Kiel Institute for World Economics Duesternbrooker Weg Kiel (Germany) Kiel Working Paper No. 1119

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1 Kel Insttute for World Economcs Duesternbrooker Weg Kel (Germany) Kel Workng Paper No Under What Condtons Do Venture Captal Markets Emerge? by Andrea Schertler July 2002 The responsblty for the contents of the workng papers rests wth the author, not the Insttute. Snce workng papers are of a prelmnary nature, t may be useful to contact the author of a partcular workng paper about results or caveats before referrng to, or quotng, a paper. Any comments on workng papers should be sent drectly to the author.

2 Under What Condtons Do Venture Captal Markets Emerge? Abstract Venture captal actvty dffers consderably across countres. Venture captal markets are hghly developed n few countres, whle these markets are almost nonexstent n many other countres. Ths paper examnes the condtons that have to be fulflled for lqud venture captal markets to emerge. Usng a general equlbrum model, two necessary condtons are dentfed. Frst, value added by venture captalsts actve nvolvement must be hgh compared to the costs of management support. Second, the number of hgh-technology enterprses demandng venture captal must exceed a crtcal level. The paper dscusses how dfferences n fnancal and nnovaton systems affect these two condtons. Keywords: Management support, hgh-technology enterprses, venture captal fnance JEL classfcaton: G24, O16, O41 Andrea Schertler Kel Insttute for World Economcs Duesternbrooker Weg Kel, Germany Tel.: +49/431/ Fax: +49/431/ E-mal:

3 1 Introducton Venture captal actvty dffers consderably across countres. Only few countres have hghly developed venture captal markets, such as the Unted States, whle n many other countres, these markets are almost nonexstent. Recent lterature has suggested that the dfferences n venture captal actvty can be explaned by dfferences n the fnancal market structure (Black and Glson 1998), dfferences n corporate governance systems and nnovaton systems (Becker and Hellmann 2000). However, the recent lterature has not dentfed basc condtons necessary for venture captal markets to emerge effcently. The purpose of ths paper s to nvestgate under what basc condtons venture captal markets emerge. Usng a general equlbrum model, t s shown that venture captal markets emerge only f the value-added by venture captalsts actve nvolvement n form of management support s hgh compared to the costs of supportng the management teams of hghtechnology enterprses. Moreover, the model shows that there s a second condton for a venture captal market to emerge: the demand for venture captal by young hgh-technology enterprses must exceed a crtcal level because nnovatve deas are ndvsble. It s argued that ths crtcal level s even hgher f venture captalsts specalzaton on partcular felds of technologes s taken nto account. After dervng these two necessary condtons, the paper dscusses the mpact of varous fnancal market structures and nnovaton systems. Ths paper dvdes nto fve sectons. In the second secton, I gve an overvew of the man ngredents of the model. In the thrd secton, I determne the steady state values analytcally and I derve under what condtons venture captal markets emerge. In the fourth secton, I dscuss the mpact of some addtonal determnants on the emergence of venture captal markets. Secton fve summarzes the man results. 2 Overvew of the Model The model takes nto account the systematc nterdependences between outsde nvestors, venture captalsts, banks, nnovators, and consumers (Fgure 1). The consumers demand hgh-technology products n addton to

4 2 tradtonal products. The development of tradtonal products can be fnanced by bank credts. The development of hgh-technology products s rsky. Venture captalsts can reduce these rsks through management support and, thus, ncrease the expected profts of hgh-technology product developments. 1 In order to produce a tradtonal or hgh-technology product, an entrepreneur must make a start-up nvestment for the development of the respectve product. Ths start-up nvestment s used for research and development actvtes f a hgh-technology product should be developed, and for organzng the busness f a tradtonal product s developed. The entrepreneur has to rase captal n the fnancal market because she does not have the means to fnance the start-up nvestment herself. After successfully establshng the enterprse, both tradtonal and hghtechnology products are produced usng only labour at constant margnal costs. A homogeneous basc product s also produced usng only labour nput to determne the wage rate n the economy. The probablty of a successful development of hgh-technology products, whch s determned by a random varable realzed only after fnancng decsons have been taken and the start-up nvestment has been made, depends on venture captalsts actve nvolvement. Venture captalsts nfluence the probablty of a successful development because they have a comparatve advantage n fnancng hgh-technology products. Ths comparatve advantage s based on the venture captalsts stage- and 1 In the US, venture-captal-backng has a postve mpact on the proftablty of enterprses as ndcated by several emprcal studes For example, Brav and Gompers (1997) fnd that venture-captal-backed enterprses outperform non-venture-captal-backed ones even after the ntal publc offerng (IPO). In the sample of Slcon Valley hghtechnology start-ups analysed by Hellmann and Pur (2000), venture-captal-backed enterprses are lkely to realze frst mover advantages because they brng ther products earler to the market than ther non-venture-captal-backed counterparts. Moreover, evdence found by Meggnson and Wess (1991) suggests that the total costs of gong publc ncludng the underwrters fee are lower for venture-captalbacked enterprses than for ther non-venture-captal-backed counterparts. In addton, n the sample by Kortum and Lerner (2000), venture-captal-backed enterprses take out sgnfcantly more patents than other comparable enterprses.

5 3 technology-specfc knowledge and experence that they need to support the management teams of the hgh-technology enterprses. Tradtonal and hgh-technology products are suppled under monopolstc competton. In the steady state, free entry leads to zero profts n the market for tradtonal products and hgh-technology products: tradtonal and hgh-technology products are sold at average costs. The zero-proft condtons are used to determne the number of tradtonal and hghtechnology enterprses n the steady state. The number of tradtonal enterprses determnes the volume of bank credts, whle the number of hgh-technology enterprses determnes the volume of venture captal. Fgure 1: Overvew of the model Consumers Employees Outsde nvestors Basc product Enterprses produce tradtonal products Bank credts Enterprses produce hgh-technology products Venture captal Venture captalst s management support Resource flows (Payments n the opposte drecton) Product flows (Payments n the opposte drecton) In each perod, the ndvduals, who own the resources n the economy, maxmze ther consumpton utlty that s gven by a love of varety functon. The consumpton utlty functon contans the basc homogeneous product, an aggregate of tradtonal products as well as an aggregate of hgh-technology products. The ndvduals maxmze ther consumpton utlty under the restrcton of ther budget constrant,.e., n the optmum ther ncome s equal to ther consumpton expendtures. The ncome s

6 4 gven by the wage ncome and captal ncome because ndvduals demand, as rsk-averse outsde nvestors, a rsk premum for captal nvested n hghtechnology enterprses. The rsk-less rate of nterest s equal to zero. The consumpton expendtures are gven by the sum of product quanttes multpled by the respectve product prces. In the steady state, the ndvduals ncome s constant and the savng rate s equal to zero. The story behnd ths s as follows. The start-up nvestments are totally sunk after they have been nvested, and each enterprse s actve for only one perod. The enterprses do not have to pay nterests but they have to repay the start-up nvestment, and enterprses producng hghtechnology products addtonally have to pay a rsk premum. The rsk premum s part of the ncome and s thus consumed, whle the start-up nvestments are repad to the rsk-averse outsde nvestors. In the next perod, the outsde nvestors offer ths captal to the next generaton of entrepreneurs for start-up nvestments. Therefore, n the steady state, the ndvduals ncome s constant, and the savng rate of the economy s equal to zero. 3 Condtons for Lqud Venture Captal Markets Consumer Behavour A representatve ndvdual maxmzes the followng consumpton utlty functon that conssts of the basc homogeneous product, an aggregate of tradtonal products and an aggregate of hgh-technology products. The tradtonal and hgh-technology products are aggregated wth a constant elastcty functon (Dxt and Stgltz 1977). The consumpton utlty functon s gven by: [1] U T T ρ ρ β t B ρ ρ t = X B X m X nt, m n β β where s and 0 < β s < 1 denotes the ncome shares of the basc product and the aggregate of tradtonal products, β wth s { B, T} X nt denotes the quantty of a partcular tradtonal product,

7 5 X m denotes the quantty of a partcular hgh-technology product, X B denotes the quantty of the basc homogeneous product, ρ j wth 0 < j < 1 j, t denotes the degree of dfferentaton n the monopolstc market for tradtonal and hgh-technology products, respectvely. The elastcty of substtuton between any two products s dentcal. The elastcty of substtuton ncreases wth the parameter ρ j. If the parameter ρ j would be equal to one (whch I rule out here) the products were perfect substtutes. ρ, { } The representatve ndvdual maxmzes the consumpton utlty functon [1] under the followng budget constrant: [2] pb X B + pm X m + pnt X nt = Y, m n p B denotes the prce of the basc homogeneous product, p nt denotes the prce of a partcular tradtonal product, p m denotes the prce of a partcular hgh-technology product, Y denotes the ncome of the ndvduals. Maxmzng the consumpton utlty under the budget constrant wth respect to the product quanttes and nsertng the ndvduals ncome gves the Marshallan demand functon for a partcular tradtonal product n as a functon of the prces for tradtonal products, the wage rate, the number of ndvduals, and the ncome shares. Snce tradtonal and hgh-technology products have the same ncome share β T, the Marshallan demand functons do not depend on the prce ndex of the respectve other product group suppled under monopolstc competton. The Marshallan demand functons for a hgh-technology product m and for a tradtonal product n are then gven by: [3] X m = β Yp n 1 ρ 1 m ρ ρ 1 p m and X nt = β Yp n 1 ρt 1 nt p ρt ρt 1 nt 1 2, wth β = β B +. βt β B

8 6 Venture Captalsts Role Let me now turn to the role of the venture captalsts n fnancng hghtechnology entrepreneurs before dscussng the proft maxmzaton problem of a hgh-technology entrepreneur. The development of hghtechnology products s uncertan. Entrepreneurs who want to develop a hgh-technology product are successful only wth the probablty ψ. Therefore, the start-up nvestment I s lost wth the probablty 1 ψ. Because of ths uncertanty, enterprses producng hgh-technology products have to repay an amount R that s hgher than the start-up nvestment, whle enterprses producng tradtonal products only have to repay the start-up nvestment snce ths nvestment s not uncertan. The venture captalst s management support ncreases the probablty of a successful development of the entrepreneur s hgh-technology product to ψ > ψ. Supportng the entrepreneur s not costless for the venture captalst. In case he supports an entrepreneur, the venture captalst has to carry costs that amount to C. Each venture captalst maxmzes hs expected profts under the restrcton that the rsk-averse outsde nvestors also offer captal for the start-up nvestments of hgh-technology entrepreneurs n the next perod. Because these nvestments are rsky, the rsk-averse outsde nvestors demand a rsk premum P per hgh-technology entrepreneur that depends on the degree of rsk averson of the outsde nvestors. The hgher the degree of rsk averson of the outsde nvestors s, the hgher the rsk premum must be. Consder a representatve rsk-neutral venture captalst. Ths venture captalst wll support a hgh-technology entrepreneur only f hs expected proft wth management support exceeds hs expected costs wthout management support. If the venture captalst supports the hgh-technology entrepreneur, hs expected proft s gven by: [4] πˆ = I + ψ R C P. If he does not support the hgh-technology entrepreneur, hs expected proft s gven by: [5] πˆ = I + ψ R P.

9 7 In the steady state, competton between venture captalsts wll drve venture captalst s expected proft to zero. Moreover, snce venture captalsts are assumed to be dentcal, they do not dffer wth respect to ther experence accumulated n the past and they do not dffer wth respect to ther reputaton, all venture captalsts do or do not support hghtechnology entrepreneurs n the steady state. The venture captalst and a hgh-technology entrepreneur specfy the level of the repayment R n a contract, whle the venture captalsts management support s not contractble. Ths assumpton s reasonable gven that t would be extremely dffcult for thrd partes, such as courts, to verfy the actual amount of support provded and to determne whether ths amount was adequate. As a result of non-contractblty, the contractually specfed repayment must provde ncentves for management support. There are two possble levels for the repayment n the steady state. If the venture captalst does not support the entrepreneur, ths repayment must be W equal to R = ( I + P) ψ because of the zero-proft condton of the venture captalst s expected profts. If the venture captalst supports the hgh-technology entrepreneur, the repayment must be equal to R = ( I + P + C) ψ. The nvestment strategy of the venture captalst n the steady state depends on the sze of the effect of hs actve nvolvement and on the costs of management support. Does the venture captalst have ncentves to support the hgh-technology entrepreneur f the repayment wthout management support has been contractually specfed? Insertng the repayment wthout management W support R nto the venture captalst s expected proft functon [4] leads to ˆ π = ( I + P + C) + ψ ( P + I ) ψ whch can be smaller or larger than zero dependng on the values of the varables. Only f [6] ( I P) ( I + P + C) ψ > 0 ψ, + the venture captalst would support the hgh-technology entrepreneur even f the repayment n whch the costs for management support s not consdered has been specfed n the contract.

10 8 Does the venture captalst actually support the hgh-technology entrepreneur f the repayment wth management support has been contractually specfed? Insertng the repayment wth management support R n the venture captalst s expected proft [4] leads to πˆ = ψ ( I + P + C) ψ ( P + I ) whch s only smaller than zero f condton [6] holds. Thus, f condton [6] holds, the venture captalst supports the hghtechnology entrepreneur ndependent of whether the repayment wth or wthout management support s contractually specfed. If the repayment wth management support s contractually specfed, the venture captalst has an expected proft that s equal to zero, whle f the repayment wthout management support s contractually specfed, hs expected proft s postve. However, f the condton s not fulflled, a venture captal market on whch fnancal means are offered n combnaton wth management support wll never develop. Whch one of the repayments wll be specfed? In ths smple model of venture captal fnance, the hgh-technology entrepreneur wll always choose the contract wth the lowest repayment because the venture captalst has no addtonal mechansm besde the repayment that he can use to commt hmself to support the hgh-technology entrepreneur after the repayment has been specfed and because of the competton between venture captalsts. Settng the repayment wth management support R = ( I + P + C) ψ smaller than the repayment wthout management W support R = ( I + P) ψ leads to condton [6]. Thus, f condton [6] holds the venture captalst supports the hgh-technology entrepreneur and has an expected proft that s equal to zero. To summarze the venture captalsts behavour: n the steady state, the venture captalsts do not only offer the fnancal means for the start-up nvestments of hgh-technology entrepreneurs but also management support whch ncreases the proftablty of hgh-technology enterprses. In exchange for the start-up nvestment I and ther management support, the venture captalsts demand a repayment R = ( I + P + C) ψ. The repayment s adjusted for the lower probablty of hgh-technology entrepreneurs to fal whch results from the venture captalsts actve

11 9 nvolvement and for the venture captalsts costs whch arse because of management support. Inequalty [6] gves the frst condton that must be fulflled for a lqud venture captal market to emerge. Only f nequalty [6] s fulflled a lqud venture captal market wll emerge snce then the expected proft of a hghtechnology entrepreneur s hgher wth than wthout venture captal and the venture captalst s management support. Put t dfferently, these markets wll develop only f the gan n the success probablty through the venture captalst s management support s substantal compared to the costs of the management support. Entrepreneur behavour Let me now turn to the proft maxmzaton of a hgh-technology entrepreneur. An entrepreneur who wants to start her own hgh-technology enterprse,.e., an enterprse that produces a hgh-technology product, maxmzes her proft and takes the Marshallan demand functon [3] as gven. If the hgh-technology entrepreneur develops her product successfully, she receves postve revenues and repays the venture captalst. If the hgh-technology entrepreneur does not develop her product successfully, her revenues are equal to zero and she repays nothng to the venture captalst. The expected proft of the entrepreneur who wants to develop a hgh-technology product m s then gven by: [7] 0 f unsuccessful ˆ π m =. X R f successful ( pm w) m Snce the venture captalst supports the hgh-technology entrepreneur, the hgh-technology entrepreneur s successful wth probablty ψ. Therefore, the expected proft can be wrtten as: [8] π = ψ ( p w) X ψ R ˆ. m m m The entrepreneur who wants to develop a hgh-technology product maxmzes the expected proft of the enterprse by settng the proftmaxmzng product prce. As usual n ths type of models, the entrepreneur does not consder the mpact of her prce settng behavour on the product

12 10 prce ndex n the Marshallan demand functon (see, for example, Romer 1986). For the optmal product prce, t follows: * 1 [9] pm = w. ρ Hence, the entrepreneur producng a hgh-technology product sells her product at a constant mark-up over the wage rate. Ths mark-up decreases wth the degree of substtuton. In the case of perfect substtutes,.e., ρ = 1, the mark-up would be equal to zero, whle n the case of complementary products,.e., ρ 0, the mark-up would be nfnte. Usng ths optmal product prce, whch s dentcal for all hgh-technology products, we can wrte the expected proft of the hgh-technology entrepreneurs as a functon of the number of hgh-technology enterprses N,.e., of the number of hgh-technology entrepreneurs that are successful. Ths yelds: [10] ψ ( 1 ρ ) Y ˆ m = βn ψ R. π The proft depends postvely on the wage rate, the ncome of the ndvduals, and the degree of dfferentaton and negatvely on the number of hgh-technology enterprses and the level of the repayment. The hgher the wage rate or the ncome of the ndvduals s, the hgher the demand for a partcular hgh-technology product s, and thus, the hgher the product quantty a hgh-technology enterprse can sell. The hgher the degree of dfferentaton,.e., the lower the parameter ρ, between hgh-technology products, the hgher the mark-up per product unt s. Moreover, the hgher the number of hgh-technology enterprses, the more ntensve the competton s, and, thus, the lower the proft s. The ndvduals ncome n the steady state s gven by the wage rate multpled by the number of ndvduals plus the rsk premum per fnanced hgh-technology entrepreneur multpled by the number of hgh-technology * entrepreneurs Y = wl + N FP. The steady state number of hgh-technology entrepreneurs s gven by the number of hgh-technology enterprses dvded by the probablty to be successful N * = * ψ. F N

13 11 The wage rate s determned n the producton of the basc homogeneous product. The basc homogeneous product s produced usng only labour. In partcular, one unt labour s transformed nto one unt of the basc homogeneous product. Therefore, the wage rate s equal to the prce of the basc homogeneous product, whch s set equal to one. In the steady state, free entry of enterprses producng hgh-technology products drves the expected profts n ths market to zero. Settng [10] equal to zero, and nsertng the ndvduals ncome gves the number of enterprses n the market for hgh-technology products as a functon of the exogenous parameters of the model: [11] N * = ψ ( 1 ρ ) L ( I + P + C) β ( 1 ρ )P. Thus, the venture captalsts actve nvolvement affects the steady state number of enterprses producng hgh-technology products because ther actve nvolvement n the form of management support ncreases the probablty of hgh-technology entrepreneurs to be successful. The larger the effect of the venture captalsts actve nvolvement on the probablty to be successful s, the hgher the number of enterprses producng hghtechnology products n the steady state. Free entry n the market for tradtonal products leads to the followng steady state number of tradtonal enterprses: [12] t * ( ρ )( L N P ψ ) t =. βit * 1 + N The demand for venture captal results from the number of hgh-technology entrepreneurs. The number of venture-captal-backed hgh-technology entrepreneurs s hgher than the number of enterprses producng hghtechnology products because not all hgh-technology entrepreneurs are successful. The venture captal demand results from the number of venturecaptal-backed hgh-technology entrepreneurs multpled by the start-up nvestment: [13] V * d = N * F I N I = ψ * = IL( 1 ρ ) ( I + P + C) β P( 1 ρ ).

14 12 As the partal dervatve of the venture captal demand wth respect to the rsk premum ndcates, the hgher the rsk premum, the lower the venture captal demand s because β > 1 > ( 1 ρ ). Lke the start-up nvestments and the venture captalsts costs for management support, the rsk premum s part of the fxed costs of the hgh-technology enterprses. Increasng these fxed costs reduces the number of hgh-technology enterprses that s needed to fulfl the zero-proft condton n ths monopolstc market. Thus, for a hgher rsk premum, fewer hgh-technology entrepreneurs try to start a hgh-technology enterprse. Moreover, the venture captal demand ncreases wth the start-up nvestment. An ncrease n the start-up nvestment has two effects. Frst, each hgh-technology entrepreneur demands more captal, whch ceters parbus ncreases the venture captal demand. Second, an ncrease n the start-up nvestment ncreases the fxed costs of each hgh-technology enterprse and, thus, reduces the optmal number of hgh-technology enterprses and, therefore, the number of hgh-technology entrepreneurs demandng venture captal. In ths model, as ndcated by the partal dervatve of equaton [13] wth respect to the start-up nvestment, the frst effect s larger than the second one. The venture captal demand ncreases wth the sze of the economy (wth L ) because the larger the economy s, the more hgh-technology products are demanded. By contrast, the venture captal demand decreases wth the costs of venture captalsts management support, whch ncrease the fxed costs of the hgh-technology enterprses, and wth the dfferentaton parameter because the more the hgh-technology products can be substtuted (the hgher the parameter ρ ), the lower the number of hghtechnology enterprses s that fulfls the zero-proft condton n ths monopolstc market. The second condton for the emergence of lqud venture captal markets results from the number of hgh-technology enterprses n the steady state. Venture captal markets wll develop only f the demand for venture captal s suffcently hgh,.e., f the optmal number of hgh-technology enterprses gven by equaton [11] s at least equal to one. Ths s because the number of hgh-technology enterprses s nteger constrant and less than one hgh-technology enterprse cannot be started. Usng equaton [11],

15 13 one can derve a condton under whch the agents of the economy,.e., the hgh-technology entrepreneurs and the venture captalsts, have ncentves to establsh a market for venture captal. Settng equaton [11] larger and equal to one and solvng for the number of ndvduals results n: [19] L ( I + P + C) β ( 1 ρ ) ψ ( 1 ρ ) P. Thus, only f the number of ndvduals s suffcently large (the rght-hand sde of ths nequalty s postve because β2 > 1 > ( 1 ρ )), a venture captal market wll develop. Assumng that [19] holds wth equalty, one can analyse how the parameters on the rght-hand sde affect the number of ndvduals n the economy that s necessary for the geness of venture captal markets. The partal dervatve ndcates that the hgher the start-up nvestment, the costs of the venture captalsts to support the management, or the rsk premum for the outsde nvestors s, the hgher the number of ndvduals for the geness of venture captal markets must be. Fgure 2 explans the reason for the postve relatonshp. The two sold lnes n Fgure 2 depct the proft wthout fxed costs and the fxed costs of a hgh-technology enterprse. For a venture captal market to develop, the ntersecton of these two lnes must result n a number of hghtechnology enterprses that s at least equal to one. An ncrease n the startup nvestment ceters parbus reduces the number of hgh-technology enterprses from one to less than one because the hgher the start-up nvestment s, the lower the number of enterprses n the monopolstc market must be that drves the profts of the hgh-technology enterprses to zero. Wthout changng the proft of the hgh-technology enterprse, a venture captal market would never develop because the optmal number of hgh-technology enterprses (whch results from the ntersecton of the proft wthout fxed costs and the fxed costs) s smaller than one. In order to ncrease the number of hgh-technology enterprses, the proft wthout fxed costs of the hgh-technology enterprse must be ncreased, and ths can be done wth an ncrease n the number of ndvduals.

16 14 Fgure 2: Revenue and fxed costs of hgh-technology enterprses Increase n the number of ndvduals Increase n the start-up nvestment Fxed costs Proft wthout fxed costs 1 Number of enterprses What about a change n the ncome shares used for the basc homogeneous good β B or for tradtonal and hgh-technology products β T? Remember that β = β B βt + 2. An ncrease n the ncome share that s used for tradtonal and hgh-technology products β T reduces the number of ndvduals requred for the geness of venture captal markets. The reason for ths s that the hgher the ncome share β T, the hgher the proft wthout fxed costs of the enterprses producng hgh-technology products s and, thus, the lower the number of ndvduals must be. The hgher the parameter whch specfes the degree of dfferentaton between hgh-technology products ρ, the hgher the number of ndvduals must be to fulfl the condton whch ensures the geness of venture captal markets. The degree of dfferentaton affects the proft of the hghtechnology enterprses. The better hgh-technology products can be substtuted, the lower the profts of the hgh-technology enterprses are. Ths effect ceters parbus lowers the optmal number of hgh-technology enterprses.

17 15 4 Addtonal Determnants The model presented above captures the behavour of the man agents actng on venture captal markets, such as hgh-technology entrepreneurs, venture captalsts, and outsde nvestors supplyng ther captal to venture captal funds. However, the model does not consder explctly some mportant aspects that affect the geness of venture captal markets. The two most mportant aspects seem to be the determnants of a suffcent venture captal demand by young hgh-technology enterprses, and stock markets for shares of young hgh-technology enterprses. 2 These aspects are to be dscussed n the followng. Venture captal markets wll emerge only f venture captal demand s suffcently large. Factors affectng the level of the venture captal demand are the nnovaton clmate, the wllngness and economc ncentves of the ndvduals to share control, 3 and the prce for management support and montorng of the venture captalsts. Whether an economy has a suffcent nnovaton potental for a lqud venture captal market depends n turn on a multtude of determnants whch are certanly not of statc nature and whch are to some extent nterdependent. Let me gve two examples. Frst, the nnovaton potental for a lqud venture captal market depends on the nnovaton system: The more n-house the research and development actvtes are, the less lkely the development of a venture captal market s. However, the less developed fnancal markets are, the more lkely are n-house research and 2 Moreover, polcy-nduced barrers embedded n tax law and regulatons of factor and good markets affect substantally the geness of venture captal markets because they nflate the user costs of venture captal (Schertler and Stolpe 2000). These polcynduced barrers affect the venture captal demand, the venture captal supply or the volume of experenced venture captalsts. For example, labour markets can be regulated n such a way that ndvduals have low ncentves to become hghtechnology entrepreneurs or actve nvolved fnancal ntermedares. Tax laws can undermne the supply of venture captal by outsde nvestors f rsk-less assets are more favourable than nvestments n rsky assets. 3 Mayer (2001) argues that the structure of nsttutons and the actvtes n the hghtechnology sector are related. Europe has opted for hgh levels of nvestor protecton and ths s not stmulatng the growth of hgh-technology enterprses.

18 16 development actvtes. Second, the nnovaton potental depends on the number of ndvduals generatng deas. Ths number n turn s affected by the desgn of the unversty system: the more creatveness and ndvdualsm a unversty system ntates, the hgher the number of ndvduals wth hgh-technology deas mght be. The prce for management support and montorng of venture captalsts can be prohbtvely hgh so that the demand s too low for a venture captal market to develop. The prce for management support and montorng s prohbtve f regulatons prevent venture captalsts to be actvely nvolved n the enterprses they fnance. Only f venture captalsts have exclusve control rghts n the enterprses, they are capable of ntervenng n the busness poltcs and by dong so they are capable of ncreasng the expected proft of the enterprses and, thus, of ther partcpatons. I have argued above that the demand for venture captal must exceed a mnmum level because hgh-technology deas are ndvsble. Ths restrcton s weak compared to the one requred for endogenous specalzaton of the venture captalsts. To put t dfferently, the demand for venture captal and, thus, the number of hgh-technology enterprses must be so hgh that venture captalsts can endogenously focus ther nvestments on partcular stages of enterprses development and/or on partcular technology areas. Amt et al. (1998) argue that due to specalzaton, venture captalsts have a comparatve advantage n the selecton and montorng of hgh-technology enterprses compared to other fnancal ntermedares. Therefore, f the technology sector as a whole s too small, or f hgh-technology deas are dspersed over a wde range of technology felds so that venture captalsts cannot specalze and cannot accumulate technology-specfc experence, one cannot expect a lqud venture captal market to develop. The second aspect that affects the geness of a lqud venture captal market s stock markets for shares of young hgh-technology enterprses. Fnancal systems are dstngushed n bank-based and stock market-based systems. 4 4 For a comparson of dfferent fnancal systems see Allen and Gale (1995), Demrgüc-Kunt and Levne (1999), Allen and Gale (2000), Carln and Mayer (2000).

19 17 For example, n Germany, large banks are the major players, whle, n the US, shareholders play an mportant role. Therefore, the German system s often called a bank-based system, whle the US system s called stock market-based. Both systems have advantages as well as dsadvantages. However, the bank-based systems seem to have more dsadvantages wth respect to fnancng hgh-technology enterprses especally because the control mechansms of banks do not work well n the case of hghtechnology enterprses. Hgh-technology enterprses that nvest a large share of ther captal nto research and development actvtes cannot offer collateral. Thus, collateral s not at bank s dsposal as a selecton mechansm. Addtonally, bank managers are less lkely to have the experence to select the most promsng hgh-technology enterprses. Offerng a sngle prce for all qualtes of hgh-technology enterprses wthout actve selecton would lead to a market falure smlar to the one presented by Akerlof (1970) for the car market and Stgltz and Wess (1981) for credt markets. Black and Glson (1998, 1999) argue that a lqud stock market offers venture captalsts and hgh-technology entrepreneurs the opportunty to enter nto an mplct contract over control. Snce an IPO gves the entrepreneur the opportunty to re-acqure control at least partly, the entrepreneur has lower ncentves for opportunstc behavour. Moreover, f entrepreneurs have the opportunty to re-acqure control, they are more nterested n venture captal fnance. In terms of the model presented above ths means that a lqud stock market can ncrease the demand for venture captal because t lowers the transacton costs of hgh-technology entrepreneurs. In addton, the presence of lqud stock markets for shares of hghtechnology enterprses can support the development of an approprate skll composton necessary for venture captal markets to develop. Lqud stock markets have a postve mpact on the number of ndvduals n an economy who have some basc experence. Entrepreneurs who sell ther enterprses on a stock market for fast-growng enterprses have hands-on experence n managng an enterprse, they have a comprehensve knowledge about a partcular technology area, and they have a basc experence about how to go publc. These entrepreneurs seem to be natural canddates for becomng

20 18 venture captalsts who offer management support n addton to fnancal means. However, Becker and Hellmann (2000) argue that the exstence of a lqud stock market 5 s a necessary but not a suffcent condton for the development of venture captal markets. 6 For a venture captal market to develop, approprate corporate governance structures must be developed that protect outsde nvestors and shareholders suffcently. Complementary changes n corporate governance and entrepreneurshp can be necessary especally f the fnancal system s bank-based. New theores on corporate governance n general emphasze the mportant role of complementartes between varous nstruments such as payment systems, owner structure, and captal structure (Henrch 2002). The corporate governance structures of venture captal markets are complex because of the relatonshp between outsde nvestors and venture captalsts, on the one hand, and because of the relatonshp between venture captalsts and hgh-technology entrepreneurs, on the other. In both relatonshps, corporate governance nstruments are used to solve substantal ncentve problems (Schertler 2001). It seems that corporate governance nstruments used n the relatonshp between venture captalsts and entrepreneurs are also complementary to the ones used n the relatonshp between venture captalsts and outsde nvestors. 5 However, for a venture captal market to develop, the lqud stock market has not to be a domestc one as the success of the Israel venture captal market suggests (Rock 2001, 2002). The ext of Israel venture-captal-backed enterprses s on the NASDAQ. But t must be questoned whether ths ext strategy s also possble n a smlar way for enterprses from other countres. Ths does not seem to be the case because the nvestor communty vews Israel venture-captal-backed enterprses gong publc as regular, Slcon Valley technology enterprses (Rock 2002). 6 Becker and Hellmann (2000) study the falure of the German WFG. They fnd evdence that the leadng German banks, whch were the founders of the WFG, were more nterested n ther reputaton and n enterprses already fnanced than n the selecton of new enterprses.

21 19 VI Summary The model that has been used to analyse under what condtons venture captal markets emerge has captured the man agents that are actve n these markets: venture captalsts, entrepreneurs, and outsde nvestors. Venture captalsts nvest management support n addton to fnancal means n hgh-technology enterprses. Venture captalsts management support ncreases the probablty of entrepreneurs to be successful and, thus, the expected proftablty of the hgh-technology enterprses. Venture captalsts do not nvest ther own fnancal resources; they have to rase captal from outsde nvestors. Outsde nvestors supply captal at a constant rsk premum to venture captal funds. Wth ths model, two condtons have been dentfed whch must be fulflled for a venture captal market to emerge. These two condtons can explan why venture captal actvty dffers substantally across countres. Frst, venture captal markets emerge only f the value-added by venture captalsts actve nvolvement n form of management support s hgh compared to the costs of ths management support. To put t dfferently, only f venture captalsts can add value that cannot be generated by entrepreneurs themselves, venture captal fnance wll emerge. Second, the demand for venture captal by young hgh-technology enterprses must exceed a crtcal level. Ths crtcal level s determned by the ndvsblty of nnovatve deas and by the specalzaton of venture captalsts on partcular felds of technologes. Moreover, t has been argued, that the emergence of lqud venture captal markets depends on nnovaton and fnancal systems. The lower the nnovaton potental of an economy, or the lower the wllngness of entrepreneurs to share control, the lower the demand for venture captal wll be. Moreover, transacton costs determne venture captal actvtes: governance structures and contract law may have a sgnfcant mpact. For example, the demand of venture captal could be extraordnarly low f regulatons do not allow venture captalsts and hgh-technology entrepreneurs to sgn contracts that allow venture captalsts to take on an actve role n hgh-technology enterprses.

22 20 Lqud stock markets for shares of fast-growng enterprses affect venture captal actvty through three channels. Frst, they allow venture captalsts and entrepreneurs to enter nto mplct contracts over control. Ths ncreases the demand for venture captal. Second, venture captalsts can buld reputaton for fnancng hgh-technology enterprses successfully through usng stock markets as an ext channel for ther partcpatons. Thrd, lqud stock markets can have a postve mpact on the number of ndvduals who have experence to support young hgh-technology enterprses. References Akerlof, G.A. (1970). The Market for "Lemons": Qualty Uncertanty and the Market Mechansm. Quarterly Journal of Economcs 84 (9): Allen, F., and D. Gale (1995). A Welfare Comparson of Intermedares and Fnancal Markets n Germany and the US. European Economc Revew 39 (2): ). and (2000). Comparng Fnancal Systems. Cambrdge, MA: The MIT Press. Amt, R., J. Brander and C. Zott (1998). Why do Venture Captal Frms Exst? Theory and Canadan Evdence. Journal of Busness Venturng 13: Becker, R., and T. Hellmann (2000). The Geness of Venture Captal: Lessons from the German Experence. Research Paper Graduate School of Busness, Stanford Unverversty. Stanford, CA. Black, B.S., and R.J. Glson (1998), Venture Captal and the Structure of Captal Markets: Banks versus Stock Markets. Journal of Fnancal Economcs 47 (3): and (1999), Does Venture Captal Requre an Actve Stock Market? Journal of Appled Corporate Fnance Brav, A., and P. Gompers (1997). Myth or Realty? The Long-Run Underperformance of Intal Publc Offerngs: Evdence from

23 21 Venture and Non Venture Captal-Backed Companes. The Journal of Fnance 52 (5): Carln, W., and C. Mayer (2000). How Do Fnancal Systems Affect Economc Performance. In X. Vves (ed.), Corporate Governance: Theoretcal and Emprcal Perspectves. Cambrdge: Cambrdge Unversty Press. Demrgüç-Kunt, A., and R. Levne (1999). Bank-Based and Market-Based Fnancal Systems. Polcy Research Workng Paper The World Bank, Washngton, D.C. Dxt, A.K., and J.E. Stgltz (1977). Monopolstc Compettton and Optmum Product Dversty. The Amercan Economc Revew 67 (3): Henrch, R.P. (2002). Complementartes n Corporate Governence. Kel Studes 316. Tübngen: Mohr Hellmann, T., and M. Pur (2000). The Interacton between Product Market and Fnancng Strategy: The Role of Venture Captal. The Revew of Fnancal Studes 13 (4): Kortum, S., and J. Lerner (2000). Assessng the Contrbuton of Venture Captal to Innovaton. The Rand Journal of Economcs 31 (4): Mayer, C. (2001). Fnancng the New Economy: Fnancal Insttutons and Corporate Governance. Dscusson Paper 2001/4. World Insttute for Development Economcs. Helsnk: WIDER. Meggnson, W.L., and K.A. Wess (1991). Venture Captalst Certfcaton n Intal Publc Offerngs. The Journal of Fnance 46 (3): Rock, E.B. (2001). Greenhorns, Yankees and Cosmopoltans: Venture Captal, IPOs, Foregn Frms and U.S. Markets. Unversty of Pennsylvana Law School Research Paper (2002). Comng to Amerca? Venture Captal, Corporate Identfy and U.S. Securtes Law. Unversty of Pennsylvana Law School Research Paper Romer, P.M. (1986). Increasng Returns and Long-Run Growth. Journal of Poltcal Economy 94:

24 22 Schertler, A. (2001). Venture Captal n Europe's Market: A Quanttatve Descrpton. Workng Paper Unted Natons Unversty, Maastrcht. Schertler, A., and M. Stolpe (2000). Venture Mana n Europe: Its Causes and Consequences. Kel Dscusson Papers 358. Kel Insttute for World Economcs, Kel. Stgltz, J.E., and A. Wess (1981). Credt Ratonng n Markets wth Imperfect Informaton. Amercan Economc Revew 71 (3):

Kiel Institute for World Economics Duesternbrooker Weg 120 24105 Kiel (Germany) Kiel Working Paper No. 1120

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