Human Capital and Innovation - Chris Parrish Dissertation Summary

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1 Human Capital and Innovation - Chris Parrish Dissertation Summary DISSERTATION QUESTION What role does human capital accumulation have in innovation? For example, are there informational advantaes for firms where venture capital (VC) is provided by VCs specializin in the firm's industry or product type? Is there a build-up of human capital at small/nascent firms associated with "knowledeable" VC companies, and are those businesses more likely to have reater commercialization success, includin initial public offerins? EMPIRICAL APPROACH The dissertation seeks to further the literature on the relationship between human capital and innovation. Specifically, there are three dimensions of firm innovation that may be analyzed: 1. likelihood of commercialization of a technoloy 2. likelihood of receivin external fundin to support the commercialization of the technoloy (e.., venture capital), and 3. whether an initial public offerin resulted from the commercialization of the technoloy The foundation for this analysis is the role of human capital (e.., education and/or experience) in facilitatin success in the development of technoloy. The expectation is to test this relationship econometrically usin data related to the Small Business Innovation Research (SBIR) proram. Those data are readily available for more than 1800 technoloy-based projects undertaken in U.S. firms from 1992 throuh The form of the dissertation is expected to be a modified unified format that includes a literature review related to human capital formation and innovation, which motivates three distinct empirical analyses. PERSONAL MOTIVATION FOR TOPIC Experience as entrepreneur and in structurin financin arranements has led to a keen interest in evaluatin the relationship between risk takin, skill set development, financin, and product innovation.

2 Bank of America Merrill Lynch Senior Vice President Risk Manaement Christopher (Chris) L Parrish, CFP 9903 Liberty Bell Court Charlotte, NC p: chris@parrishhouse.net WORK EXPERIENCE * Operational Risk Manaer over Corporate Investments, Treasury, Private Equity and Corporate Stratey. * Identify and manae operational risks, includin key process, systems, people and external risks. * Continuously challene businesses and drive chane to achieve operational risk manaement excellence. * Review and audit the Credit and Market Risk functions within the businesses to identify emerin risks as well as project manain tareted reviews, includin VaR methodoloy and enterprise stress testin. ReSupply Industries, Inc Executive Director * Established 501(c)3 not-for-profit corporation to help local non-profits reduce operatin costs. * ReSupply diverts office supplies that are bound for landfills to non-profits, free of chare. * Maintain relationships with 50+ non-profit oranizations and numerous individual and corporate donors. * Execute business plan, includin Infrastructure, Development, Outreach and Website. Parrish Wealth Plannin, LLC Founder, Owner and Wealth Manaer * Founded and manaed an independent Reistered Investment Advisor (RIA), which provided fee-only financial plannin, customized asset allocation and investment manaement services to clients. * Sourced assets throuh referrals and manaed investments based on individualized investment policies. * Performed all duties related to maintainin RIA status, includin compliance and reulatory requirements, settin policies and procedures and record keepin. Columbia Manaement Advisors Director Senior Research Analyst * Performed buy-side fundamental credit research, includin due dilience, financial analysis, cash flow modelin and relative value analysis to support buy/sell recommendations. * Published research to traders, portfolio manaers, senior manaement, clients and fund board of directors. * Created comprehensive database of financial and asset performance information to supplement research. * Six Sima Green Belt project resulted in a US patent for a new Credit Research Measurement process. Banc of America Securities Principal Global Markets * Senior Risk Manaer coverin credit risk within the Securitization Finance and Structured Rates units. * Reviewed, approved and risk manaed structured loans and rates provided to bank clients. * Precedin role of Deal Team Leader in Securitization Finance business. * As Deal Team Leader, performed all aspects of loan oriination, includin due dilience, neotiatin terms, structurin credit support and manain the documentation process and monitored performance. * Bean bank as a quantitative modeler usin SAS to build loss forecastin models in an effort to develop a framework to manae losses within the asset securitizations and consumer product lines. Wells Faro Securities Junior Research Analyst Fixed Income Moody s Investors Service Business Analyst Financial Services EDUCATION & CERTIFICATIONS * Master of Science in Economics, University of North Carolina at Charlotte (1997) * Bachelor of Science in Business Economics, Appalachian State University (1992) * CERTIFIED FINANCIAL PLANNER * Six Sima Greenbelt * Inventor, US Patent 7,720,753 B1 - Quantifyin the Output of Credit Research Systems

3 Human Capital and Innovation - Chris Parrish Dissertation DRAFT INTRODUCTION Firms that are in the process of researchin or developin a new product may find fundin a sinificant problem and impediment to success. In many cases, the cost of research and development (R&D) can become so lare that a firm may simply run out of money and resources before it can brin the product to the point of realizin income or commercialization. Even if the product is thouht to have material commercialization potential, lack of access to continued fundin can preclude any meaninful outcome from R&D. Given the hih cost of R&D, firms are left with a minimal set of choices in determinin how to fund their product R&D. Additionally, fundin sources are evolvin due to chanin market conditions, chanes in fundin infrastructure, and overnment support. Broad cateories of fundin R&D include traditional bank and alternative lendin, peer-to-business fundin, private equity (includin venture capital), and public-private partnerships, such as the Small Business Innovation Research (SBIR) proram. In evaluatin the fundin options of their firms, manaers must consider the costs and benefits associated with each fundin option. A key consideration for firms when seekin fundin is the benefit from advice, uidance and counselin available when enain a potential lender or investor. In particular, venture capital fundin, which is enerally an arranement where a venture capitalist provides a certain amount of money in return for an ownership interest in the firm, can result in an infusion of business knowlede from the venture's principals. The incremental knowlede that a firm obtains throuh a venture capital arranement may increase the overall human capital of the firm and the chances of product commercialization. A VC's participation in a firm could also be a positive sinal of future success as VCs draw upon their own human capital to sort potential investments and invest in firms where they expect the hihest returns.

4 A theoretical model is developed within the paper to illustrate this transfer and the choices that a firm faces with respect to venture capital participation. There is an assumed benefit to production (commercialization) from knowlede transferred from venture capital firms and that both firms and their venture capital investors will seek to find an equilibrium that maximizes their respective utilities. The remainder of the paper is oranized as follows: Section 1 provides a literature review on the intersection of human capital and innovation, how human capital may manifest itself within fundin options available for firms with nascent products, and initial public offerin activity of entrepreneurial firms; Section 2 outlines a theoretical model of the choices a firm faces in fundin R&D with a particular focus on the potential transfer of knowlede from venture capitalists and accumulation of human capital at the firm; and Section 3 lays out the empirical models to analyze the relationship between the build-up of human capital and commercialization success. SECTION 1: LITERATURE REVIEW HUMAN CAPITAL AND INNOVATION Human capital is a broad term that encompasses the cumulative amount of "knowhow" associated with and individual (or roup/unit) which is enerally acquired throuh education, experience, trainin, mentorin or some other source. Innovation is enerally considered the commercialization of a technoloy or some other new knowlede. [literature review to be completed with focus on intersection of human capital and innovation] FIRM FUNDING OPTIONS AND VENTURE CAPITAL While not exhaustive, there are four broad cateories of fundin options for firms to fund their R&D: traditional bank and alternative lendin, peer-to-business fundin, private equity and public-private partnerships. Other potential sources include other cash on hand, rants or awards from foundations or other non-profits, and tax incentives, but since firms are enerally

5 seekin to obtain loner-term, sustainable sources of fundin for R&D and may not have profits from which tax incentives are useful, the discussion is enerally limited to the aforementioned list of fundin options. A. Traditional Bank and Alternative Lendin While securin a loan from a local bank to fund a start-up company's new product is difficult, the traditional bank lendin route may be feasible for those firms who have a track record in their business and are seekin to finance their next product. Small Business Administration loans or asset-based loans are potential options under certain circumstances, but for the majority of small firms seekin to fund R&D for a new or sinificant product, bank lendin may not be the best alternative. Further, obtainin loans from a third party is not likely to provide meaninful additional human capital as small business lenders are not typically industry experts. However, there are aps in the lendin business that have drawn interest from alternative lendin firms. Firms like OnDeck, which provides small business lendin, and Opportunity Fund, a non-profit microlender, have been born out of the notion that small business lendin is underserved. Unfortunately, loans from these types of alternative lenders may not be available on a lare enouh scale and at reasonable enouh interest rates to justify the hassle and expense of assemblin multiple sources to fund R&D. Additionally, similar to traditional bank lendin, the firms seekin R&D fundin are likely not eneratin any incremental human capital benefit from enain with alternative lenders. B. Peer-to-Business Fundin Peer-to-business fundin is a colloquial term to describe financial transactions between entities (usually individuals) willin and able to invest or lend and those businesses seekin funds. This sector is also enerally referred to as "crowdfundin" or "crowdlendin." Crowdfundin and crowdlendin are relatively new channels for businesses and provide an intriuin and potentially sinificant source of capital for firms seekin to find relatively quick and easy fundin solutions.

6 With roots in raisin money to support creative endeavors, crowdfundin has quickly evolved to become a source of capital for innovative business prospects. The success of the firm Oculus Rift, which was initially funded throuh Kickstarter and later acquired by Facebook, is widely cited as an example of the power of crowdfundin (Profatilov 2014). Furtherin potential rowth of small firm fundin is the pendin implementation of the CROWDFUND Act section within the Jumpstart Our Business Startups (JOBS) Act of Currently, the JOBS Act allows only investors of a certain net worth to acquire equity in companies via crowdfundin. However, subject to further SEC review, the JOBS Act allows for equity-based participation by the eneral public in "fundin portal" channels, such as AnelList or Crowdfunder. If implemented as written, firms can raise up to $1 million throuh this method of solicitation and up to $50 million under a streamlined public issuance. Althouh the rules are not yet final, the ability of firms to tap into sinificant capital directly from the eneral public could be a transformative development that blurs the line between crowdfundin and traditional venture capital. Accordin to Crowdnetic, a data areation source for the crowdfundin industry, the amount of capital raised (measured in capital commitments) from 4Q14-4Q15 (5 quarters) is $482.5 million coverin 5,122 offerins. Source: Crowdnetic

7 Crowdlendin is not a new concept, but the infrastructure to seek out lendin options has chaned materially over the past few years. Companies such as Lendin Club and Prosper provide platforms to link borrowers with lenders. While initially structured for peer-to-peer lendin, the platforms have expanded to offer business loans. For those businesses seekin a loan throuh this channel, these intermediaries provide a mechanism to allow lenders to customize a loan portfolio by reviewin terms of the borrower, and businesses seekin a loan may be able to appeal to a wider pool of lenders. From the borrower's perspective, there is one lender to which payments are made, which creates a seamless transaction. From the lender's perspective, they are issued reistered notes by the issuin entity and payments are deposited directly into their online account. While crowdlendin may row to be a more formidable competitor to other types of lendin options in the future, the amounts enerally available throuh this channel are not likely at a level necessary to fund R&D. Peer-to-business fundin platforms are clearly rowin and may become a truly important source of R&D fundin. As it stands today, however, crowdfundin/crowdlendin are not natural options for firms seekin loner-term financin. As well, it is unlikely this particular channel would yield any increase in human capital by transactin. Nonetheless, this channel is an important area to explore in the future to evaluate its potential impact on innovation and commercialization. C. PRIVATE EQUITY Private equity is a broad cateory of investin that includes, but is not limited to, full company purchases (throuh debt, equity or a combination), anel investin and venture capital. Generally, both anel investin and venture capital focus on purchases of equity in businesses seekin to fund activities related to a new innovation or product. Anel investors, who may be individuals or families, may have more flexibility in timin or repayment while venture capitalists enerally have specific investment oals and return expectations over a set period time. Further, venture capitalists often look to the public stock market to monetize their investments. With volume, this disciplined approach allows venture capital firms to potentially

8 acquire key industry expertise related to product development and commercialization. As such, for firms seekin R&D fundin, venture capital is an appealin source of both information and capital. Venture capital, which is enerally fundin provided to firms in exchane for some amount of private equity ownership, has been a sinificant source of capital to firms where traditional financin sources, such as public equity and debt-financin, are limited or not available. The amount of available venture capital and the types of firm in which capital is deployed varies considerably. Accordin to The MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association based on data from Thomson Reuters, the amount of venture capital invested in 2014 was over $48 billion in 4,356 deals. While software is the clear leader in venture capital fundin, total investments in the biotechnoloy industry are the next larest. Industry 2014 Biotechnoloy 5,966,376,500 12% Business Products and Services 377,092,800 1% Computers and Peripherals 1,456,265,900 3% Consumer Products and Services 2,230,140,400 5% Electronics/Instrumentation 694,643,700 1% Financial Services 1,068,473,400 2% Healthcare Services 360,187,000 1% Industrial/Enery 2,406,730,600 5% IT Services 3,259,005,500 7% Media and Entertainment 5,747,918,500 12% Medical Devices and Equipment 2,661,741,400 6% Networkin and Equipment 467,742,700 1% Other 6,150,000 0% Retailin/Distribution 789,905,300 2% Semiconductors 727,936,000 2% Software 19,803,561,000 41% Telecommunications 324,715,700 1% Grand Total 48,348,586, % Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree Report, Data: Thomson Reuters

9 While recent venture capital investments have been the stronest since the early 2000's, returns on venture capital are a mixed story. Cochrane (2005) found returns to vary sinificantly iven selection bias since it is common for venture capitalists to spread out their risk amon a portfolio of investments, due to overall hih level of failures. Further, Gompers et al. (2008) assert that investments can be influenced by several factors, such as venture capital firm experience and IPO valuations, which creates a level of cyclicality with this type of fundin source. It is precisely this type of selection by venture capital firms that can provide small firms with a key informational advantae. It is very typical for venture capital firms to invest as well as participate in the manaement of the firms in which they take an equity position (enerally in the form of a board position(s) and/or special consultant). Thus, start-up firms with venture capital financin often find access to skilled individuals who may provide critical information transfers to firms, thereby buildin start-up firms' overall human capital and potentially increasin the likelihood of commercialization success. Offsettin that advantae to some extent is the historically hih failure rate of firms with venture capital financin (vs. those with loner-term fundin - Lerner 2002) as well as wide variations in the rate of innovation. The potential for this outcome could have material implications if policymakers hold a view that innovation is necessary to enerate economic rowth. If there are uncertain returns in venture capital iven the relatively hih rate of venture capital firm failures, then the natural question is whether venture capital financin works for all parties. D. PUBLIC-PRIVATE PARTNERSHIPS There are multiple mechanisms to promote innovation and the acceleration of commercialization by the federal overnment. To expand R&D research, the overnment can support universities and research centers, use the tax code to stimulate private sector R&D spendin, and provide direct overnment fundin in a private-public partnership arranement.

10 One of the initial moves by the U.S. overnment to accelerate commercialization was passin leislation (Bayh-Dole Act of 1980 and the Stevenson-Wydler Act of 1980) to promote the movement of existin research and innovation into the private sector. Althouh this leislation was aimed at universities and overnment aencies and not in direct support of private sector R&D, it spurred the creation of Technoloy Transfer Offices across the U.S. university system and National Laboratories, advancin the awareness and potential of financial incentives to promote commercialization from the overnment. Empirically, analyses evaluatin the effectiveness of the leislation shows mixed results, however. Mowery et al. (2001), Mowery and Sampat (2005), Jaffe et al. (1998), Jaffe and Lerner (2001) and Link et al. (2011), enerally find that while patentin and licensin activity increased after 1980, there is not clear evidence of a correlation between passae of the leislation and knowlede transfer, which would presumably lead to commercialization. To expand private R&D, the overnment enacted the Research and Experimentation (R&E) Tax Credit in 1981, which initially provided partial credits on incremental research and was later expanded to accommodate smaller firms with no meaninful base of R&D. The motivation for the credit is based on the theory that tax credits are market neutral (as companies can decide whether or not to enae versus direct overnment fundin that is more tareted and potentially favors certain industries or technoloies) and thus can provide an indiscriminate incentive to potentially increase research investments. Bozeman and Link (1984) reviewed tax incentives as policy tools for increasin R&D spendin and found that tax incentives can be one of several tools to stimulate spendin, but it is not likely a viable sinular tool. Additionally, Tassey (2007) and Atkinson (2007) assert the structure and the implementation of any tax credits can mute or distort any potential benefits. They both make aruments about the efficacy of the R&E Tax Credit, and while they take somewhat opposin views of its current impact, both suest sinificant chanes to the credit in order to increase private sector R&D spendin. Overall, tax credits are one tool available for private companies to fund their research and product development, but they likely do not provide the key loner-term sustainable fundin necessary to brin a lare scale project to commercialization.

11 The overnment has also been involved with supportin private sector advancement in R&D throuh accommodative policy and direct financial support. Prorams such as the National Cooperative Research Act (NCRA) of 1984 (and further amended) and the American Technoloy Preeminence Act of 1991 were implemented to relax certain leal restrictions around research participation by private firms and provide direct fundin for joint research ventures, respectively. Link and Scott (2001) reviewed the impact of public/private partnerships and showed that social returns were hiher under the partnership than would have been otherwise. These results imply it is possible for small firms that participate in strateic ventures and partnerships to reap benefits not only for themselves but also can increase social rates of return. While participatin in research joint ventures can increase overall knowlede throuh collaboration, there are risks of spillover effects which can diminish firm-specific benefits. In the case of firms seekin R&D fundin to support commercialization of a product, joint ventures may not provide the same level of human capital accumulation as throuh direct support, such as venture capital participation. Incorporatin the potential informational advantaes of venture capital with public/private partnerships is the Small Business Innovation Research (SBIR) proram (and similar but smaller Small Business Technoloy Transfer (STTR) proram, which is focused on collaboration with research institutions). As SBIR.ov notes, the SBIR proram was developed in 1982 and is desined to provide fundin directly to firms unable to financially sustain themselves while transitionin from idea development to product commercialization. Reconizin that research intensive projects require loner-term fundin to carry research across the "valley of death" and into the commercialization stae, the overnment requires federal aencies with extramural budets in excess of $100 million to allocate 2.8% of their R&D budets to SBIR rants. Applicants apply to the federal aencies directly. If awarded, SBIR has three distinct phases: 1. Phase I: develop the technical specifications and commercial viability of the project (up to $150m for 1 year)

12 2. Phase II: further the development of the research and commercialization potential (usually up to $1mm for 2 years) 3. Phase III: (unfunded) expects businesses to acquire additional fundin (includin venture capital) to commercialize product(s) supported by SBIR SBIR is available to U.S. small firms (<500 employees) where U.S. individuals own 51% or more of the firm. SBIR also allows venture capital firms (throuh joint ventures) to own the businesses seekin the award if the venture capital firm itself is majority-owned by individuals, which is still a relatively strinent requirement. However, venture capital, hede funds and private equity firms are allowed to hold minority shares of business so lon as they do not have control of the award applicant. The Department of Health and Human Services/NIH is one of the few participatin aencies to fund businesses that are majority-owned by venture capitalists, which makes it an interestin case study of the potential benefits of firms with venture capital participation seekin SBIR fundin. There has been interest in determinin the SBIR proram's effectiveness. Link and Scott (2012) and Qian and Haynes (2014) have each studied the SBIR, but since the focus of their analyses related to employment rowth and the promotion of entrepreneurship, respectively, there was not a direct measurement of SBIR and commercialization. The difficulty in measurin its effectiveness is a combination of developin rich enouh data to evaluate the relationship between fundin and commercialization and the potential different definitions of success (or lack thereof). Further, aencies providin the fundin do not track the performance of those businesses that were not iven awards, which does not allow for a control roup comparison. ENTREPRENEURIAL IPOs [literature review on initial public offerins of entrepreneurial firms]

13 SECTION 2: THEORETICAL MODEL To evaluate the potential for marinal informational advantaes obtained throuh enaement with a venture capital firm specializin in industry- or product-specific investments, a theoretical model of human capital accumulation throuh venture capital fundin is developed below. Assume Firm S is a start-up firm that is in the process of developin product G. There is 1 venture capital firm (VC1) interested in investin in Firm S. It is assumed that if VC1 invests in Firm S, they could transfer some portion of their specialized human capital to Firm S in order increase production of G, potentially increasin their return on investment. The actual level of knowlede transfer will be a function of VC1's ability and willinness to impart that knowlede (σ) to Firm S as mentorin and advisin by VC1 takes time and is costly. Borrowin the principal/aent construct from Macho-Stadler and Perez-Castrillo (2001), Firm S seeks to maximize their profit with a venture capital investment subject to VC1 participatin. In this sense, Firm S is the principal and is decidin whether or not to offer an equity contract to VC1 based on the effort level exerted to transfer knowlede (i.e., incremental human capital) to Firm S. In a basic 1-period model, the followin assumptions are asserted: Firm S has the followin utility function: F(G c) where G is the monetary value of observable production and c is a return to VC1 Firm S's objective is to obtain the reatest possible profit The probability of any particular production output G i : p i (σ) is due to a random component to production and based on the effort σ exerted by VC1 to transfer knowlede to Firm S under a base (perfect information) model, σ is verifiable by Firm S and Firm S will dictate effort level consistent with profit objectives of the contract

14 The set of possible results G = { 1,, n } follows a distribution such that i=1 p i (σ) = 1 probability density function of results: f( σ) worst result out of distribution: best result out of distribution: n VC1 has the followin utility function: U(c, σ) = u(c) v(σ) where total utility is positively affected by hiher returns and neatively affected by more effort to transfer knowlede VC1 has a reservation utility value of U which drives contract accept/reject decision VC1 wants to maximize utility Both Firm S and VC1 have concave utility functions (linear or diminishin marinal utility) Concavity of utility functions allows for risk-neutral or risk-averse preferences Assumes VC1's risk-aversion does not vary with the level of effort exerted Conflicts of interest are inherent in model in a strict manner: o Firm S cares about since their motives are profit driven; VC1 does not o VC1 cares about effort (more effort lowers utility); Firm S does not o However, the larer the effort, the better the results The von Neumann-Morenstern expected utility functions can be used to solve for the optimal equity participation contract. n EU() = p i (σ) u( i ) An optimal return to VC1 is the function which maximizes the utility (profit) of Firm S subject to VC1 acceptin the offer to participate in the equity of Firm S that meets VC1's reservation utility. i=1

15 So the function would take the form: max EU(Firm S) s. t. EU(VC1) U max F( i c) f( i σ) d s. t. [u(c) v(σ)] f( i σ) d U Since the density function for the results is conditional on VC1s' efforts, v(σ) can be treated as a constant and pulled out of the interation. Also, Firm S decides upfront the level of effort of knowlede transfer it demands and provides a return accordin to results. Thus, the returns to VC1 will be function of the result: max c( i ), σ F( i c( i )) f( i σ) d s. t. [u(c( i ))] f( i σ) d v(σ) U Laranian: L c( i ), σ = F( i c( i )) f( i σ) d + λ[ [u(c( i ))] f( i σ) d v(σ) U ] To calculate the optimal return for VC1, the objective function is differentiated with respect to investor return c. However, each return is dependent on each level of output, and each level of output is based on a level of effort of knowlede transfer demanded, so there is a circular issue. To resolve this, there is an assumed fixed level of optimal effort to transfer knowlede noted as σ o. Therefore, the Laranian will be differentiated with respect to c o ( i ). Since this is a partial derivative of an interation of a function that includes the choice variable (itself a function), the Chain Rule will be used. L c o ( i ) = F i c o ( i ) f( i σ o ) + λ o u c o ( i ) f( i σ o ) 0, c o ( i ) 0 c. s.

16 Solvin in terms of λ o : λ o = F i c o ( i ) f( i σ o ) u c o ( i ) f( i σ o ) The multiplier in this case shows the ratio of expected marinal utility of Firm S to the expected marinal utility of VC1. Cancelin out the densities shows that the optimal investment contract is the ratio of marinal utilities. Also, λ o must be positive and binds the constraint of a minimum reservation utility. If λ o = 0, then Firm S's marinal utility would be zero or VC1's marinal utility would be positive infinity, both of which are not possible under the assumptions. Under this basic scenario of perfect information, Firm S demands a level of effort in knowlede transfer to achieve a desired production and VC1 accepts the contract for a return commensurate with that level of output. It follow then that the ratio of marinal utilities will be constant under these contracts. While simplistic, this theoretical model assumes firms see value in venture capital knowlede, and incremental knowlede transfers increase production throuh human capital accumulation. This model could be extended to consider increasin levels of asymmetric information and moral hazard, but the intent is to illustrate on a very basic level the potential for increases in human capital with venture capital involvement and its potential effect on production (commercialization).

17 SECTION 3: EMPIRICAL MODELS The basic framework of the empirical analysis is to evaluate the relationship between human capital and innovation within firms enaed in research to develop a new product or innovation. It has been established that firms enaed in R&D need capital to overcome the "valley of death," and one potential source of fundin is from venture capital. Venture capital participation can also result in the accumulation of human capital at the firm. It follows then that firms with venture capital fundin may be more commercially successful than those firms without venture capital participation. SBIR provides an opportunity to study the interaction of human capital and innovation since the SBIR proram allows for awards to be iven to firms that are minority or majority owned by venture capital entities. Therefore, survey data from SBIR recipients are used to evaluate the potential impact of human capital build-up from venture capital and commercialization success relative to those who have received SBIR awards without venture capital investments. A basic model for the relationship is proposed to have the followin form: commercialization = VC participation + VC majority + X i β + ε i Commercialization is defined as whether a product has been brouht to market and is eneratin revenue. VC Participation may be a binary variable or an actual level/cateory of fundin to indicate whether a venture capital firm has invested in the firm. This variable also encapsulates the incremental human capital provided to the firm by way of venture capital participation. VC Majority is a binary variable equity to 1 if the firm is 51% or more owned by one or more venture capitalists and is intended to control for those firms with sinificant venture capital participation. The proposed model also controls for other factors represented by the X vector, includin whether the firm received prior SBIR fundin at either the Phase I or Phase II state. It could also be suested that there is an unobserved omitted variable related to firm heteroeneity, potentially creatin endoeneity in the model as venture capital firms are likely

18 selectin investments based on commercial viability. However, that arument would only hold if there is some belief that venture capitalists are more correct in their assessment of commercial success. Studies performed on active asset manaement indicate (Malkiel 2005), active manaers do not consistently beat market returns and therefore do not hold any special skill sets that allow for a more accurate prediction of payoffs. However, venture capital is a different type of investment stratey and enerally involves some level of active board of directors participation. As such, the issue of endoeneity will need to be further evaluated within the model. An extension of the model includes evaluatin the implications of receivin Phase I and/or Phase II fundin on commercialization. Given the potential for different distribution assumptions at each stae of fundin, conditional on Phase I fundin, the probability of Phase II fundin with/without venture capital could be evaluated. Firms that apply for Phase II fundin have already received Phase I fundin, so it may make the probability of commercialization success more likely than simply assumin any particular firm can receive Phase II funds. Other models to be considered include: conditional on Phase I and Phase II fundin, the probability of commercialization with/without venture capital, and conditional on Phase I and Phase II fundin, the probability of an initial public offerin (IPO) with/without venture capital.

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