The Link between Venture Capital and Innovation: a Review
The profit motive of venture capitalists has been discussed to great lengths in the media over the past years, and recent academic literature has suggested that this type of finance also has real effects. It has been argued that venture capital represents an important engine for the Schumpeterian process of "creative destruction", and that it is a major force in transforming scientific knowledge into commercial output. This effect has come both through the impact of venture capital on existing industries and through its role in creating and developing entirely new industries. At nowadays, only a thin literature exists on the connection between venture capital and innovation, whereas the connection between venture capital and performance has been examined more systematically.
The first rigorous estimation of the ability of private equity and venture capital to stimulate innovation has been provided by Kortum and Lerner (2000). They explored the experience of twenty industries covering the U.S. manufacturing sector between 1965 and 1992. They used reduced-form regressions to explore whether, controlling for industrial R&D spending, venture capital has an impact on the number of patented innovations. They found that a dollar of venture capital could be as much as 10 times as effective in stimulating patents as a dollar of corporate R&D and that venture capital is associated with a substantial increase in innovation. Meticulous interpretation must be applied as far as the number of patents and R&D expenditure is concerned. Certainly, both are proxies for firm's innovative behavior and certainly there is a strong relationship between them, but it should be noted that the first item is an indicator of the output of the innovation process, while the second measures (or estimates) the input of the same process.
A study by Mollica and Zingales (2007) shows that venture capital investments have a positive impact on innovation and on the creation of new companies. The Authors control for various reverse causality explanations, and suggest that venture capital has a significant effect on both patenting counts and new firm creation. According to a study conducted by Caselli, Gatti and Perrini (2009) on the Italian venture capital market, a distinction has to be made between the relevance of innovation and whether it is present when venture capitalists decide to invest; the behavior of venture capitalists after investing, to investigate if it is to sustain innovation, or simply to take advantage of it. The Authors' findings suggest that equity capital investment is based on researching companies with high growth prospects and strong innovation in place. Although, when an agreement is made, venture capitalist commitment is focused on trading former innovations, rather than developing new innovative projects. The role of venture capital in Italian firms cannot be associated with promoting innovation, but mainly to developing sales. This verdict seems to be characteristic for Europe as well.
Risk Capital and the Finance of Young Innovative Companies: Policy Implications
The private equity industry in Europe has been slow to reproduce the flow of money that picked up in the U.S. into venture funds in the late 1970s and the early 1980s. In fact, prior to the 1979 clarification of the "prudent man" rule, governing pension funds investments, the ERISA (Employee Retirement Income Security Act) severely limited the ability of pension funds to invest in risk capital markets. In 1979, the U.S. Department of Labor issued a clarification of the rule stating that diversification is an inalienable part of the prudential investment behavior. Only recently did the European Commission undertake explicit regulatory intervention to prohibit national legislation from preventing insurance companies and pension funds from investing in risk capital markets. Prior to 2006, the extend of the recommended prudential behavior by institutional investors was left to the discretion of national governments, and as a result, there were large differences across countries and over time in the degree of regulation of these activities before the current harmonization drive. As a result, only in 2006 did pension funds become the largest source of private equity funds raised by investors, with this role asserted by banks prior to that. This recent pan-European regulation can be credited with a role in encouraging the European venture capital industry. Popov and Roosenboom (2008) argue that such policies, together with well-functioning exit markets and labor regulation aimed at promoting the mobility of skilled labor, are instrumental in unlocking Europe's innovative potential. To this extent, the Authors find that variations in regulations regarding the behavior of Europe's institutional investors - like pension funds and insurance companies - explain a large portion of the variations in private equity investments across countries and industries.
The Casual Relationship between Venture Capital and Innovation: Diverging Evidence
Studies on European data are generally less conclusive than the U.S. ones. Academic research has shown a positive link between private equity investment and innovation but, however, some studies have found diverging evidence on the casual relationship. A part of the intrinsic problem of finding the less erratic proxy to measure innovation, venture-capital backed companies generally have a higher patenting activities and some studies argue that it is just because venture capital firms fund companies that are already more innovative, rather than actually increasing the companies' innovativeness.
According to Hellman and Puri (2000), firms that pursue an innovation strategy are more likely to obtain venture funding than imitating firms, and thus innovators obtain venture capital more quickly. Their results, together with the conclusions reached by Engel and Keilback (2007), therefore suggest that venture capital may not stimulate innovation via incentives and monitoring, but via screening of firms. Venture capital investments may follow innovation, not the other way around. A study conducted by Popov and Roosenboom (2008) shows that private equity investment activity causes a significant patent increase in patent filings. They chose to use private equity investment as a proxy for risk capital because the exclusion of private equity may bias the true effect of risk capital on innovation by eliminating the effect of innovation which was undertaken to attract future private equity funds. The Authors take evidence from two main sources: on patent applications and grants from the EPO and USPTO, and on private equity investment from the EVCA yearbook.
Venture Capital as an Instrument for Development
Innovative ideas seem to lack more than funds in the E.U: According to Popov and Roosenboom (2008) estimates, the European risk capital markets are somewhat less efficient than their US counterparts in spurring innovation. For comparison, Kortum and Lerner (2000) find that venture capital accounted for 8% of industrial innovation between 1965 and 1992, while accounting for less than 3% of industrial R&D. Nevertheless, this may not necessarily be due to a less effective private equity market, but rather to more stringent employment practices, less developed exit markets, stricter regulatory policies, and Europe's still undeveloped knowledge networks. While the European private equity and venture capital industry has developed rapidly in recent years, labor market reforms have been slow and the deregulation of investment activity by large institutional investors like pension funds and insurance companies has only recently been put in place. The combined effect of such reforms can significantly improve Europe's innovative potential. However, according to Caselli, Gatti and Perrini (2009), to convert venture capital into support for innovation development a radical cultural revolution is definitely needed. Financial institutions should recognize their participation in potential innovation as well as profitable capital gains and should, therefore, revise their institutional goals and assume a greater social capacity. For firms, venture capital must generate a double positive effect, in developing both the firm as a whole and its innovative process. This is also needed to support initiatives in sector which, because of the idiosyncratic risk, venture funding is the only technique to finance companies (Stolis and Goodman, 2004). Lastly, venture capital financing should not affect the basic business idea, but must try to improve it, making it more efficient: venture capitalists must give it a central role in all firm decisions, avoiding corrections of business plans or modifications in the key roles of some human resources. Innovation is actually an important factor during the selection phase, but once the investment is made, the company does not promote continued innovation and concentrates all efforts to improve other economic and managerial aspects. These considerations could transform venture capital into an instrument for development, rather than one of simple investment.
The Case of the Biotechnology Industry: an Interview with BioXpr's CEO
In this Chapter we will present the case of BioXpr, a biotech firm originated from an university spin-off in Namur, Belgium. BioXpr is a company providing expert services in the field of bioinformatics. We will analyze the case and show how the company was financed with different funding sources accordingly to its development phase, from start-up phase to the early growth phase, until present. Moreover, we will analyze the effect of the establishment of the venture capital firm's representatives in the share capital, as well as the effect on the mixing of key roles of BioXpr, the development of a new business model and the recent established partnership with PGC Canada (Performance Group Corportation), a leading expert in change management and interpersonal skills, to transfer, distribute, install and maintain the software "Turbo Pilot ©". This is adding a exciting new page to BioXpr's growing portfolioto develop a new software for bioinformatics.
"BioXpr offers state-of-the-art software solutions to store, extract, analyze, compare and translate in value-added knowledge the ever-expanding amount of data generated from today's high-throughput experiments, clinical trials, bio databases and literature, hence creating an unmatched high-level business intelligence solution for the pharma and the other Life Science R&D sectors.
Our company can deal with diverse and wide-ranging sets of data, from Next-generation Sequencing to Mass spectrometry, from Microarrays to Protein structure.,... Using powerful proprietary algorithms, BioXpr integrate and combine that information to predict and detect biomarkers, to draw up companion diagnostic strategies, and to set up analysis pipelines or data warehousing facilities.
Thanks to our unique business approach and our team of high caliber Bioinformaticians (PhDs combining proven laboratory track records in molecular biology, proteomics, genomics, metabolomics and Neurology with cutting-edge expertise in computer science and statistics), we rapidly succeeded in becoming the preferred bioinformatics partner of many Pharmaceutical, Biotechnology and Agro/Agri-Food companies."
From the company's website (www.bioxpr.com)
- This is the so-called hypothesis of the innovation, which sees in innovation the determining cause for the creation of new companies. Along with the hypothesis of the market, the incubator - and its two derivations, territorial and company - and of the self-employment, the hypothesis of the innovation represents the attempt of some industrial economy studies to explain the phenomenon of company creation in aggregated terms with reference to particular sectors and/or geographical areas. However, most recent studies underline the process of originating the individual companies to confront the theme of company creation. For a detailed review, see Caselli, Gatti (2004).
- The Authors also pointed out that VC funding and patenting are positively related to the arrival of technological opportunities. This causality problem has to be considered when adjusting the research methodology for biases. They suggested that it may disappear once the effect of private equity finance is measured on the patent-R&D ratio rather than on patents per se.
- Even if nothing can be said with certainty, the "block" in innovation after the entry of venture capital may be associated with a mixing of key roles (i.e., a researcher becomes a CEO and has neither time nor resources to carry on his research) and an alteration of major concerns (i.e., financial resources are used to build the sales network rather than continue to innovate).
- It has to be said that the study relies on data from participating companies that chose IPO as exit strategies, mainly for availability reasons. The case for venture capitalists with trade sales as exit strategies may conduct to different results, consistently with the Authors conjecture that, in this case, they may be more interested in keeping or increasing the level of innovation instead of focusing on growth of profits and sales.
- Roughly, venture capital plus buy-out finance.
- Kortum and Lerner, 1998 and 1999.
- Directives 2002/13/EC and 2002/83/EC concern the investment behavior of insurance companies, and directive 2003/41/EC the investment behavior of EU pension funds.
- This is also valid for the case of adverse-selection phenomenon, that is to prevent entrepreneurs to consider venture capital as an option to develop, because of the mismatch with the relevant characteristics for venture capitalists during the pre-screening phase of potential backed companies (Assuming that the financial needs of the entrepreneurial initiative might induce to consider venture capital as an option). In this sense, the most significant variables are: the sector in which it is intended to launch the new initiative, the strategy followed and the preparation level of the potential entrepreneur. For further details, see Caselli, Gatti (2004).
- Turbo Pilot © is a powerfull & user-friendly online collaboration tool resulting of a collaboration with GSK-Biologicals since 1997 in the field of change management.