Boom and Bust in the Venture Capital Industry and the Impact on Innovation

Josh Lerner

Harvard University and NBER

Extraordinary drop in venture activity…

0

10

20

30

2000Q1 2000Q2 2000Q3 2000Q4 2001Q1 2001Q2 2001Q3

Bill

ion

s o

f d

olla

rs

Biotechnology

Medical/Health/Life Science

Semiconductors/Other Electronics

Non-High-Technology

Communications and Media

Computer Related

… has triggered worries about consequences

“Most venture capitalists are shelving the expensive change-the-world bets of the past few years.. The danger is that cutbacks will go too fast and too deep.”

• Business Week, 2001.

Agenda

Seeks to understand implications of venture investment collapse for innovation: Demystifying booms and busts in venture

capital. Understanding implications for public policy. Exploring public policy consequences.

Basic elements

Not different from any other markets: Supply and demand!

Supply is willingness of investors to provide capital. Likely to increase with expected rate of return.

Supply Curve for Venture Capital

Return

Quantity

Basic elements (2)

Demand is supply of acceptable businesses. Varies with return demanded by investors:

The higher the return expectation, the fewer firms satisfy the test.

Together supply, demand will determine quantity Q, return R. Crude but useful! Can illustrate historical shifts from U.S.

Steady-State Level of Venture Capital

Return

Quantity

S

D

R

Q

Example 1: 1995-98

Expansion of opportunity associated with diffusion of the Internet.

Can be seen as shift of demand curve outward.

Increase in VC funding, and rising returns: Predictions of inevitable decline misguided.

Impact of Demand Shock

Return

Quantity

S

D2

R2

Q1

R1

D1

Q2

Example 2: 1979

Prior to 1979, pension funds essentially prohibited from VC investing.

Policy shift allowed these investments, shifted demand curve out.

Led to decline in considerable growth, but decline in returns.

Impact of a Supply Shock

Quantity

Return

R1

Q1

R2

Q2

S1

S2

D

Example 3: 1957

Sputnik launch led to two policy shifts: SBIC program, which made it easier to raise

venture pools (supply). Boost in government high-tech procurement,

which increased demand for VC. Led to substantial increase in quantity, but

little impact on returns.

Quantity

Return

R2

Q1

R1

Q2

Impact of a Supply and Demand Shock

S1 S2

D2

D1

Painful adjustments

So far, assumed smooth adjustment. In actuality, may see under- or over-

reaction: Dramatic swings in fundraising levels and

returns. How do these effects come about?

Level of fundraising

0

20

40

60

Billions of 1998 $s Source: Venture Economics and Asset Alternatives.

Level of returns

-25%

0%

25%

50%

75%

100%

125%

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Source: Venture Economics

2001 represents first nine months only.

Rationales for stickiness

VC funds are raised for extended periods. Investors shift targets only on occasion. VC groups often limit rate of growth to

avoid adjustment problems. Even after decision is made, draw-downs

and liquidations take many years. Funds “self-liquidate”: must run faster in

hot periods to stay even.

Consequences of stickiness

In long run, supply curve may be upward-sloping.

But in short run, may be nearly vertical. Immediate consequence of demand shocks

may be spike in returns, not volume.

Quantity

Return

R2

Q1

R1

Q2

Impact on Quantity of a Demand Shock

R3

D2

D1

SS

SL

Rationales for overshooting

Hard to assess promise of new technologies: Uncertainty is what created opportunity in first

place! Public markets provide very noisy--but

highly visible--signals of industry promised: “Irrational exuberance.”

Consequences of overshooting

Public market, other signals may lead VCs to conclude that major demand shift: Actual shift may be far more modest.

Supply may swing out to perceived value, leading to: Surge in funding of investments. Poor returns.

Quantity

Return

R1

Q1

R3

Q3

Misleading Public Market Signals

SS1SL

SS3

D2D1

D3

Venture capital appears to spur innovation

Venture capital is well suited for funding high-risk innovative projects: Intensive scrutiny of business plans. Restrictions in preferred stock agreements. Staged financing. Board service and monitoring. Informal advice.

Not surprising that dominant funding source.

Supporting evidence

Hellmann and Puri [2000]: Look at 170 Silicon Valley firms. Venture capital-backed firms seem more

innovative on several measures. Unfortunately, hard to control for causality:

Does VC spur innovation or does innovation spur VC?

Supporting evidence (2)

Kortum and Lerner [2000] look at industry level: VC appears to have a strong positive effect:

Even after controlling for corporate and government R&D spending.

Use 1979 ERISA shift to address causality issues.

In 1983-95 period, while VC <3% of corporate R&D, accounted for ~10% of innovation.

But is impact of market cycles as bad as it seems?

During “overshooting” periods, too similar companies funded at too high valuations: Biotech financing surge in early 1990s led to

dozens of similar firms pursuing same approach to same disease. Mean pre-money value of VC-funded biotech firms

in mid-1992 was $70MM. By 12/93, only 42 of 262 public biotechnology companies had a

market capitalization above $70MM. Financial and social returns modest.

Similar stories form Internet boom.

But is impact of market cycles as bad as it seems? (2)

Supporting evidence from regression analyses: Look at impact of venture capital on innovation

in boom periods and others. Coefficient is about 15% lower during the years

and industries with venture investments : Effect is strongly statistically significant.

Effect widens when add controls for causality.

But is impact of market cycles as bad as it seems? (3)

Thus, while cycles in activity are dramatic, impact on innovation may be more modest.

Quality of companies funded during booms is often lower. Caution: if complete melt-down in fundraising,

investments, could be very harmful.

Policy implications

“Public venture capital” programs have far too often added “fuel to the fire”: Concentrating on “hot sectors” in boom

periods: May lead to “success stories,” but unlikely to boost

innovation much.

Much better strategy is to focus on “out of favor” sectors and technologies: In-Q-Tel, SBIR provide models.

Policy implications (2)

More generally, may be best to focus on boosting demand for funds: Less emphasis on supply of capital. Possible efforts:

Easing access to early-stage federally funded research.

Tax incentives.

Less direct efforts likely to enjoy greatest success!