Does Venture Capital Spur Innovation - Research Paper Example

Does Venture Capital Spur Innovation? An Assessment Section 1: Introduction Venture capital became a prominent feature of economic development in the eighties when such funds gained in volume and prominence. Capital made available purportedly for higher risk, highly innovative projects captures interest as a likely driver of economic development. However, changes in tax laws, the bursting of the high technology (translated: high innovation) bubble, and the present financial crisis may have caused venture capitalists to re-evaluate their risk position and seek sanctuary in safer, more proven projects. The question thus arises: Does venture capital spur innovation, and if it does, in what way and to what extent? Some authorities aver its importance, some its insignificance, and others its deterrent effect on the development of innovative projects. This discussion aims to address this question by conducting a survey of academic literature contained in journal articles concerning venture capital’s role and effect in innovation. It will begin with a description of what innovation is and how it is undertaken, relate findings of empirical studies on innovation supported by venture capital, and derive insight into the role of venture capital as driver of innovation. Section 2: INNOVATION Innovation described; motivation behind it According to Sylver (2006), the term “innovation” is defined simply as “introducing something new.” She perceptively notes that there are no qualifiers to this simple statement, no standard as to how radical or ground-breaking the new development would be, only that it should be better than what used to be the standard. Actually, innovation means different things to different people, depending upon the proponent’s motivation. Sylver classifies three situations wherein corporations would typically pursue innovations, as follows: (1) The corporations are currently suffering in the situation termed the “burning platform”; that is, their profits are dropping, their products are not selling, and they do not know what to do about it. (2) They firms have emerged from the “burning platform” and had realized that innovation is not a temporary recourse (a “start/stop process”, according to Sylver), but a continuing evolution that demands constant attention. (3) The corporations are the leader in their industry, and they are determined to maintain that position. A reasonable degree of failure is acceptable within their organizational culture, due to their understanding of statistical risks in product development. For each of these motivations, there is a different meaning given to innovation. For the first situation approaching a “burning platform” event, innovation is a reactive undertaking, where speed is of the essence, defined by a “me-too” approach to what their competitors are doing. For the second motivation, the focus of innovation is for quick hits and small wins, with a sense of relief for the company’s survival but feeling too close to the crisis period to strategize a “blue skies” approach. Finally, for the third situation, industry leaders approach innovation strategically, consistently and deliberately, systematically planning for it and clear about the goals they want to achieve. Timmons and Bygrave (1986) distinguished between invention and innovation. While the initial concept or design is the result of invention, innovation encompasses the next critical step: combining the “offspring of invention” with technology transfer and entrepreneurship. Innovation in large part necessitates the integration of different and divergent knowledge content (Dushnitsky & Lenox, 2005, p. 167). Within any single organization, there are constraints in the generation and dispersion of knowledge, such that firms may discover that the do not possess the requisite knowledge required to innovate. Innovation process Professor Clayton M. Christensen of the Harvard Business School adopted the Big Idea Group’s four stages of innovation, emphasizing the first two stages (idea generation and winnowing phases) as critical in business innovation (Gray, 2002). The four phases are: (1) Initiate: This is the phase where several alternative innovative ideas are generated. (2) Deliberate: Also called “the winnowing phase,” this is the stage where the alternative propositions are preliminarily assessed to determine which should be further explored. (3) Elaborate: This is the phase where the innovative idea is fleshed out and detailed. (4) Appreciate: This is the stage where the completed plans for an innovation idea are assessed and proposed to the venture capitalist. Figure 1 on the page following shows a conceptual diagram of the phases of the innovation process and how they relate to external factors that create advantages and constraints on the innovation development. Two critical issues that define how the innovation will be appraised by investors is the tax effects of capital gains that may be realized on the venture, based on the country’s tax regulations, and the financial gains that may be realized given the risks of financing the venture. Figure 1: Stages of the innovation process Source: http://www.unleashbuzz.com/word-of-mouth_marketing_innovation.htm Section 3: VENTURE CAPITAL AND INNOVATION How Venture Capital (VC) affects innovation Callahan & Muegge (2003, p. 655) succinctly put the general perspective of viewpoints concerning the mechanics of venture capital’s causal effects on innovation. Three popular theories as to whether VCs fosters innovation, although research as to which theory is supported by empirical data is so far unconfirmed: (1) venture capital unleashes innovation. VCs free innovative firms from capital constraints and add genuine value that helps them become successful; (2) venture capital is neutral to innovation. VCs identify the best new ventures, and are the intermediary gatekeepers for funding; and (3) venture capital stifles innovation. VCs back only conventional ideas. Unconventional innovative ventures are screened out as too risky, and never receive funding. Timmons and Bygrave (1983) distinguished among three types of innovativeness as suggested by cluster analyses of 464 venture capital firms, namely the Highly Innovative, Least Innovative, and The Rest. The classification was based on their involvement in what the study differentiated as Highly or Least Innovative Technological Ventures (HITV and LITV respectively). The study found that: (1) HITV investing requires less capital than do initial investment in LITV, because first-round investing in HITV is a specialized, management (not capital) intensive activity. (2) A core group of highly skilled and experienced VC firms account for a dis-proportionately larger share of HITV investing; that is, less than 5% of the firms surveyed account for 25% of all investments in HITV. (3) Entry of VC investors occur at a significantly early stage in HITVs than in LITVs. (4) VCs who invest in HITVs actively identify promising innovations and innovators rather than wait for proposals from them. This causes an “acceleration effect” on the velocity and time span needed to bring new technologies to commercial maturity and societal utility. Murray & Marriott, 1998, examined the causes for the poor performance of technology-specialist European venture capital funds. Performance indicators used were the Internal Rate of Return (IRR) and Net Present Value (NPV), and basis of observations was a number of specialist, independent venture capital firms. The study found that economic returns of venture capital funds were sensitive to the scale of the investment activity; funds under €21 million or US$25 million displayed increasing economic vulnerability. Eight years later, Allen & Hevert (2006) conducted an investigation on whether venture capital investing in information technology companies yielded positive results in the venture’s financial returns; they concluded that direct gains or losses were widely dispersed based on IRR and net cash flow metrics, yielding no conclusive results that VCs deliver economically significant value to the sponsoring firms (p. 262). There are studies that appear to contradict each other concerning the hypothesis that VCs have a positive effect on innovation. According to Kortun and Lerner (2000), the state of US patent filing (as indication of innovation) correlated positively with early stage venture capital disbursements. On the other hand, an apparent contradictory finding was reported by Tredennick (2001), that venture capitalists and their technical experts tend to favourably consider very conventional and proven ideas. According to this study, if the innovation strays too far from conventional theory, the tendency is for venture capitalists not to understand or appreciate the proposed innovation, and because of this uncertainty, perceive the risk as too great. Furthermore, Bhide (2000) finds that VCs tend to look for ventures that present the greatest promise of success, because VC-backed entrepreneurs have to deal with the extensive scrutiny of their plans and monitoring of their performance by the capital providers. This causes them to lean more towards less uncertainty, preferring to anticipate and plan rather than improvise and adapt. These authors suggest that VCs screen out the most significant innovations and prefer to go with minor variations of what has proven to be successful in the past. Treddenick (2001) further found that venture capitalists display a behaviour called “herding” – that is, making investments that are similar to those made by other firms, or “riding the crest of a fad.” Whether or not such causal relationships exist, the research by Callahan & Muegge (2003) appears to lead to the conclusion that VC-backed firms are more successful than non-VC backed firms, both before and after IPO. While causalities are inconclusive, the following have been determined by empirical research (all cited in Callahan & Muegge, 2003) (1) VC backed firms bring product to market faster (Hellman & Puri, 2000) (2) VC-backing time IPOs more effectively to the market (Lerner, 1994) (3) VC supported businesses have higher valuations at least five years after IPO (Gompers & Brav, 1997); and (4) VC-backed IPOs pay lower fees and are less underpriced (Megginson & Weiss, 1991) Modelling the role of VC in the innovation process In a study by Florida and Kenney in 1987, the dynamic rise of venture capital (which fell off in the nineties) transformed the manner innovation was undertaken in the US. Venture capital became the integration of traditional business finance and economics on the one hand, and various entrepreneurial groups on the other. Venture capital became the main driver of innovation. This was considered new, because in earlier models of the innovation process, the main driving agent had been entrepreneurs, or entrepreneurial groups. While corporations used to undertaken innovation through their R&D efforts, but such were largely internalized and technological change was less sporadic, and more gradual and continuous. Figure 2 on the page following presents the model as conceptualized by Florida & Kenney. Figure 2: Venture capital in the institutional framework for innovation (Source: Florida & Kenney, 1987, p 127) A new model was developed by Chen (2009), who examined the effects of technology commercialization, incubator support, venture capital support, and new venture performance. Technological commercialization (TC) competence refers to “the competence of firms to use technologies in products across a wider range of markets, incorporate a greater breadth of technologies in products, and get products to market faster” (Chen, 2009, p. 93). The study concluded that organizational resource and innovative capability define the level of TC competence of the firm; however, the effect of TC competence on new venture performance is qualified by incubator support and venture capital support. The model in Figure 3 below graphically depicts Chen’s findings. Figure 3: Model for factors affecting new venture performance (Source: Chen, 2009, p. 94) Corporate Venture Capital Corporate venture capital (CVC) is equity investment by incumbent firms in independent entrepreneurial ventures, that is, new, unlisted companies seeking capital to continue operation, as defined by Dutshnitsky & Lenox (2005, p, 615). This study found sufficient evidence of positive correlation of CVC with future patent citation levels – that is, an increase in CVC tends to be followed by a proportional increase in future patent citation levels. The study also found that this relationship was driven by CVC investments in industries where patent effectiveness is low (p. 635), suggesting, without confirming, a probably causal relationship. This viewpoint is shared by Husted and Vintergaard (2004) who stress a series of concrete actions that may improve the functionality of the venture base as stimulator of innovation. A subsequent study by Weber & Weber (2007) treated of the manner a CVC may undertake innovation, without directly dealing with the degree to which the CVC induces innovation. CVC units are set up by corporations in collaboration with the small, innovative firm, in order to pursue innovation directions the corporation may wish to undertake. The technological innovativeness that such ventures embark upon assume a relatively higher level of uncertainty and risk, but also have the potential for technological breakthroughs and high growth rates. Should the venture take off successfully, the CVC unit could spin off into new business units, gain a large proportion of market share at least at the beginning phase of the new technology, and the above-normal returns that come with early market dominance. According to Weber et al., the critical factors that contribute to the success of CVCs is the level of social capital employed in the business, and knowledge relatedness. Social capital enables the mutual exchange of knowledge possessed by the partners in the venture, thereby deepening and increasing the efficiency of the processing of knowledge in the new business. Knowledge relatedness, on the other hand, is the degree to which an organization’s existing knowledge is related to the new knowledge assimilated – in other words, the degree of similarity and compatibility of knowledge between the partners in the venture. Figure 4: Detailed framework of relational fit (Weber & Weber, 2007, p. 13) Returning to social capital, two aspects of this factor are important to consider: contative fit, which is the intention and willingness of the partners to cooperate with each other; and affective fit, which refers to the functional compatibility of sentiments and emotions between individuals or small groups. Figure 4 preceding shows the framework of relational fit. Timing of VC investment in innovation Yong-Li (2008) determined the venture capital staging decision and the factors that affect its timing. Empirical results suggest that, at each round of financing, market uncertainty cause venture capital firms to delay investing; on the other hand, competition, project-specific uncertainty and agency concerns prompt venture capital firms to invest sooner (p. 497). The fact that venture capitalists are concerned with market, or systematic, risk rather than total or firm-specific risk is likewise determined by Callahan and Muegge (2003). This is behaviour that is opposite that of entrepreneurs, who are concerned with total risk. Callahan and Muegge explain this as a result of venture capitalists being relatively well diversified as investors, whereas entrepreneurs are not (p. 164). Finally, Dal-Pont Legrand & Pommet (2009) determined that the nature of syndication of venture capitalists matters upon the decision to finance and re-finance innovative projects. Oftentimes, there are different natures of syndicates that decide to support a project; certain syndicates may be a collaboration of experts, and others of financiers. The study determined that the relative efficiency of expertise syndication compared to the purely financial syndication is strongly dependent upon the degree of innovation that characterizes the project being financed. Section 4: THE IMPACT OF VENTURE CAPITAL ON INNOVATION From the preceding discussion, it is apparent that in the early studies dating to the 1980s, there was a strong showing that venture capital had a positive impact on innovation, on the basis of empirical data using patent filings and citations statistically correlated to the size of venture funds. In the nineties, the strength of this correlation appeared to weaken as the size of venture funds fell at a rate faster than patent citations. Despite the statistical data, anecdotal evidence continued to provide a link between the two, however, the testimonies appear to be divergent as they were emphatic: some say that venture capital aids innovation, some that it ignores innovation, and others that it discourages innovation by preferring to support projects that have less lower risk and follow a proven track record, rather than pursue never-before-done innovations. Thus, there is no empirically conclusive evidence that would prove with finality whether venture capital promotes innovation. The primary reason appears to be the presence of many other factors, tangible and intangible, that mitigate the effect of venture capital, if any, on the development of innovation. This is because innovation is not a creature of science, nor is venture capital entirely a financial entity. As shown in Figure 1, the creative process that leads to innovation is circumscribed by the social, political, economic and cultural milieu surrounding the innovating agent. Furthermore, the very process of knowledge transfer by which venture capital seeks to build innovation is also tempered by the relational fit described by Weber et al. in figure 4, which is very much dependent upon the institutional knowledge and psyche of both CVC and innovating firm. Other than this, there is a general divergence of perspectives on how to view venture capital as a driver for innovation. Some studies dealt with venture capitalists as a homogeneous group with the same risk and return profiles and the same strategic goals. Statistical analysis adopting this perspective tend to arrive at inconclusive results, probably due to the diminution of sensitivity of the statistical test due to averaging among essentially diverse venture capitalists. Qualitative analyses based on testimonials that do not distinguish among different types of venture capitalists tend to be contradictory, such as those of Tredennick (2001) and Bhide (2000), due apparently to generalizations based on a few specific anecdotes. While the phenomena they describe may bear some truth, they could not all the same be definitive. On the other hand, there are studies such as that by Timmons and Bygrave (1983) chose to differentiate among venture capitalists by their risk-return profiles and strategies, distinguishing those that specialize in highly innovative technological ventures from those that invest in least innovative technological ventures. With this greater selectivity of data, the research was able to identify salient trends among those few who invested heavily in the HITVs. Finally, one remarkable difference between the context in which venture capital’s role in innovation is viewed can be noted between Figure 2 (model by Florida and Kenney, 1987) and Figure 3 (model by Chen, 2009). The earlier model sees venture capital as the prime driver and originator of innovation, with the support of traditional and financial institutions and market forces. On the other hand, the latest model shows venture capital as a moderator of the primary driver of innovation which is technology commercialization. This is an important redirection in paradigm; innovation is seen now as inevitable, brought about by technology commercialization which is supported by organizational resource and innovative capability. The role of venture capital is to enhance this phenomenon; while the presence of venture capital may spell the difference between the success or failure of the innovation, it by no means does not determine the initiation of the innovative effort, which will in any case take place. Section 5: CONCLUSION A survey of the available literature on venture capital’s role in innovation shows contradictory findings which, is appears, is due as much to a variation in methodology and inconsistency in metrics or basis as it is to ambiguity of data and multiplicity of explanatory factors. There appears to be a general agreement, however, that venture capital is strategically positioned to absorb a higher level of risk than conventional sources of capital, and there is a variety of projects with a range of risks that different venture capitalists specialize in. Likewise, innovation takes different forms, from those undertaken to avert business failure to those that are systematically pursued as a matter of strategic application. In conclusion, innovation is undertaken by business, as survival technique or continuing goal. Venture capital in selective cases may be a principal driver of innovation, and in other cases provide support towards the success of the innovative process. Corporate venture capitalism is one development that resulted from the collaboration of small innovative firms and the corporate need for new and creative directions. Thus, venture capital will continue to have a profound effect on the success of the commercialization of technological innovations. 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