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Venture Capital - Policy lessons from the VICO project

Author: VICO Project
Date: September 2011

VICO - Financing Entrepreneurial Ventures in Europe: impact on innovation, employment growth, and competitiveness

Executive summary

The VICO project, funded from the EU Seventh Framework Programme1, studied the impact of venture capital (VC) financing on the innovation rate, employment creation, growth, and competitiveness of high-tech entrepreneurial ventures in Europe and the role VC investors play in helping entrepreneurial firms bridge their resource and competence gaps. The project created a unique hand-collected, large-scale longitudinal dataset on European high-tech companies and VC investments. This dataset provided the backbone for several studies within the project. The project also drew on survey, interview and documentary data. One of the major objectives of the project was to investigate the impact of the heterogeneity of VC investors on the performance of the portfolio firms. This heterogeneity is an important peculiarity of the VC landscape in Europe. In particu-lar, in Europe governmental and bank-controlled VCs are far more important than elsewhere. Moreover, different types of VC investors (independent VC, corporate VC, bank-controlled VC, governmental VC) exhibit different investment patterns and post-investment behaviour. Governmental VCs are specialized in investments in small, young firms, especially in the biotechnology sector, which are relatively neglected by other investor types. They also rarely participate in investment syndicates. Conversely, independent VCs are specialized in expansion investments in relatively older and larger firms.

The VICO project devoted considerable attention to disentangling the “selection” and “treatment” effects of VC investors on the investee firm. The treatment effect refers to the improvement in the performance of the portfolio firm caused by the VC investment, while selection refers to the VC investors being able to choose high quality firms with superior future prospects. Our findings generally supported the view that VC investors had a considerable positive treatment effect on firms’ growth, productivity, as well as investment and innovation performance. VC investors helped their portfolio firms to outperform firms not backed by venture capital even during the financial crisis in 2008–2009. They provided their portfolio firms with the resources and competencies necessary to rapidly readjust their product/market offer during the global crisis.

However, the extent of the treatment effect was contingent on the characteristics of the investor (type, experience) and to some extent also of investee firms. The project demonstrated that experienced VC investors have disproportionally positive effects on employment generation and asset accumulation within the economy. Furthermore, the project showed that independent VC firms exerted an unequivocally positive impact, greater than that documented in previous studies, on the productivity and sales growth of European high-tech entrepreneurial ventures. This effect was largely attributable to the treatment effect rather than to selection by VC investors of highly efficient firms with superior growth prospects. The effect of corporate VC investments on productivity, instead, turned out to be negligible.

With regard to the impacts of the (direct) investments by governmental VCs, when we distinguished between firms backed in the early stages of their life (firms aged five years or less) and relatively more mature firms (aged more than five years), governmental VCs appeared to have a positive impact on the growth of the early stage firms, while the impact was negligible for the more mature ones. University VCs, by contrast, appeared to have a negligible impact regardless of the age of the portfolio firm.

The development stage of the firm during the first investment obviously affected the way in which the VC investor was able to exit. Dissolved companies were likely to have had their first investment earlier on during their development cycle while the firms that went public were likely to have had their first VC investment later on when their product was further developed.

Both independent and governmental VCs were helpful in alleviating the financial constraints of the portfolio firms, while bank-controlled and corporate VCs did not have any significant effect in that respect. VCs tended to select firms which were active in patenting and in turn VC-backed companies outperformed otherwise similar non-VC-backed companies in terms of innovation output. Most interestingly, syndicates led by independent VCs but including also governmental VCs exhibit the greatest positive impact on firms’ innovation.

The mechanisms by which VCs add value to their portfolio firms were studied by a survey comparing the activity intensity and profiles of government and independent VCs. Independent VCs turned out to be important for the firm in a number of activities which were of significance for the development of the business, such as professionalization (changing the management team and finding board members) and exit orientation. Governmental VCs played a fairly modest role in shaping value-adding behaviour of firms, and this finding held when controlling for factors such as firm age.

The VICO studies suggest that the availability of VC at fair terms seems to motivate nascent entrepreneurs to adopt high growth innovative strategies; they can expect that their ventures will be sustained and supported by VC later on. This implies that the availability of VC has a wider positive impact which goes beyond the investee firms and is related to the emergence of gazelle-type entrepreneurship.

Factors promoting the development of the VC industry include liquid IPO and trade sale markets, which make it easier for VC firms to divest their investments and, thus, to raise further funds as money flows back to the original investors with attractive returns. In this way, VC firms would be able to play an active role investing in unlisted firms to fill the equity gap. Furthermore, VC investments in a country are positively correlated with R&D expenditures, and negatively correlated with the unemployment rate and average span of job tenure. Similarly, demand for VC investments is negatively affected by rigidity in the labour market.

In spite of the fact that during the last decade more than one third of worldwide VC investments have been cross-border deals, the internationalization process of the Euro-
pean VC industry is lagging behind, and the European VC landscape remains quite fragmented. For establishing viable VC industries, promotion of the internationalization process of the European VC industry offers clear benefits. In particular, cross-border VC inflows can partly compensate for unfavourable conditions that local VCs face in countries with underdeveloped stock markets or unfavourable tax and legal conditions for VC investments. We have also found that a combination of cross-border and domestic venture capital promotes the best performance in a portfolio firm.

The VICO project examined policies for venture capital in three countries: France, UK, and Finland. In spite of positive developments, for instance, in the promotion of high-tech entrepreneurial ventures, there is overall failure in the promotion of viable VC industries. Even in the UK, which has been most successful in the emergence of VC, there are inefficiencies in the policy mix of support schemes and ambiguity about the expected returns of public schemes. There are also weaknesses in the skills of managers working in public funds.

The VICO project suggests several policy recommendations, first, emphasizing a systemic view and targeting framework conditions for the emergence of the VC industry. Furthermore, it notes that a failure to recognize the need for coordinated policies is an important determinant of the modest success of previous policy initiatives in Europe. At the macro level, the project recommends:

– shaping the educational system and European culture in favour of an entrepreneurial risk-taking and innovation prone attitude;
– the creation of a VC-friendly tax and regulatory environment, e.g. elimination of double taxation and registration problems, to encourage cross-border VC investments and to reduce national and local fragmentation of the European VC industry;
– encouraging serial entrepreneurship through measures such as changes in bankruptcy laws;
– the creation of liquid markets (IPO and trade sale markets) which facilitate exit strategies for VC investments. For example, schemes providing incentives to individuals investing in firms not listed on the official stock exchanges would increase supply and demand in second tier markets. In this regard, incentives to business angels should also be implemented in a harmonized way.

There are also several micro-level measures recommended, such as:

– provision of selected subsidies on a competitive basis to entrepreneurial firms to improve the pool of entrepreneurial ventures with high-level human capital and high aspirations;
– promotion of support services (like business incubator services) by experienced actors;
– provision of tax-based incentives and co-investment schemes to stimulate private VC firms to invest in young and small high-tech firms, especially in the seed stage;
– measures favouring the entry of VC firms managed by experienced managers through public funds of funds;
– provision of governmental VC funding only through co-investment schemes with experienced private VCs which take the lead, make the screening and selection of the investee firms and provide value-adding services to the investee firms;
– focussing government VC funding on the seed and start-up phases with the objective of attracting private VC investors in subsequent rounds;
– avoiding regional focus in government VC initiatives because it is too narrow a basis for high quality deal flow and operating at the national and/or European level;
– in governmental

Geography: Europe

Type of study: Academic article

Relevant for: Venture capital

Source: VICO - Financing Entrepreneurial Ventures in Europe