Venture capital is often referred to as the “money of invention” (see, e.g., Black and Gilson 1998; Gompers and Lerner 1999; Kortum and Lerner 2000), and venture capital fund managers as those that not only provide the money but also other value-added resources to entrepreneurial firms.
Venture capital fund managers play a significant role in enhancing the value of their entrepreneurial investments as they provide financial, administrative, marketing, and strategic advice to entrepreneurial firms, as well as facilitating a network of support for an entrepreneurial firm with access to the best accountants, lawyers, investment bankers, and organizations specific to the industry in which the entrepreneurial firm operates (Sahlman 1990; Sapienza, Manigart, and Vermeir 1996; Gompers and Lerner 1999; Manigart et al. 2002, 2006; Leleux and Surlemont 2003; Wright and Lockett 2003).
In terms of innovativeness (Kortum and Lerner 2000), profitability, and share price performance upon going public (Gompers and Lerner 1999), academic studies have shown that entrepreneurial firms backed by venture capital are on average significantly more successful than entrepreneurial firms that are not.
There are massive differences in the size and success of venture capital markets around the world. These differences have been attributable to differences in share- holder protection (Jeng and Wells 2000), government venture capital funds and other government policies (Jääskeläinen, Maula, and Murray 2007; Keuschnigg and Nielsen 2001, 2003a,b, 2004a,b), bankruptcy laws and capital gains taxes (Armour and Cumming 2006), and the strength of a country’s stock market (Black and Gilson 1998). International differences in the size and success of venture capital and private equity markets are highlighted for select European and North American countries in Exhibit 1.1. As governments around the world recognize that entrepreneurship and innovation are important drivers of economic growth and that venture capital is an important source of capital for entrepreneurship and innovation, there has been a growing interest in rigorous theoretical and empirical analyses of venture capital markets worldwide.
In the 1980s and 1990s, there was comparatively little academic work on venture capital finance. This gap in the literature was largely attributable to a dearth of systematic venture capital data. More recently, however, there have been a growing number of academics that have taken an interest in the topic and have collected systematic data for empirical studies both in the U.S. con- text and abroad.
This empirical work has in turn inspired theoretical analyses of venture capital finance. As at 2009 there are a significant number of academics that have contributed greatly to our understanding of venture capital markets. These studies include, but are not limited to, work on fund-raising and fund structure, the nature of financing agreements with entrepreneurs, exit transactions and returns, impacts on regional development and employment, and international differences that are attributable to public policy, as well as legal and other factors. In view of these significant and rapid developments in the literature, a comprehensive review of the literature in a unified source is not only desirable but indeed essential.
The purpose of this book is to provide a comprehensive view of venture capital by describing the current state of research and practices on this topic. The chapters included here discuss sources of capital (angel investment, limited partnerships, corporate funds, government funds), due diligence, financial contracts and monitoring, the efficiency implications of VC investment, investment returns and performance, international differences in venture capital markets, and regulation and public policy. This book is organized into five parts, which collectively cover each of these areas, as explained below. This brief introduction serves as a roadmap to the range of topic areas.
Part One of this book begins with a review of alternative forms of venture capital. In Chapter 2, Andrew Zacharakis explains some of the unique features of venture capital markets, including how venture capitalists source deals, screen investments, and negotiate deals. The ways in which venture capital finance differs from bank finance is explained by Jean Etienne de Bettignies in Chapter 3.
In Chapter 4, Vladimir Ivanov and Fei Zie explain differences between corporate venture capital funds and limited partnerships. Andrew Wong analyzes differences between venture capital and angel investment in Chapter 5 and focuses on unique features of financing from earlier-stage angel investors.
In Chapter 6, Darek Klonowski analyzes the connection between business incubators and venture capital. Thereafter, Luisa Alemany and Mariarosa Scarlata describe in Chapter 7 the philanthropic model of venture capital, a model that has been significantly growing in importance in recent years as this market segment continues to expand.
Part Two of this book highlights the structure of venture capital investments. Venture capitalists write detailed contracts that separately allocate cash flow and control rights. These contracts have the potential to significantly affect the performance of venture capital–backed firms. Catherine Casamatta and Roberta Dessi in Chapters 8 and 9, respectively, explain how venture capital contracts influence the incentives for venture capital fund managers to monitor and advise their portfolio firms.
In Chapter 10, Dima Leschinskii explains how investment structures and portfolio design for a venture capitalist can influence venture capitalist investment activities and outcomes. In Chapter 11, Dirk De Clercq and Dimo Dimov examine the role of syndication in venture capital, including the rationales for syndication and the implications of syndication for investment performance.
Part Three of this book examines various aspects of the role of venture capitalists in adding value to their investee firms. In Chapter 12, John Hand pro- vides evidence on how venture capital–backed firms mature over time. Empirical evidence on the various things that venture capitalists do to add value to their investees is reviewed in Chapter 13 by Tom Chemmanur, Karthik Krishnan, and Debarshi Nandy. The role of venture capital in stimulating innovation is studied in Chapter 14 by Masako Ueda.
There are significant differences in the reputations of different venture capital funds; the implications of these reputational effects are discussed in Chapter 15 by Rajarishi Nahata. Of course, not all venture capitalists are of sound repute, and sometimes venture capitalists take advantage of their investee firms. These governance issues in venture capital are discussed by Brian Broughman in Chapter 16. Conflicts of interest between venture capitalists and their investees are analyzed in Chapter 17 by Vladimir Atanasov.
Part Four of this book examines drivers of venture capitalists’ returns. Because venture capital–backed firms typically do not have cash flows to pay interest on debt or dividends on equity, venture capitalists seek capital gains by exiting from their investments. The five main exit routes are initial public offerings, acquisitions, secondary sales, buy-backs and write-offs, as explained by Armin Schwienbacher in Chapter 18.
Factors that influence the financial return to venture capital–backed firms are surveyed by Mike Wright and Riya Chopraa in Chapter 19. Whether or not venture capitalist control helps or hinders venture capital–backed firms is empirically studied in Chapter 20 by April Knill.
Finally, Part Five of this book examines international differences in venture capital and the role of public policy. It is worthwhile to provide a comparative perspective on international venture capital markets to understand how and why venture capital markets differ across countries in terms of size and success, and the role of government policy in stimulating venture capital investment and inter- national venture capital investment. Markku Maula explores cross-border venture capital investment activities in Chapter 21.
Unique features of venture capital in Canada are analyzed in Chapter 22 by Cécile Carpentier and Jean-Marc Suret, which is interesting to examine given the large amount of public subsidies in Canada, and the relatively low level of success of those government expenditures. To understand why government-created venture capital programs are difficult to implement in practice, it is useful to have a strong theoretical perspective.
Christian Keuschnigg theoretically examines the role of public policy for stimulating venture capital finance in Chapter 23.3 Finally, practical lessons on the role of government policy in stimulating venture capital and private equity are offered by Gordon Murray and David Lingelbach in Chapter 24.
Specific features of later-stage private equity deals are not covered in this volume, but are covered in The Companion to Private Equity, a related volume published by Wiley in the Companion to Finance Series. There are various other topics related to entrepreneurial finance, and other authors have made important contributions, many of which are highlighted in each of the chapters herein.
Areas where further research is needed are likewise highlighted in each chapter. In view of the empirically documented importance of venture capital in stimulating entrepreneurship, innovation, and economic growth, we hope and expect that venture capital research will help guide the theoretical understanding and practical implementation among students, academics, practitioners, and policy makers alike.