venture capital backed growth.docx

1、venture capital backed growthAbstract (Document Summary)The paper proposes a simple equilibrium model of venture capital, start-up entrepreneurship and innovation. Venture capitalists not only finance but also advise start-up entrepreneurs and thereby add value to new firms. The paper shows how a pr

2、oductive and active venture capital industry boosts innovation based growth. It also demonstrates the potential of tax policy to promote innovation and growth by strengthening incentives for more intensive venture capital support. PUBLICATION ABSTRACTFull Text(11039 words)Copyright Kluwer Academic P

3、ublishers Jun 2004 HeadnoteThe paper proposes a simple equilibrium model of venture capital, start-up entrepreneurship and innovation. Venture capitalists not only finance but also advise start-up entrepreneurs and thereby add value to new firms. The paper shows how a productive and active venture c

4、apital industry boosts innovation based growth. It also demonstrates the potential of tax policy to promote innovation and growth by strengthening incentives for more intensive venture capital support.Keywords: Venture capital, double moral hazard, innovation, growthJEL classification: D82, G32, 016

5、, O40(ProQuest Information and Learning: . denotes formulae omitted.)1. IntroductionCreation of innovative young firms is an important source of innovation and growth. It is widely claimed among economists that the existence of a sophisticated venture capital industry is a major factor behind Americ

6、as ability to encourage and sustain technological innovation and growth. The argument is that venture capital (VC) makes young firms grow faster, create more value and generate more employment than other start-ups. Empirical research in the United States has shown indeed that VC can importantly enha

7、nce the ability of new firms to create wealth and jobs.1 According to Kortum and Lerner (2000), VC backed firms are more innovative and produce more and more valuable patents. Hellmann and Puri (2000, 2002) show that they aim at more radical innovations, are significantly faster in introducing their

8、 products to the market and pursue more aggressive market strategies than other start-up firms. They are found to have a higher rate of executive turnover and to be faster in hiring a specialized marketing director. It seems that the existence of an active VC sector can show up in superior macroecon

9、omic performance. Recently, Wasmer and Weil (2000) econometrically investigated panel data of 20 OECD countries over the years 1986-1995. They found that an increase in the GNP share of VC by 0.075 would reduce the short-run unemployment rate by 0.25 percentage points while the long-run effect would

10、 amount to a reduction of 0.9 to 2.5 percentage points.2The empirical study by Bottazzi and Da Rin (2002) suggests that European VC has grown vigorously in terms of volume invested but, in contrast to the US evidence, apparently had not much influence on growth and employment of portfolio firms. Thi

11、s raises the question what the real contribution of VC exactly is and how incentives in VC investing are determined. Venture Capitalists (VCs) carefully screen firms, structure contracts to strengthen incentives, and monitor firms (Kaplan and Stromberg 2001). They add value to new firms, promote the

12、ir professionalization, and induce them to behave more aggressively. It is often stated that the United States with an active VC sector is faster in adopting new technologies. Kortum and Lerner (2000) estimate indeed that a dollar of VC seems about three times more potent in stimulating patenting th

13、an a dollar of traditional corporate R&D. They also concluded that by 1998, venture funding accounted for about 14 percent of US innovative activity. Yet, this literature has left unspecified the precise transmission channels through which VC investing affects the economys equilibrium rate of innova

14、tion.The main contribution of this paper is to model the real effects of VC as a determinant of innovation driven growth. We show how an active VC sector with experienced and sophisticated investors can enhance the success of start-up entrepreneurs and can thereby raise the equilibrium rate of innov

15、ation. The model explores how the joint inputs of both entrepreneurs and VCs interact to determine the prospects of start-up firms. While entrepreneurs contribute the key technological idea, they tend to be commercially inexperienced. VCs support the firm with managerial advice that draws on their i

16、ndustry knowledge and commercial expertise. We study analytically how certain structural parameters determine the quality of VC finance and how this affects entrepreneurship and innovation in general equilibrium. For example, Gompers and Lerner (1999, p. 4) pointed to the fact that the skills needed

17、 for successful VC investing are difficult and timeconsuming to acquire and are likely to be an important constraint in the development of an active VC industry. We thus study how an increase in investor sophistication raises the quality of VC financing and how this translates into a higher rate of

18、innovation in general equilibrium. We also explore the consequences of other structural parameters and of policy initiatives aiming at VC backed growth.In developing a model of VC with double moral hazard, we explain not only the incentives of entrepreneurs but also those of VCs to add value. The an

19、alysis importantly draws on Holmstrom (1982), Aghion and Tirole (1994), Repullo and Suarez (1999), Casamatta (2002), Inderst and Mueller (2002) and Schmidt (2003), to mention only a few. This literature in finance, however, is mostly confined to an analysis of contracts and the associated incentives

20、 for agents efforts in partial equilibrium. According to Gompers and Lerner (2001), an analysis of the real effects of VC is largely missing.3 The main contribution of this paper is to progress towards this end by integrating financial contracting and advising into a general equilibrium model that e

21、ndogenously explains (i) the incentives of entrepreneurs to start a firm (occupational choice with an endogenously determined outside wage), (ii) the willingness of VCs to add value to start-up firms, (iii) the equilibrium venture returns, or market value of new firms, as a key determinant of entry,

22、 and (iv) the equilibrium rate of innovation. A comparative static analysis shows how some deep structural parameters of the VC sector as well as tax policy addressed to the VC industry affect start-up entrepreneurship and innovation based growth.The following section introduces the analytical frame

23、work. It extends the two period overlapping generations model pioneered by Diamond (1965) and its application to growth theory by Grossman and Yanagawa (1993) by including occupational choice of potential entrepreneurs and double moral hazard in the relation between entrepreneurs and VC firms. Start

24、-up entrepreneurs if successful produce new capital goods which boost the factor productivity in final goods production. Based on comparative static analysis, Section 3 shows how key characteristics of the VC sector determine the quality and quantity of start-up investment by young entrepreneurial f

25、irms and the equilibrium innovation rate. We also consider how tax policy can promote growth by strengthening incentives for increased VC support to start-up firms. The final section concludes.2. The Model2.1. Life-Cycle of FirmsAn overlapping generations model of entrepreneurship and innovation is

26、proposed. Production of a final good uses specialized capital goods which are introduced by innovative start-up firms. Entrepreneurs have ideas but no own capital. In addition, they are commercially inexperienced. VCs have managerial knowhow and access to capital. They collect savings and finance a

27、portfolio of start-up firms. They not only provide finance but also add value in giving managerial advice. The success of the company in developing a marketable capital good critically depends on the effort of the entrepreneur but is further enhanced by the managerial support of the VC. The efforts

28、of both the entrepreneur and the VC are not contractible, giving rise to double moral hazard. If the firm successfully matures to production stage, a specialized capital good is produced and supplied to final goods producers. The present value of monopolistic profits must cover the expected start-up

29、 cost of the firm.The process of business creation starting with the entrepreneurs initial idea to the firms successful market introduction and production of the good involves a natural sequence of events. First, an agent decides for entrepreneurship or else for a workers career. When starting a fir

30、m, she must overcome the lack of capital and her commercial inexperience. She thus contacts a VC to obtain finance and advice. Second, the entrepreneur sells a concentrated equity stake in the firm for a price that covers the physical start-up cost and may also include a possible profit upfront. The

31、 VC accepts this offer or otherwise turns to other investment opportunities. Third, after the deal is finalized, both the entrepreneur and VC expend effort to develop the firm. Joint effort is conditional on the incentives provided by the terms of contract. Fourth, risk is resolved and firms which h

32、ave successfully matured to production stage, introduce a specialized capital goods variety on the market. At this point in time, the firm is sold at a competitive price and revenues are distributed according to the agreed equity stakes. Finally, given their income, all agents choose consumption and

33、 savings.The paper embeds this type of innovation finance in a growth model with overlapping generations. Following the principle of backward induction in solving the model, the subsequent sections first consider consumption and savings and then turn to the production side which determines venture returns. With these preliminar