofotherstructuralparametersandofpolicyinitiativesaimingatVCbackedgrowth.

IndevelopingamodelofVCwithdoublemoralhazard,weexplainnotonlytheincentivesofentrepreneursbutalsothoseofVCstoaddvalue.TheanalysisimportantlydrawsonHolmstrom（1982）,AghionandTirole（1994）,RepulloandSuarez（1999）,Casamatta（2002）,InderstandMueller（2002）andSchmidt（2003）,tomentiononlyafew.Thisliteratureinfinance,however,ismostlyconfinedtoananalysisofcontractsandtheassociatedincentivesforagents'effortsinpartialequilibrium.AccordingtoGompersandLerner（2001）,ananalysisoftherealeffectsofVCislargelymissing.3Themaincontributionofthispaperistoprogresstowardsthisendbyintegratingfinancialcontractingandadvisingintoageneralequilibriummodelthatendogenouslyexplains（i）theincentivesofentrepreneurstostartafirm（occupationalchoicewithanendogenouslydeterminedoutsidewage）,（ii）thewillingnessofVCstoaddvaluetostart-upfirms,（iii）theequilibriumventurereturns,ormarketvalueofnewfirms,asakeydeterminantofentry,and（iv）theequilibriumrateofinnovation.AcomparativestaticanalysisshowshowsomedeepstructuralparametersoftheVCsectoraswellastaxpolicyaddressedtotheVCindustryaffectstart-upentrepreneurshipandinnovationbasedgrowth.

Thefollowingsectionintroducestheanalyticalframework.ItextendsthetwoperiodoverlappinggenerationsmodelpioneeredbyDiamond（1965）anditsapplicationtogrowththeorybyGrossmanandYanagawa（1993）byincludingoccupationalchoiceofpotentialentrepreneursanddoublemoralhazardintherelationbetweenentrepreneursandVCfirms.Start-upentrepreneursifsuccessfulproducenewcapitalgoodswhichboostthefactorproductivityinfinalgoodsproduction.Basedoncomparativestaticanalysis,Section3showshowkeycharacteristicsoftheVCsectordeterminethequalityandquantityofstart-upinvestmentbyyoungentrepreneurialfirmsandtheequilibriuminnovationrate.WealsoconsiderhowtaxpolicycanpromotegrowthbystrengtheningincentivesforincreasedVCsupporttostart-upfirms.Thefinalsectionconcludes.

2.TheModel

2.1.Life-CycleofFirms

Anoverlappinggenerationsmodelofentrepreneurshipandinnovationisproposed.Productionofafinalgoodusesspecializedcapitalgoodswhichareintroducedbyinnovativestart-upfirms.Entrepreneurshaveideasbutnoowncapital.Inaddition,theyarecommerciallyinexperienced.VCshavemanagerialknowhowandaccesstocapital.Theycollectsavingsandfinanceaportfolioofstart-upfirms.Theynotonlyprovidefinancebutalsoaddvalueingivingmanagerialadvice.ThesuccessofthecompanyindevelopingamarketablecapitalgoodcriticallydependsontheeffortoftheentrepreneurbutisfurtherenhancedbythemanagerialsupportoftheVC.TheeffortsofboththeentrepreneurandtheVCarenotcontractible,givingrisetodoublemoralhazard.Ifthefirmsuccessfullymaturestoproductionstage,aspecializedcapitalgoodisproducedandsuppliedtofinalgoodsproducers.Thepresentvalueofmonopolisticprofitsmustcovertheexpectedstart-upcostofthefirm.

Theprocessofbusinesscreationstartingwiththeentrepreneur'sinitialideatothefirm'ssuccessfulmarketintroductionandproductionofthegoodinvolvesanaturalsequenceofevents.First,anagentdecidesforentrepreneurshiporelseforaworker'scareer.Whenstartingafirm,shemustovercomethelackofcapitalandhercommercialinexperience.ShethuscontactsaVCtoobtainfinanceandadvice.Second,theentrepreneursellsaconcentratedequitystakeinthefirmforapricethatcoversthephysicalstart-upcostandmayalsoincludeapossibleprofitupfront.TheVCacceptsthisofferorotherwiseturnstootherinvestmentopportunities.Third,afterthedealisfinalized,boththeentrepreneurandVCexpendefforttodevelopthefirm.Jointeffortisconditionalontheincentivesprovidedbythetermsofcontract.Fourth,riskisresolvedandfirmswhichhavesuccessfullymaturedtoproductionstage,introduceaspecializedcapitalgoodsvarietyonthemarket.Atthispointintime,thefirmissoldatacompetitivepriceandrevenuesaredistributedaccordingtotheagreedequitystakes.Finally,giventheirincome,allagentschooseconsumptionandsavings.

Thepaperembedsthistypeofinnovationfinanceinagrowthmodelwithoverlappinggenerations.Followingtheprincipleofbackwardinductioninsolvingthemodel,thesubsequentsectionsfirstconsiderconsumptionandsavingsandthenturntotheproductionsidewhichdeterminesventurereturns.Withthesepreliminar