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Venture Capital and The Inventive Process VC Funds For Ideas-Led Growth-Palgrave Macmillan UK (2016) PDF
Venture Capital and The Inventive Process VC Funds For Ideas-Led Growth-Palgrave Macmillan UK (2016) PDF
THE INVENTIVE
PROCESS
VC Funds for
Ideas-Led Growth
v
vi CONTENTS
2.6 Summary 24
References 25
Afterword 115
References 117
Index 119
LIST OF ABBREVIATIONS
VC Venture Capital
LP Limited Partner
GP General Partner
IPO Initial Public Offer
GDP Gross Domestic Product
R&D Research and Development
ERISA The Employee Retirement Security Act
DC Defined Contribution
DB Defined Benefit
ix
LIST OF FIGURES
xi
LIST OF TABLES
xiii
xiv LIST OF TABLES
goods and services and new production technologies that change the way
people live in the world have come into being. As a consequence of the
agglomeration of the world’s ever-rising population into industrial cen-
ters, new cities and states have risen continually from the ashes of the old.
In this way, even the lines on the map were and continue to be influenced
by the inventive process.
The venture capital industry and the venture capital (VC) funds at its
core are a small but important part of the inventive process that leads from
an innovative idea to increased consumption and an extension in con-
sumption possibilities. The important role of VC funds and the VC indus-
try in the inventive process justifies what seems to be a disproportionately
large interest in the venture capital industry in general and in VC funds in
particular in the business world, in academia, and in the public in large.
There are, of course, different answers as to why the venture capital
industry gets so much attention. One answer is that VC funds turn radi-
cal innovative ideas into major components of economic growth. In the
world of today, these changes are rapid and affect the life of everybody.
People find such changes fascinating. An example of a VC-backed radi-
cal change is the development of Apple, Inc. In 1978, two VC funds,
Sequoia and Matrix Partners, invested about $1.2 million in Apple at
$3 million in pre-money valuation. At the time, Apple was one of many
early-stage start-ups in California. Apple went public on December 22,
1980 and sold 4.6 million shares at $22 each for $101.2 million. The price
went up that day by 32 %, leaving a market value of $1.7 billion. Today
(mid-2016) the market value of Apple Inc. is more than $600 billion. In
the process, Apple changed the lives of many people. This is heady stuff.
A second answer is that the general partners (GPs) who manage VC funds
are making a lot of money, even relative to other senior professionals in the
financial services industry in the U.S. This type of rapid financial success
always makes a good story.
In this book, we focus on a third answer as to why VC funds are of
general interest: VC funds provide an important ingredient for economic
growth in the U.S. and in the rest of the world. The main proposition of
this book is that by taking a comprehensive look at VC funds in the con-
text of the inventive process we can better understand the venture capital
industry and the way that VC funds operate. A comprehensive look at
VC funds requires bringing together different aspects of economics and
finance and weaving them into a complete picture. Once VC funds are
placed in the context of the long-term inventive process and economic
A COMPREHENSIVE ECONOMIC LOOK AT VC FUNDS 3
financial valuation tools, the returns generated by the assets in the market
portfolio are assumed to follow and be described by a symmetric normal
distribution. The returns that may be generated by “assets in process”
based on radical ideas do not match this assumption and are instead better
described by a binomial distribution. This is the case because “assets in
process” based on radical ideas will become assets in the market portfolio
only if the development of the idea is successful. If not, the idea will disap-
pear and will not become a part of the market portfolio, and the invest-
ment in this radical idea will yield no value.
Ideas are different from other goods. Ideas are non-rivalrous and have
increasing returns to scale. That makes ideas like a public good (see e.g.
Boldrin & Levine, 2005; Cornes and Sandler, 1986; Romer, 1998; Boldrin
& Levine, 2005). A necessary condition for investors to invest in the risky
development and commercialization of radical ideas is the ability to appro-
priate some of the public benefits to themselves. This requires government
intervention in the form of allowing economic rents to the generators
and the developers of successful radical ideas. The need for government
intervention in the market for radical innovative ideas is acknowledged
in the U.S. Constitution as well as by the legal codes of most developed
countries. Governments also intervene in the market for ideas via public
R&D spending and basic research funding with the purpose of increasing
the number of ideas that can be turned into commercial products.
portfolio for this purpose and by designing a specific contract with those
who decide in which projects to invest. The decision makers in VC funds
are the GPs. The contract between the LPs and the GPs is the cornerstone
of VC funds. This contract determines to a great extent the projects that
GPs of VC funds are looking for. The GPs then sign a contract between
the VC fund and the entrepreneurs in which the VC fund invests. Both the
contracts between the LPs and the GPs and the contracts between the GPs
and the entrepreneurs have explicit and implicit parts and together they
determine the operations of VC funds.
In Chaps. 7 and 8, such investment decision rules are shown to be opti-
mal for all parties involved in VC funds: the LPs, the entrepreneurs and
the GPs. Financial intermediaries have fiduciary obligations to their bene-
ficiaries. In Chap. 7 the focus shifts from VC funds to their main source of
capital – institutional investors. The discussion focuses on pension funds in
general and to public pension funds in the U.S. in particular. Institutional
investors are the main source of capital for VC funds. Yet, institutional sav-
ings and institutional investors like pension funds are a new phenomenon
that has started in the U.S. at the beginning of the twentieth century. The
development of institutional savings went hand in hand with the develop-
ment of the middle class in the U.S. The middle class accounts for most
consumptions and savings today. It took the telephone 71 years to reach
50 % of the American households; contrastingly, it took the Internet 10
years to reach this level of use. Therefore, the development of institutional
investors in the U.S. is relevant to the growth of VC funds that draw a
substantial proportion of their capital from asset allocation by institutional
investors. Savings behavior is analyzed and discussed in the economic lit-
erature by what is known as the life-cycle savings model (Bodie et al.,
2007). The objective of savings, according to the model, is to maximize
the utility of lifetime consumption (including intergenerational transfer).
Allocating a small fraction of one’s savings to “assets in process” with their
high risk of all or nothing is congruent with such a model, if the prize in
case of winning is large enough. Friedman and Savage (1948) argue that
highly risky projects that will change the life of a person if the project suc-
ceeds justify risk-loving investment rules. The potential of metamorphic
change of radical ideas in innovative technology justifies a small asset allo-
cation to such investment. Large increases in consumers’ surplus as a result
of successful investments in radical ideas like the Internet justify a small
allocation of savings for this purpose. However, pension funds and other
institutional investors do not measure the utility of the lifetime consump-
A COMPREHENSIVE ECONOMIC LOOK AT VC FUNDS 9
tion of their beneficiaries and their goals are measured in terms of financial
return on their portfolio. For example, CalPERS, the largest public pen-
sion fund in the U.S., defines its objective as a three years average return
on its portfolio, where the target return reflects the risk of the portfolio
measured in comparison to the total market portfolio. The question is,
what is the return to institutional investors (LPs of VC funds) on invest-
ment in VC funds and is the actual return sufficiently high to compensate
for the risk haunts the venture capital industry? The return on the invest-
ment in VC funds by their LPs is measured over the total investment in
the VC fund over the life of the fund, typically 10–12 years where money
goes in and out during this period. The Kauffman Report (2012) claims
that the return to the LPs is too low relative to the risk. The issue of how
the valuation of VC funds should be done and what is the appropriate way
to measure the return on the investment by LPs in VC funds, as well as
the allocation of value by VC funds to different stakeholders is discussed
in Chap. 8.
Chapter 8 is titled, “Externalities, Consumers’ Surplus and the Long-
Term Return on Investments by VC Funds”. All the literature that deals
with the definition of the measurement of the return on the investment
in VC funds measures the return to the LPs over the relevant horizon of
VC funds. The return on the investment of LPs in VC funds depends on
the success of the investments of the VC funds in “assets in process”. The
success is the result of either an Initial public offer (IPO) or an acquisition
of successful projects of VC funds by an existing company. This is known
as an exit. An exit transfers “assets in process” to the market portfolio.
The exit changes the probability distribution of the project (the asset)
from binomial to normal. This is because the exit separates the “assets in
process” to two groups, successful and unsuccessful. The ex-ante bino-
mial distribution of the “assets in process” is not relevant for the ex-post
successful projects that are now a part of the market portfolio. However,
adding the successful projects to the market portfolio has externalities
and it increases the return on some assets already in the portfolio, and
an increase in the return which is not captured by the exit. The portfo-
lio of institutional investors mimics the market portfolio. Therefore, they
capture both the return to the LPs that represent them and the post-exit
externalities through their holdings in the post-exit market portfolio. The
measurement of the return on investment in VC funds by institutional
investors by the return to the LPs is incomplete. The post-exit return
explains why institutional investors should continue to allocate assets to
10 T. AGMON AND S. SJÖGREN
VC funds with what appears as insufficient compensation for the risk from
a societal point of view. The contribution of the successful projects of VC
funds to the value of the other assets in the portfolio post-exit creates an
incentive for institutional investors, if the free rider problem is overcome,
to allocate capital for the high-risk investments in the development test-
ing and commercialization of radical ideas in innovative technology: an
allocation which is congruent with optimal lifetime savings decisions by
households.
The last chapter of the book, Chap. 9, is titled, “The Future of VC
Funds: The Effects of Technology and Globalization”. The chapter is a
preliminary discussion of the direction that the venture capital industry
and VC funds may take in the future. We see two major developments:
technology and globalization. The relevant development in technology
is digital platforms that change the structure and organization of firms
and may have an effect on financing through crowdfunding. Globalization
introduces new actors into the venture capital markets. China, India, and
Brazil have become relevant markets in addition to the U.S. and Europe.
These changes may change the nature of VC funds and create new inter-
mediaries in the future, in the same way that technology and social policy
in the U.S. create VC funds as we know them today.
REFERENCES
Admati, A. R., & Plfeider, P. (1994). Robust financial contracting and the role of
venture capitalists. The Journal of Finance, 49(2), 371–402.
Bodie, Z., Treussard, J., & Willen, P. (2007). The theory of life-cycle saving and
investing. Boston: Federal Reserve Bank of Boston.
Boldrin, M., & Levine, D. K. (2005). The economics of ideas and intellectual prop-
erty (Research Department Staff Report 357). Federal Reserve Bank of
Minneapolis.
Chan, Y.-S. (1983). On the positive role of financial intermediation in allocation
of venture capital in a market with imperfect information. The Journal of
Finance, 38(5), 1543–1568.
Cornes, R., & Sandler, T. (1986). The theory of externalities, public goods, and club
goods. Cambridge: Cambridge University Press.
Denis, D. J. (2014). Entrepreneurial finance: An overview of the issues and evi-
dence. Journal of Corporate Finance, 10, 301–326.
Friedman, M., & Savage, L. J. (1948). The utility analysis of choices involving risk.
Journal of Political Economy, LVI(4), 279–304.
A COMPREHENSIVE ECONOMIC LOOK AT VC FUNDS 11
2.1 INTRODUCTION
This chapter aims to give a description of the size of the VC industry. The
description is mainly based on numbers and statistics and is tilted towards
information about the U.S. VC industry. We complement the U.S. infor-
mation with data from European countries and the global VC industry.
Venture capital (VC) funds are special-purpose financial intermediaries
that raise high-risk capital and invest the capital in developing radical ideas
in innovative technology. Where successful, the investment projects in
Net worth
VC funds are comprised of limited partners (LPs) that provide the capital
and general partners (GPs) that manage the fund according to a contract
between the LPs and the VC fund. The liabilities match the limited and
general partners’ investments in the fund. The corresponding assets are
the holdings in the portfolio companies.
VC funds can be described by the contracts that define the relation-
ships between the LPs, the GP, and the VC fund. The contracts are the
small arrows in the picture. These contracts determine the way that VC
funds operate. One contract is between the VC fund and the LPs. The
LPs agree to commit a certain amount of capital to the VC fund, to be
invested in particular types of projects, which are specified in the con-
tract. The GP of the VC fund has the right to call on the capital accord-
ing to investment needs. A second contract is between the LPs, the VC
fund, and the GP. This contract specifies the payments for the GP. In
most if not all cases the payment to the GP is comprised of a certain per-
centage per year of the total capital raised by the VC fund. This payment
is called a management fee and it ranges between 1 % and 2 % of the total
capital raised by the VC fund. The second component of the payment
for the GP is defined as a share of the profits of the VC funds over its
life, called ‘carried interest’ or a ‘performance fee’. A common payment
is 20 % of the profits, conditional on profits above a certain hurdle rate.
We discuss the functionality of the contracts between the LPs and the
GP in Chap. 6.
The portfolio companies are the investment objective and vary in size
and in stage of development. Usually each VC fund will invest in up to 15
companies. It is between the VC fund and the entrepreneur that we find
the third contract or group of contracts. These contracts deal with cash-
flow rights and decision rights of the entrepreneurs who are the source for
the idea and, in some cases, entreprenuers have proprietary rights and the
VC fund that provides the capital. Given the risky nature of the investment
projects these contracts are relational and they have a mechanism of rene-
gotiation for both decision rights and cash flow rights. What determines
the size and the nature of the assets of VC funds is the contract between
the LPs and the VC fund. Given the capital allocation and the specifica-
tion of the type of investment for which the capital was allocated (e.g. a
specific industry like software, or a specific country like China or Finland)
the GP has a crucial role in the success or the failure of VC funds. This is
so because, given the contract between the LPs and the VC fund, the GP
has to select a small number of projects from a large universe of potential
investment projects.
16 T. AGMON AND S. SJÖGREN
from 2008 to 2014 and the number of investment projects per year are
presented in Table 2.1.
In Table 2.2 we present the geographical distribution of VC funds by
geopolitical areas. The table includes invested capital, and investment
rounds per area. China and India, two newcomers to the VC world, are
getting close to Europe in the amount invested and the number of deals.
Israel, a small country, is an exception and should be counted as an exten-
sion of the U.S. venture capital industry as almost all the capital invested
in VC funds in Israel comes from U.S. institutional investors.
In recent years the venture capital industry has becomemore global.
China is now a focal point for many VC funds, both as a source of capital
and as an investment target. This was not so five years ago. Yet, most of the
venture capital industry and VC funds are in the U.S. Also, while today
used worldwide, the investment model of the venture capital industry as
a cooperative effort between institutional investors, VC funds, and entre-
preneurs was developed and practiced in the U.S. Therefore, we focus in
this chapter on the size and the characteristics of the venture capital indus-
try and VC funds in the U.S.
120
100
80
60
40
20
0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Fig. 2.2 Venture capital investments in the US, between 1985 and 2014 ($ billions).
Source: NVCA (2015)
Table 2.3 The dimensions of the VC industry in the US 1994 and 2014
1994 2014 % Change
2% 32 % 42 % 25 %
Table 2.5 Investment by U.S. VC funds by industry groups and stage of invest-
ment in 2014
Industry All investments Initial stage
of pension funds are primarily middle class and working class savers. The
beneficiaries of family offices are wealthy families, and the beneficiaries of
endowments and foundations are their donors.
In China, India, and the European Union member states, the govern-
ments provide capital to VC funds, and in some cases also participate in
the management of VC funds. Table 2.8 shows the distribution of sources
of capital for European VC funds.
The first four sources in Table 2.7 are institutional investors and
together they contribute 51 % of the capital for U.S. VC funds. The com-
parable number for European VC funds is 32.1 %. There is an interest-
ing mismatchbetween the importance of the capital for the VC funds and
the intermediaries that allocate capital for investment in VC funds. Public
THE SIZE AND THE CHARACTERISTICS OF THE VENTURE CAPITAL INDUSTRY 23
pension funds are crucial for VC funds as a source of capital. This is par-
ticularly true for small or new VC funds as public pension funds tend to
allocate capital to a large number of VC funds, and they are also regarded
by other potential investors in VC fund as necessary LPs. But public pen-
sion funds allocate 0.5 % to 1.6 % of their portfolio to VC funds and the
effect of this investment on their total portfolio return is very small. The
role of pension funds and other institutional investors in the venture capi-
tal industry is discussed in Chap. 7.
1994 130 5 84 56
2000 230 25 245 326
2009 10 1 109 113
2014 115 12 459 350
2.6 SUMMARY
VC funds are unique financial intermediaries. They are small by any mea-
surement: annual investment, assets under management, number of VC
funds, or number of people employed by the venture capital firms, the
GPs. Unlike most financial intermediaries that are organized as limited
liabilities companies, VC funds are organized as limited partnerships with
a relatively short horizon. VC funds also have a unique business model
wherein they are looking for the rare early-stage investments that will have
exceptionally high profits at the exit and will ultimately develop into com-
panies like Apple, Facebook and Alibaba. Yet, VC funds and the venture
capital industry attract a lot of attention in the financial world, among
global policy makers, in the world of research, and in the public at large.
THE SIZE AND THE CHARACTERISTICS OF THE VENTURE CAPITAL INDUSTRY 25
NOTE
1. Companies that were funded for the first time by VC funds before or at
2000 cannot be held by them 14 years later in 2014.
REFERENCES
Agmon, T., & Messica, A. (2007). Empirical evidence on supply driven venture
capital market in the U.S. International Journal of Techno Entrepreneurship,
1(2), 207–219.
BloombergBusiness (2014, September 23). Behind the venture capital boom: Public
pensions.
EVCA. (2015). 2014 European private equity activity statistics on fundraising,
investment & divestment. Retrieved from http://www.investeurope.eu/
media/385581/2014-european-private-equity-activity-final-v2.pdf
Pearce, B. (2014). Adapting and evolving: Global venture capital insights and
trends 2014. Retrieved from http://www.ey.com/Publication/vwLUAssets/
Global_venture_capital_insights_and_trends_2014/$FILE/EY_Global_VC_
insights_and_trends_report_2014.pdf
NVCA. (2015). NVCA year book 2015. National Venture Capital Association and
Thomson Reuters. Retrieved from: http://nvca.org/research/stats-studies/
CHAPTER 3
3.1 INTRODUCTION
The development of the semiconductor industry from an abstract, radical
innovative idea to a major industry that changed the patterns of consump-
tion of most people in the world is an excellent illustration of the process
from idea to consumption and of the role of VC funds in this process.
Discussing a concrete case provides a good overview of the process before
we deal with the various facets of the venture capital industry and the
VC funds. In an article on the history of semiconductors (Lukasiak &
Jakubowski, 2010), the authors compare the invention and the develop-
ment of semiconductors to the invention and the development of the
printing press. In both cases the outcome was the creation of general
media with an extremely large number of applications. Both inventions
were metamorphic and affected almost all aspects of human life. Today
the total semiconductor industry counts for a predicted $344.5 billion
in total sales (http://www.semiconductors.org/industry_statistics/), a
big number but not even close to the sum of total turnover of industries
that use semiconductor devices to produce goods and services, especially
within the IT and computer sectors, which in turn is a very small part of
the total producer and consumer surplus made possible by semiconductor
technology.
were developed, refined devices based on the concepts and theory were
designed and built. A number of patents were awarded to such devices.
After more than a hundred years since the first documented observa-
tion of the semiconductor effect, semiconductors became products. This
development would not been possible without simultaneous discoveries in
other fields of physics, such as the development of quantum physics and
the subsequent understanding of electrons’ wave-like behavior in solid-
state devices (i.e., transistors).
own company using their own savings as the initial investment. The group
included Gordon Moore and Robert Noyce who founded Intel ten years
later. Their main development was a method of mass-producing silicon
transistors. Given the success of the development the young company
needed financing. Within the first year, the group was able to convince
Fairchild Camera and Instruments Corporation to invest $1.5 million in
setting up a new company called Fairchild Semiconductors. The market
for semiconductors grew. By 1964, sales reached $1 billion per year. In
1968, Noyce and Moore left Fairchild Semiconductors and established
Intel with financing from venture capitalist Arthur Rock who personally
invested $10,000 in the company and raised $2.5 million. In 1971, Intel
went public with an IPO value of $6.8 million. Intel is today the leading
semiconductor company in the world with more than 100,000 employ-
ees worldwide and sales of more than $55 billion. The total sales of the
semiconductor industry in 2014 were about $344 billion. Two main pro-
cesses drove the growth of the semiconductor industry: first, a constant
and rapid increase in quality combined with a simultaneous decline in
price. The second process was the rapid development of applications. The
first transistors in the late 1950s were used primarily for radios. Today,
semiconductors are the basis for the new world of digital communications.
According to data collected by Paik (2014), 135 early-stage companies
(start-ups) in the semiconductor industry were financed by VC funds in
the period from 1990 to 1995. The five years between 1990 and 1995
were a fast growth period for the U.S.-based semiconductor industry. Sales
tripled from $20 billion to $60 billion per year. Out of the 135 VC-backed
start-ups in that time period, 16 went through an IPO, 85 were merged
into or acquired by other companies, and 34 failed.2
Guzy (2010) provides data on VC backed semiconductor start-ups
in this period. Based on data collected by VantagePoint Venture, she
reports that the average return on the investment by VC funds on IPOs
of VC-backed start-ups was 5.65X, with a median return at the IPO of
2.85X. Three VC-backed semiconductor private companies yielded more
than 10X at the IPO. Those are Leadis, Marvell, and PowerDsine. The
contribution of VC funds to the development of the semiconductor
industry is measured not just by the successes, but by the total number of
VC-backed companies in the industry. It is likely that many of the 85 start-
ups that were acquired in the period 1995–2000 developed new applica-
tions for the industry. They were acquired by more established and bigger
companies because they added more uses for semiconductors, reduced
VC FUNDS AND THE SEMICONDUCTOR INDUSTRY: AN ILLUSTRATION 31
Computers 50 34
Communication 21 32.5
Consumer 14 14.3
Industrial & 9 9.7
Governments
Auto 6 9.5
Over the 14-year period between 1999 and 2013, a long period in
terms of the semiconductor industry, the share of communication uses
became equivalent in importance to the uses in the computer sector. The
share of the automotive sector rose by 50 % between 1999 and 2013. At
the same time, the sales of the semiconductor industry grew substantially.
In 1999 the global market size was $135 billion, half of it in the U.S. In
2013, the market grew to more than $300 billion, half of it in the Asia
Pacific region.
Due to rapid technological changes and increases in quality, it is not
simple to measure the changes in price of semiconductors. Yet, there is
a broad agreement that prices of semiconductors are declining rapidly
and that the price reduction brings about a reduction in relative prices of
important categories of other products. According to a study by Aizcorbe,
Oliner, and Sichel (2008), the prices of integrated circuits (IC) fell by an
average of 36 % per year in the period from 1993 to 1999. Most of the
price decline was due to technological innovation and increased produc-
tivity. Some of the decline was associated with a decline in the monopo-
listic power of the leaders in the industry. The decline in the price of
semiconductors was translated to a decline in the relative prices of the
goods produced by sectors that use semiconductors as important inputs.
In the period from 1991 to 1999 lower prices of semiconductors contrib-
uted to 16–23 % of the decline in the price of computers, to 6–10 % of the
decline in the prices of communication devices, and to 4–6 % of the decline
in the prices of consumers’ audio products. This trend continues into the
twenty-first century where industry sources estimates that the annual cost
per function continues to decline at a rate of 35 % per year.
VC FUNDS AND THE SEMICONDUCTOR INDUSTRY: AN ILLUSTRATION 33
NOTES
1. The list of Nobel laureates in physics related to semiconductor and transis-
tor related development is long; http://www.nobelprize.org/educational/
physics
2. A large part of this activity took place in Silicon Valley, and it was here the
silicon-based integrated circuit, the microprocessor, and the microcom-
puter, among other key technologies, were developed. A third of all VC
investments during the 1990 was invested in Silicon Valley located
start-ups.
VC FUNDS AND THE SEMICONDUCTOR INDUSTRY: AN ILLUSTRATION 35
REFERENCES
Aizcorbe, A. (2002, March). Why are semiconductor price indexes falling so fast?
Federal Reserve Board Finance and Economics Discussion Series Paper 2002–
2020, Washington D.C.
Aizcorbe, A., Oliner, S. D., & Sichel, D. E. (2008). Shifting trends in semiconduc-
tors and the pace of technology progress. Business Economics, 43(3), 23–39.
Ferary, M., & Granovetter, M. (2009). The role of VC firms in silicon valley inno-
vation network. Economy and Society, 38(2), 326–359.
Guzy, M. C. (2010). Venture capital returns and public market performance.
Thesis. University of Florida.
Hall, H., & Ziedonis, R. M. (2001). The patent paradox revisited: An empirical
study of patenting in the U.S. semiconductor industry, 1979-1995. The Rand
Journal of Economics, 31(1), 101–128.
Lukasiak, L., & Jakubowski, A. (2010). History of the semiconductors. Journal of
Telecom and IT, 1, 1–12.
Paik, Y. (2014). Serial entrepreneurs and venture survival: Evidence from U.S.
venture capital financed semiconductor industry. Strategic Entrepreneurship,
8(3), 254–268.
Parpala, M. (2014). The U.S. semiconductor industry: Growing our economy through
innovation. Semiconductor Industry Association (SIA).
Semiconductor Industry Association (2014). Factbook 2014.
CHAPTER 4
4.1 INTRODUCTION
Over most of the documented history of the Western world, until the last
decade of the eighteenth century there was no growth of consumption
per capita. This situation has changed radically in the last two and a half
centuries, where the rate of growth of consumption per capita grew even
as there was a substantial increase in the number of people in the world
by the business sector. The U.S. invests about 2.5 % of its GDP in research
and development. This amount can be used as an estimate for the national
resources allocated for generating developing and commercializing innova-
tive ideas in technology and management. In 2013, the GDP of the U.S.
was about $17 trillion U.S. dollars of this. 2.5 % is $425 billion. According
to the R&D statistics in the U.S. this amount is divided into basic research
(20 %), development (60 %) and application (20 %). Most if not all of basic
research is funded by the government and by donors and foundations. Most
of the development and the applications are financed by the business sector,
and much of this financing comes through the capital markets.
The ideas-led growth model developed by Jones is conceptual and
abstract. Ideas often led to very tangible results that are expressed in the
variety and the cost of goods and services that most of us consume on a
daily basis. A major example of the growth implications of radical innova-
tive ideas in technology is the history of silicon and the developments of
its uses. Silicon is a common material on Earth (and used not only for the
semiconductor development discussed in Chap. 3). The development of
goods based on silicon goes back in history. The ancient Romans were
the first to produce glass and ceramics out of silicates. At the beginning
of the inventive period in the Western world in the nineteenth century,
pure silicon was synthesized (Berzilius, a Swedish researcher, was the first
to prepare elemental silicon in 1823, and in 1866 Alfred Nobel mixed
nitroglycerin with silicon to produce dynamite). Early in the twentieth cen-
tury, silicon was transformed into polymers that were used to coat and
impregnate glass and to produce rubber like materials and adhesives (Neil
Armstrong stepped on the moon in silicon boots). In the second half of the
twentieth century, silicon was an important material in the development of
semiconductors, in medicine, and in many other fields. The combination
of new innovative radical ideas with silicon is expected to bring about more
growth from new technologies like photonics, nanotechnology and plasma.
What gives silicon more and more value and makes it a growing part in the
consumption of people is innovative ideas in technology.
new entrants willing to pay the full value of the idea, it is in the best inter-
est of the incumbents to develop and commercialize the idea.
Siemens were the first to design and build local direct current (DC) elec-
tric power devices (Edison personally designed and sold the Long-Legged
Mary Ann, an early DC dynamo) Financing radical ideas was done by
individuals as well. Edison established his own company, Edison General
Electric Company, in 1890. In 1892, he and his major competitor Coffin
of Lynn, Massachusetts got together and started the General Electric
Company. As we will see in later chapters, radical innovative ideas are
still generated by individuals or small groups of individuals and they are
financed outside the main stream of the capital market.
A major part of ideas-led growth is the development of new industries.
The telephone industry and the electric power industries are two major
examples of new industries that were developed at the end of the nine-
teenth century and at the beginning of the twentieth century. These two
industrie contributed significantly to the growth process. The new indus-
tries of the nineteenth century were developed from radical innovative
ideas of individuals that were financed by small groups of other wealthy
individuals. Radical innovative ideas today are often initiated by teams of
researchers in universities and research laboratories. Their research is often
funded by the government, but the need for an intermediary to bridge
the distance between radical innovative ideas and actual production still
exits. The biomed industry, the scanning industry, and the application of
Internet to various devices (called the “Internet of Things”) are examples
of new industries that were developed with the help of VC funds.
ogy push”. VC funds are part of the technology push process that begins
with what Kuhn (1962) defines as “puzzle solving activity” and ends with
concrete products made possible by investment in radical innovative ideas
in technology.
Radical innovative ideas at the beginning of the twenty-first century are
different than what they were in the second half of the nineteenth century.
It takes many more people, more time, and more resources to move from
a radical idea to actual production, but the nature of the process has not
changed. Dosi (1982) defines the relationship of technological changes to
economic growth as taking place within a “technological trajectory”. He
defines it as, “a cluster of possible technological directions whose outer bound-
aries are defined by the nature of the paradigm itself” Ibid, p. 154. The role
of VC funds within a new technological trajectory is comprised of three
parts: selecting radical ideas with growth potential, providing finance and
management services to the selected ideas, and transferring successful rad-
ical ideas after initial development and commercialization to the business
sector through IPOs or acquisitions (exits).
A recent example for the role of VC funds in this context is Nest. Nest
was established in 2010 by Fadell and Rogers, two ex-Apple engineers.
Their early stage operations were financed by two VC funds: Kleiner,
Perkins, Caufield & Byer and Shasta. Nest is an example of a start-up that
is an application of the general concept of the Internet applied to what is
called the “Internet of Things”. If successful the “Internet of Things” will
change many industries that provide products for the home, such as home
appliances. Nest’s specific application was to make “unloved products” in
the home more attractive by making them a part of an Internet system.
As of today Nest has produced only one product: a smart home thermo-
stat. In January 2014, Nest was acquired by Google for $3.2 billion. The
acquisition price reflects estimated potential of the radical idea developed
by Nest to be the standard of the future. If successful the “Internet of
Things” will contribute substantially to economic growth after 2025. The
two VC funds that invested at the early stage of Nest provide a crucial link
in the process of making an idea into a future economic growth. Another
example of the role of VC funds in developing radical ideas is the acquisi-
tion of Waze by Google in 2013 for $1.3 billion. Waze, an Israeli start-up,
developed and tested a crowd-sourced application for free driving direc-
tions based on information provided by the users of the application. Waze
was established in 2008 by three Israeli entrepreneurs. It was financed at
46 T. AGMON AND S. SJÖGREN
the early stage by two VC funds, Magma and Vertex. Two additional VC
funds, Blue Run Ventures and Qualcomm Ventures, joined the second
round of financing. Waze today is an important part of the consumption
of many people in the world and its service contributes to the welfare of
its users. Without the intermediary role of VC funds Waze might not be
available to consumers today.
4.7 SUMMARY
The focus of this chapter is less on VC funds as such, and is more concerned
with the context in which VC funds operate. Ideas-led growth is the reason
that VC funds exist. From a societal, macroeconomic view the only reason
for VC funds to exist is their ability to facilitate the process from ideas
to growth—a long-term economic and social process that has shaped our
world for the last two hundred years and is likely to do so in the future.
NOTE
1. The washing machine has been considered as perhaps the most important
innovation for changes in our daily life. It freed more time than other inno-
vations (compare TV that absorbs time) for doing other activities and has
had a special gender effect increasing the possibilities for women to spend
time on other activities (see Hans Rosling at https://www.ted.com/talks/
hans_rosling_and_the_magic_washing_machine for an amusing presenta-
tion on statistics on the “washing line” and world development).
REFERENCES
Agmon, T., Gangopadhyay, S., & Sjögren, S. (2014). Savings and innovation in
the U.S. capital market: Defined benefits plans and venture capital funds. In
J. E. Daily, F. S. Kieff, & A. E. Wilmarth (Eds.), Perspectives in financial inno-
vation. London: Routledge.
Arrow, K. J. (1962). Economic welfare and the allocation of resources for inven-
tion. In R. R. R. Nelson (Ed.), The rate and direction of inventive activity
(pp. 609–625). Princeton, NJ: Princeton University Press.
Christensen, C. M., & Rosenbloom, R. S. (1995). Explaining the attacker’s advan-
tage: Technological paradigms, organizational dynamics, and the value net-
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Dosi, G. (1982). Technological paradigms and technological trajectories. A sug-
gested interpretation of the determinants and directions of technical change.
Research Policy, 11, 147–162.
A MACRO PERSPECTIVE ON THE UNIQUE ROLE OF VC FUNDS IN THE … 47
Epstein, L. G., & Ji, S. (2014). Ambiguous volatility, possibility and utility in con-
tinuous time. Journal of Mathematical Economics, 50, January, 269–282.
Fudenberg, D., & Tirole, J. (1984). The fat cat effect, the puppy dog ploy and the
lean and hungry look. American Economic Review, 74(2), 361–366.
Garcia, R., & Calantone, R. (2002). A critical look at technological typology and
innovativeness terminology: A literature review. The Journal of Productive
Innovation Management, 19, 110–132.
Gordon R. (2012). Is U.S. growth over? Faltering Innovation confronts the six head-
winds (Working Paper No 18315). National Bureau of Economic Research.
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Handbook of economic growth (Vol. B, pp. 1065–1111). Amsterdam: Elsevier.
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Chicago Press.
Maddison, A. (1995). Monitoring the world economy 1820–1992. Paris: OECD.
Norbäck, P.-J., & Persson, L. (2009). The organization of the innovation indus-
try: Entrepreneurs, venture capitalists, and oligopolists. Journal of the European
Economics Association, 7(6), 1261–1290.
Norman, D. A., & Verganti, R. (2012). Incremental and radical innovation:
Design research versus technology and meaning change. Design Issues, 30(1),
78–96.
Ramsden, J. (2013). Applied nanotechnology. Amsterdam: Elsevier Science.
Romer, P. M. (1990). Endogenous technological change. The Journal of Political
Economy, 98(5, Part 2).
Schumpeter, J. A. (1934). The theory of economic development. New Brunswick, NJ:
Transaction Publishers.
CHAPTER 5
5.1 INTRODUCTION
Governments intervene in markets for three main reasons: first, to change
the income and wealth distribution, second, to correct market failures that
reduce welfare, and third, to promote specific forms of future growth that
will be lost without government intervention. Ideas-led growth is a pro-
cess that requires government intervention. In Fig. 5.1 we use the concept
Government interventions
Institutional
Research
IP Laws
Funded
savings
The Market for ldeas
of the “market for ideas” to summarize the markets and actors involved in
developing, transferring and commercializing ideas into products.
tutional investors like pension funds and endowments (Sect. 5.4). In addi-
tion, radical ideas are based on proprietary information. The idiosyncrasies
of radical ideas make them unfit to be traded in arm’s length atomistic
markets with free and full information available to all participants. Yet, the
development of radical ideas in technology and the amount needed for
their development requires access to the biggest part of the capital market.
In the U.S., this is the market of institutional savings. The growth of VC
funds since 1994 is the solution developed by the market to allow insti-
tutions like pension funds, endowments and other managers of savings
like family offices to create VC funds as specific financial intermediaries to
finance the transition from ideas to “normal” firms. Once an exit occurs,
financing moves from the functional and structural institutional arrange-
ment to the market.
Radical ideas in technology are public goods in the sense that they are
non-rivalrous and non-excludable. Often radical ideas that developed for
one purpose find their way to other related and non-related industries. As
we saw in Chap. 3, semiconductors were developed primarily within the
IT and communications sectors, but soon found their way to the automo-
tive industry. Broadband is regarded as public good and is comparable to
electricity and running water. Yet as Honig (2012) points out, broadband
in the U.S. is the outcome of private investment. In 2008–2012 broad-
band providers invested more than $250 million and they own the system.
Radical ideas in technology are not coming out of nowhere. In the
early days of the inventive process individuals who were not related to
any research institutions were responsible for many inventions. Addison,
Morse, and Bell are well-known names, but there were others like Jacob
Dyson who invented a revolutionary drill and other individuals who con-
tributed much to the development of radical ideas that changed the world
in the second half of the nineteenth century. In the second part of the
twentieth century and the beginning of the twenty-first century, basic
research became a large industry, funded in most cases by the govern-
ment. The National Institute of Health (NIH) is a major funder of ideas.
The NIH invests about $30 billion annually. In 2012 NIH supported
about 400,000 jobs in research. In 2014, the U.S. government invested
$60 billion in non-defense research. Governments, globally, follow dif-
ferent strategies on how to support and spur technological innovation.
The amount spent on R&D is of significant size (Fig. 5.2) and for some
European countries (and South Korea) it is close to 1 % of GNP.
Radical ideas in technology are assets in the sense that given an invest-
ment they generate probable cash flows in the future. The value of the
idea at the day of the investment by VC funds reflects the current risk-
adjusted value of the future cash flows, given the probability distribution
of future cash flows. In his book “Economic Dynamics” Baumol (1970)
argues that although the value of an asset is the risk- adjusted present value
of the future cash flows, the cash flows and their probability distribution
depends on investment decisions that were made in the past. Therefore,
the past history of an asset affects its current value. It follows that public
investment in basic research affects the value of radical ideas in technology.
VC funds consider the potential of the project if successful. The value of
the investment in the project, an asset based on radical ideas, depends on
future cash flows, but the future cash flows emanate from earlier work that
were done in a framework of funded research. The current investments by
GOVERNMENT INTERVENTION TO PROMOTE RADICAL IDEAS … 53
Fig. 5.2 Government spending on R&D as percentage of GNP, 2013, for some
OECD and non-OECD members. Source: OECD.Stat
on the idea of the entrepreneurs. The venture capital fund and the entre-
preneurs set up a new company (start-up). The new company has two
assets: cash ($100) and an idea. VC funds never pay the expected value.
In reality, what they pay has no relation to the ex-ante valuation based on
the business plan of the entrepreneurs. According to the assumed contract
between the entrepreneurs and the VC fund, the fund receives 40 % of the
shares of the new start-up and the entrepreneurs receive 60 % of the shares.
The entrepreneurs agree to spend the cash received from the VC fund on
the labor necessary to develop and test the idea.
The value of the idea is derived from the payments by the VC fund.
Given a payment of $100 for 40 % of the share of the value of the idea
(the only asset of the company) is $250. The cash contribution of $100
is an asset, but there is an obligation to use it for wages. Therefore, in an
economic balance sheet there is an asset of $100 (cash) and liabilities to
labor of $100 (in an accounting based balance sheet there are no liabilities
to labor). Therefore total assets and liabilities are $350 as above. The VC
agrees to pay $100 after the patent is registered. The balance sheet of the
start-up on the first day is described in Table 5.1.
Assume further that the VC fund has only one investment and that
its total capital prior to the investment was $100. The economic balance
sheet of the VC fund looks as follows (Table 5.2).
The assets of the start-up are the risk-adjusted net present value of its
future cash flows and the liabilities are the risk-adjusted current value of
the future payments of the start-up. For simplicity, assume a two-period
model where the start-up invests $100 (labor inputs) in period one and
will receive cash flows in the second period. The cash flows generated by
the investment in period 2 as a result of the investment and their prob-
ability are described in Table 5.3.
Due to the high risk, the VC fund pays $100 where its expected value
in this case is $500. The current value of the idea is based on what the
VC fund paid for its share of the equity. In case of success in our example,
the cash flow from the investment will be $10,000. The cash flows are
composed of two parts; 4000 is the value of the cash flows if the entre-
preneurs would not have a patent. Given a patent the cash flows in case
of success will be 10,000. The patent protection increases the cash flows
given success from 4000 to 10,000. The reason for the increased cash
flows given success and a patent is that the patent prevents competition
and gives the developers and the financiers of the new idea economic rent.
In extreme examples when the radical idea is easy to copy once it is devel-
oped, not having a patent makes an investment impossible. Without a
patent the VC would ask for more than 40 % of the shares. In the example
above where the VC is asked to invest $100 for an expected value of $200
($4000 × 0.05), no patent would probably lead to no deal.
The following is a description of a real case where the inability to have a
patent prevented what might have been a profitable and useful new medi-
cal test. In the mid 1990s, a scientist came up with a test for HIV based on
a biological analysis which was radically different than the then-common
test based on chemical analysis. The main advantage of the new test was
the very short time needed to get an answer. The then common test took
two weeks to develop an answer whereas the new biological test required
only 24 hours to develop an answer. The response of VC funds to this
idea was extremely positive and a negotiation with the entrepreneur for an
investment in a new start-up to develop and commercialize the proposed
test was begun days after the preliminary approach by the entrepreneur.
During the negotiation it was found that the entrepreneur (a professor of
biology) had presented a paper in a scientific conference describing the
idea of such a biological test for HIV and therefore the entrepreneur can-
not get patent protection for the idea. The interest of the VC funds in the
idea went down to zero.
GOVERNMENT INTERVENTION TO PROMOTE RADICAL IDEAS … 59
1940
1926
1935 More than 4 million workers 1943
The Reveneue Act of 1926
The Social Security Act is (15% of all workers in the Pension were exempted
favours payment top
enacted private sector) are covered from war me freeze
pensions
by pension plans
1999
Almost all the workers in the
US are covered either by ...
contribun or defined
benefits pension plan.
Fig. 5.3 A timeline over the development of institutional savings and govern-
ment intervention. Source: Workplace Flexibility, Georgetown University Law
Center (2010)
the lower-middle-class and the middle-class in the U.S. the groups that
provide most of the capital for investment in the economy. It also makes
institutional investors in general and pension funds in particular into major
investors in all asset classes.
An important component in U.S.-government policy towards insti-
tutional savings is a both explicit and implicit insurance against the risk
involved in the investment of the accumulated assets and the on-going
contribution of the beneficiaries of pension funds. Pension plans in the
U.S. are divided into two groups: defined benefits (DB) and defined con-
tribution (DC) plans. In defined benefits plans the beneficiary, the retiree,
receives a contractual pension usually as a proportion of the past wages.
The beneficiary does not contribute to the plan and it is the responsibil-
ity of the employer to fund the plan. In defined contribution plans the
beneficiary and the employer contribute monthly to the plan and the ben-
eficiary receives pension based on the accumulated amount in the plan.
Historically all public employees in the U.S. had DB plans as well as many
employees in the private sector. In recent years there is a shift in the U.S.
62 T. AGMON AND S. SJÖGREN
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the U.S. capital market: Defined benefits plans and venture capital funds. In
J. E. Daily, F. S. Kieff, & A. E. Wilmarth (Eds.), Perspectives in financial inno-
vation. London: Routledge.
Arrow, K. J. (1962). Economic welfare and the allocation of resources for inven-
tion. In R. R. R. Nelson (Ed.), The rate and direction of inventive activity
(pp. 609–625). Princeton, NJ: Princeton University Press.
Atkinson, R. C., & Blanpied, W. A. (2008). Research Universities: Core of the US
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Baumol, W. J. (1970). Economic dynamics. New York: MacMillan.
Besley, T., & Ghatak, M. (2001). Competition and incentives with motivated
agents. The American Economic Review, 95(3), 616–636.
Bohannan, C., & Hovenkamp, H. (2012). Creation without restraint. Oxford,
UK: Oxford University Press.
Boldrin, M., & Levine, D. K. (2005). The economics of ideas and intellectual prop-
erty (Research Department Staff Report 357). Federal Reserve Bank of
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line of the evolution of retirement in the United States. Memos and Fact Sheets
(Paper 50). Retrieved from http://scholarship.law.georgetown.edu/legal/50
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Europe (Working Paper). University of Thessaloniki.
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Graham, E. M., & Richardson, J. D. (Eds.). (1997). Intellectual property rights in
the global economy. Washington, DC: Institute for International Economics.
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(Working Paper No. 17773). National Bureau of Economic Research.
Honig, D. (2012). More wireless broadband is what consumers want, U.S. needs to
close the digital divide. Huffington Post, 01/03/2012.
Hirukawa, M., & Ueda, M. (2011). Venture Capital and Innovation: Which
Comes First? Pacific Economic Review, 16(4), 421–465.
Lemley, M. (2007). A new balance between IP and antitrust. Southwestern Journal
of Law and Trade in the Americas, 13, 237.
Lerner, J. (2002). 150 years of patent protection. American Economic Review,
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vations: A better way (NBER Working paper). National Bureau of Economic
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Merton, R. C., & Bodie, Z. (2005). Design of financial systems: Towards a synthe-
sis of function and structure. Journal of Investment Management, 3(1), 1–23.
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Journal, 25, 159.
Wright, M., Lockett, A., Clarysse, B., & Binks, M. (2006). University spin-out
companies and venture capital. Research Policy, 35(4), 481–501.
CHAPTER 6
6.1 INTRODUCTION
Like any financial intermediary, VC funds transfer funds from savers to
investment projects. The basic contract that sets up VC funds defines
that they will invest in radical innovative ideas in technology. The nature
of the investment project determines the two operational contracts that
rule their operations: the contract between the limited partners (LPs) and
the general partners (GPs), and the contract between the VC funds and
the entrepreneurs. The contracts between the LPs and the GPs affect the
liabilities of VC funds. The contracts between the VC funds and the entre-
preneurs affect the assets of the VC funds. VC funds invest in radical inno-
vative ideas in technology. This is a unique class of assets different than
most assets in the portfolio of institutional investors and through them in
the portfolio of the households. The uniqueness of radical ideas as a basis
for potential assets is reflected in the unique nature of the contracts that
form the liabilities and the assets of VC funds.
Financial intermediary
are large and high-risk. The matching of the supply of investment to the
demand of savings for future consumption needs financial intermediaries.
The financial market, with their actors, such as banks, brokers, hedge funds,
pension funds, and so on, are all special-purpose entities lowering the trans-
action cost of transferring money from the demand-side to the supply-side.
Banks, for example, transfer savings to debt instruments and mutual funds
transfer savings to equity. In this chapter, the financial intermediary is the
VC fund (we will also describe the pension fund as a financial intermediary
between household savings and production in the next chapter). Because
ideas are inherently non-rivalrous, risky, and inseparable from human capi-
tal, traditional markets for ideas are uncommon (Gans & Stern, 2010).
Instead, trades of ideas are settled in a negotiation between two parties.
A wide body of literature tries to explain the specific role of VC funds
as intermediaries between high-risk capital and potentially successful radi-
cal ideas. Explanations provided in the VC literature claim that VC-backed
companies are more professional in human resources policies, compared to
non VC-backed companies (Bottazzi, Da Rin, & Hellmann, 2008). The
literature also claims that GPs bring business experience, hands-on help
with recruiting, and independent professional boards to firms they support
(Baker & Gompers, 2003). VC-backed firms are also found to be more
active in patent applications; moreover, their patents are more valuable com-
pared to non VC-backed firms (Kortum & Lerner, 2000) and have shorter
time to market Hellman & Puri, 2000, 2002). One problem, called ‘survi-
vorship bias’, is that we can only observe the successful investment projects
of VC funds, as only VC backed companies that went through exit and
survived long enough to have accumulated data are included in the sample.
A related question is, why do existing, non-VC-backed firms (incum-
bents) not use the same inputs as VC-backed firms? These inputs are avail-
able in the market. Lerner (2009), investigating recent studies, writes
that incumbents may have “blind spots”, such as weak incentive struc-
tures, or organizational constraints rooted in traditional low risk strate-
gies, which make them less innovative. This does not appear to be a valid
explanation. It is unlikely that the reason why financing of new ideas is
funneled via VC-funds is due to the weaknesses of incumbents, particu-
larly as VC-backed companies like Microsoft, Apple, or Intel are now
themselves incumbents. We suggest that VC funds are a response to mar-
ket frictions and as such, are good examples of functional and structural
finance1 intermediaries aimed at transferring savings to specific, high-risk
“assets in process”. The specific nature of VC funds is expressed by con-
68 T. AGMON AND S. SJÖGREN
tracts, described in detail later in this chapter. The contracts assure that
VC funds will select projects with an appropriate risk profile, and speed
up the time to commercialization. The VC as a new entrant in the mar-
ket does not have to take into consideration the destructive part of a
new commercialized product (discussed in Sect. 4.3). The limited time
horizon of the contracts ensures that VC funds avoid taking protective
strategic decisions.
Coval and Thakor (2005) discuss the major role of financial interme-
diation as building a bridge between optimistic entrepreneurs and pes-
simistic investors. Entrepreneurs that generate radical innovative ideas
in technology are optimistic. Households (savers) are conservative. To
bridge the financial gap between the optimistic entrepreneur and the
pessimistic investor we need a rational financial intermediary. Coval and
Thakor (2005) state that: “The intermediary’s contribution lies not in any
special information processing or monitoring skills, but in its ability to cred-
ibly commit to screen projects efficiently -- something neither the optimists nor
the pessimists can do, and design contracts that enable capital to be raised
from the pessimists” (p.3). To overcome the pessimists’ skepticism a ratio-
nal actor forms a financial intermediary, invest some capital, and offer
the pessimist investor a “credible (riskless) debt contracts whose payoffs are
divorced from the pessimists’ beliefs about project payoffs. The intermediary
itself accepts junior (risky) debt claims on projects – which could also be inter-
preted as preferred stock – that compensate for its screening cost and make it
incentive compatible for it to screen projects. All optimistic entrepreneurs get
funded.” (Ibid, p.3).
Financial intermediaries like public pension funds construct a large
and diversified portfolio by collecting savings from a very large number
of households through long-term contracts between them and their ben-
eficiaries. This makes it possible to invest savings in risky and sometimes
illiquid investment projects and yet maintain low risk level for the individ-
ual saver (compare Fig. 6.1). In general large institutional investors mimic
the market created by the other financial intermediaries especially the stock
and bond markets. Therefore they allocate very small portion of the port-
folio to the unique high risk radical ideas that if successful become a part of
the market portfolio. VC funds act as a connector (or a bridge to use Coval
and Thakor terms) between household and high risk radical ideas.
Coval and Thakor suggest that financial intermediaries create credibil-
ity in their selection process of risky projects by assuming some of the
risk. GPs in VC funds participate in the investment in a very minimal
HOW THE CONTRACTS BETWEEN THE LPS, GPS, AND THE ENTREPRENEURS … 69
way (usually about one per cent of the committed capital), but they do
assume personal risk as they have very high alternative cost. The follow-
ing example illustrates the nature of the alternative cost bore by GPs in
VC funds. When a GP signs a contract with LPs in a new VC funds she
has two constraints; time constraints and capital constraints. GPs have to
select projects, negotiate the initial investment, manage the projects and if
successful organize 2–3 consecutive investment rounds and then organize
an exit all within 10–12 years. The total payoff for GPs depends on the
return on the total committed capital over the life time of VC funds. GPs
receive payments (above management fees) only if the return on the fund
as a whole exceeds an agreed upon hurdle rate. The contract between VC
funds and GPs specifies that GPs invest in very high risk projects. The data
presented and discussed in Chap. 2 above shows that large proportion
of the investment projects selected by GPs in the U.S. end up with a loss
or with return below the hurdle rate. That means that GPs are aiming at
project that if successful will yield very high return. Bad selection of proj-
ects by GP will lead to no return on a substantial effort over a number of
years. The nature of the investment targets of VC funds and the contract
between LPs and GPs create a strong incentive for GPs to put much effort
in the selection and management process of their investment projects. The
cost of mistakes is high for the GP, and that built up the GPs credibility.
its operations with a loss of $200 million to the VC funds that invested
in the company. Prockets Network is another large size failure. Prockets
Network was founded in 1999. The purpose of Prockets was to design
innovative router. The company raised $300 million. In 2004 Cisco
acquired the intellectual property of Prockets Network for $89 million.
Successes of VC investments were as big. A recent example is Nest. Nest
was founded by Fadel and Rogers, two ex-Apple engineers in 2010. Two
VC funds, KPCB and Shasta invested $30 million in Nest in two invest-
ment rounds in 2010 and in 2011. In 2014 Google has acquired Nest for
$3.2 billion. KPCB realized $400 million on an investment of $20 mil-
lion. The investment was made as a part of KPCB XIV Fund of $210 mil-
lion which means that profits from one highly successful investment was
equal to the total capital committed to the fund. Shasta realized $200 mil-
lion on an investment of $10 million out of a $250 million AllAdvantage,
Procket Networks, and Nest are extreme examples, but they demonstrate
the binomial big losses and big profits of investment projects selected by
GPs for VC funds.
The contract between LPs and GPs has two components: an explicit
contract and an implicit (relational) contract. The explicit contract defines
the payoff of GPs from the current VC fund that he or she manages. The
implicit contract deals with the probability of raising a consecutive VC fund
by the GP who manages the current fund. Both the explicit and the implicit
contracts determine the amount of effort and the project-selection process
by the GP. The common explicit contract between LPs and GPs is com-
prised of an annual management fee taken as a percentage of the committed
capital to the VC plus 20 per cents of the total profits of the LPs over the
life of the VC funds, given an agreed upon minimum profits (known as a
hurdle rate). The effect of the explicit contract on the decision making of
the GP is shown by following example. Suppose that the VC fund invested
$1000 for 40 % of the shares. The management of a start-up in which a
VC fund invests considers two alternative business policies to develop the
innovative idea that is the basis for the startup: first,, a high risk strategy
where in case of success the value is $22,000, with a probability of .05.
The second alternative is a lower risk strategy. In this case the value of the
startup at the beginning of the second period in case of success is $1500
and the probability of success is .7333. Both projects pay $0 if they fail. The
expected value of the two alternatives at the beginning of period 1 is the
same: $1100 ($22,000 × 0.05 and $1500 × 0.7333 respectively). The man-
agement of the start-up has to decide which strategy to follow: high-risk or
low-risk (this is often a bone of contention between GPs of VC funds and
the entrepreneurs in the start-up). The entrepreneurs are also employees of
the start-up. As such, they have an interest in the length of their employ-
ment. As they know that there is a substantial probability of terminating the
start-up soon if the high-risk strategy is followed they are likely to prefer
the low-risk strategy. The contract of the GP creates an incentive for high
risk taking because the share of the GP in the success depends on the size
of the success and it approaches 20 % of the success as the success is bigger,
(this assumes no catch-up). Assume that the contract with the LPs gives
the GP 20 % of the return above 10 %. Assume that the share for the GP
is 40 %. In this case the risky business policy, if successful, will pay the GP
(($22,000 × 0.40) − $1100) × 0.20 = $1540. The less risky business policy, if
successful, will pay (($1500 × 0.40) − $1100) × 0.20 = $100 so the GP will
receive nothing. The difference in the attitude to risk is intentional, as the
projects selected by GPs in VC funds comprise the most risky component
of the investment by institutional investors and other investors in VC funds.
The contracts will affect the GP as a decision maker to take on risk-taking
72 T. AGMON AND S. SJÖGREN
behavior. The contracts between the VC fund and the entrepreneurs, dis-
cussed in the next section, create a difference in risk preferences between
GPs and entrepreneurs.
The effects of the implicit contract between LPs and GPs are more
long-term, but they have an impact on the investment decisions by GPs in
the current VC funds that they manage. Having more than one VC fund
increases the payoff to the GP greatly. Yet, according to a study by Tyabji
and Sathe (2010), for two thirds of the GPs their first VC fund is also their
last. Only 10 per cent of VC firms (GPs) launch more than 4 VC funds. As
the lifetime of a VC fund is only 10–12 years long, a second VC fund has
to be launched while the first one is still alive. This puts a large premium
on early successes. If a VC fund can report 20X on an investment three
years after the investment (as was the case with KPCB and Nest) it makes
it easy to raise another fund. Raising another fund increases the payoff for
the GP substantially. Therefore, if a first fund has a large, early success the
GP’s risk appetite will increase, due to the implicit relationship between
a successful first fund and consecutive funds. Big successes are measured
relative to market conditions at the time. This makes the payoff for the
GP partially dependent on the performance of other GPs. In a situation of
one principal and many agents, contracts that take into account the rela-
tive performance of each one of the agents are efficient and optimal.2 The
efficiency of the contracts between LPs and GPs, given the objective func-
tion of the LPs, explains why the payoff structure of GPs has continued in
the face of much criticism.
also congruent with the purposes of the contract between the LPs and the
GPs of VC funds. Entrepreneurs in portfolio companies of VC funds have
two major interests: they receive wages as executives in their start-up com-
panies and they have a chance for capital gains from an exit if the project
is successful. The first component is riskless and the second is highly risky.
The wages are financed by the investment of VC funds. The entrepreneurs
have an interest in using all the investment by the VC fund as more time
may increase the probability of success as well as maximize their benefits
from the wages. Given the time constraints discussed above, the LPs and
the GPs have an interest in finding out as fast as possible if the project is
successful or not. Dropping an unsuccessful project as fast as possible is in
the interest of the LPs and the GPs, but not in the interest of the entre-
preneurs. The structure of the contract between the VC fund and the
entrepreneurs is designed to minimize the potential conflict between the
VC fund and the entrepreneurs by shifting the control straight to the VC
fund if the project does not perform as planned.
The contract between the LPs and the GPs makes GPs behave as if
they prefer projects with very high return if successful, even at a cost
of very high risk. This risk preference by GPs is translated into giving
GPs decision rights that give them the power to make the strategy of the
portfolio companies of VC funds congruent with their preferences for a
high return conditional on success, even when it means high risk for the
entrepreneurs.
liabilities. The companies decide how much they want to invest, and sav-
ings of households finance the investment. Clearly, investment decisions
by firms are affected by the supply of funds. Ex post savings are identically
equal to investment.
VC funds are a different type of financial intermediaries. They operate
outside existing companies. What GPs of VC funds do is select a small per-
centage of a large flow of radical innovative ideas in technology and then
invest capital in those ideas, in an effort to turn the ideas into assets that
are part of the market portfolio. If successful, the radical ideas selected by
GPs of VC funds become assets of new companies (through IPOs) or a
part of existing companies (through mergers and acquisitions). MobilEye
is an example of a VC-backed IPO and Nest is an example of a successful
acquisition. AllAdvantage and Prockets are two examples of investment
led by VC funds that did not end up with adding new future cash flows
and assets to the market portfolio.
The different role of VC funds as financial intermediaries is expressed
in the special relationship between them and the institutional investors
that provide them with most of the capital. Whereas most other finan-
cial intermediation (like transferring savings to the equity and the debt
markets) is done by employees of the institutional investors, VC funds
are arm’s length intermediaries that have a contract with the institutional
investors. The three contracts that rule VC funds are the contract that
specifies the horizon, the capital commitment, and the type of the invest-
ment projects, then the contract between the LPs and the GP, and finally
the contract between VC funds and the entrepreneurs. These contracts
are aimed to encourage VC funds to assume high risks. The construction
of these contracts is functional for the inherent characteristics of ideas as
being non-rivalrous (needs negotiation), binominal in the return profile
(encourage risk taking), and destructive for existing assets in place (lim-
ited time horizon). In Chaps. 7 and 8 we show that this unique high-risk
investment policy is optimal for the savers as well as for the institutional
investors that manage the savings.
NOTES
1. The phrase ‘functional and structural finance’ was suggested by Merton and
Bodie (2005).
2. Similar results in a different context are described by DeMarzo and Kaniel
(2015).
76 T. AGMON AND S. SJÖGREN
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tem and other secrets. Ivy Business Journal. July/August.
CHAPTER 7
7.1 INTRODUCTION
Financial contracting can be defined as the “theory of what kinds of deals
are made between financiers and those who need financing” (Oliver
Hart, 2001, p. 1079). Hart motivates the definition by posing the fol-
lowing question: “Suppose an entrepreneur has an idea but no money
and an investor has money but no idea. There are gains from trade,
but will they be realized? If the idea (project) will go off the ground,
how will it be financed?” In this chapter, we discuss the way that radi-
cal innovative ideas are financed through VC funds as a way to gener-
ate “gains from trade” that will extend future consumption possibilities.
Radical innovation and finance have gone hand in hand since the begin-
ning of the modern inventive process in the Western world, at the end of
the eighteenth century. The close relationship and mutual dependence
between innovative ideas and finance during the second industrial revo-
lution in the U.S. is illustrated in a study of venture capital in Cleveland
in the period 1870–1920 (Lamoreaux, Levenstein, & Sokoloff, 2006).
The researchers recount the beginning of a start-up company at the time
named Cleveland Twisted Drill Company. Jacob Dolson Cox, a machin-
ist from Cleveland, meets C.C. Newton an inventor of cutting tools in
Buffalo, NY. Newton sets up shop to develop new cutting tools but
has no money to support his inventive efforts. Cox and Newton form
a partnership to move the company to Cleveland, where Cox raises the
initial investment of $2000 from his father as a loan (at 7 % interest).
The partnership of the two entrepreneurs that was financed by the father
of one of them developed over the years to become a large and suc-
cessful company called Cleveland Twisted Drill Company. The combina-
tion of entrepreneurs who have an idea and financiers who are ready to
finance such ideas is still an important part of the inventive process today.
Individual mechanics of the nineteenth and the early twentieth centu-
ries were replaced by teams of scientists, and wealthy individuals were
replaced by VC funds that rely on small parts of the savings of middle
class savers, but providers of risk capital are still a necessary condition for
successful radical innovation.
In Chap. 6 we discussed VC funds as specific financial intermediaries
that finance the transition of radical ideas in technology from potential
to realization. Lundvall’s (2009) statement, “A substantial part of the
innovative activities take place in units separated from the potential users
of the innovation” is a testimony to the need for a “special unit” to
perform this transition. In Chap. 5, we discuss how government inter-
vention can contribute to innovation. Related to this chapter is how
institutional savings have developed over the years. In this chapter, the
focus of the discussion is on the question of why the financing of the
transition of radical ideas from potential to actual contribution to cur-
rent and future consumption (a contribution to consumers’ surplus) is
done primarily by institutional investors. To answer this question, we
use the life-cycle savings model and show how pension funds, an insti-
THE ALLOCATION OF SAVINGS TO VC FUNDS, CONSUMERS’ SURPLUS … 79
The life-cycle savings deals with consumption and not with financial
return. There is a need to motivate institutional investors to allocate capi-
tal to investments based on radical ideas that contribute to future con-
sumption possibilities of their beneficiaries even if their aggregate return
as an asset class in itself is insufficient to cover the risk as it is measured by
LPs in VC funds. In the next chapter, we show that due to externalities
to the portfolio of all other assets held by institutional investors, there is
congruence between the financial measurement of the return on the port-
folio by institutional investors and the long-term utility of consumption
of their beneficiaries.
By investing in the market at large, the institutional investors who
manage the savings provide the savers the protection that they seek in
terms of their future consumption. This is because financial assets are the
rights to future cash flows. The cash flows are generated by the produc-
80 T. AGMON AND S. SJÖGREN
Households
“Savers”
Future consumption Savings
that issue the securities (their liabilities). The securities held as assets by
institutional investors are liabilities in a balance sheet of the companies in
which they invest. The assets of these companies represent the cash flows
from sales of goods and services that these companies will produce in the
future. As is shown in Fig. 7.1, expected future consumption is mapped
against the current assets’ allocation (investment) of institutional inves-
tors. Most of the asset allocation of institutional investors goes to existing
companies and other organizations that produce the goods and services
that comprise current consumption and the expected improvements in
future consumption due to incremental innovation. A part of future con-
sumption is comprised of goods, services, and production technologies
that do not exist today and that are not part of the process of incremen-
tal innovation. This part of future consumption depends on successful
radical ideas in technology. A well-known example is the cellular phone
that did not exist and was not anticipated to become an important part
of the consumption basket not so many years ago. Radical ideas surprise
incumbents and the market. That is why they are radical. Households
do not know which radical ideas will be successful in the future. They
do know that some radical ideas will be successful in the future and that
their future consumption will be affected by the outcomes of these ideas.
Therefore, it makes sense for households to invest some of their savings in
the development testing and commercialization of radical ideas knowing
well that most of them will not prove to be successful. Asset allocation by
institutional investors to VC funds is a way for households to invest in the
unknown changes in their future consumption as a result of radical new
production processes or radical new goods and services. In earlier chap-
ters, we have shown that successful radical ideas changed the life of most
if not all consumers and that radical ideas in technology and their applica-
tions are the reason for the continuing process of increasing consumption
per capita in the last 200 years. As we have shown in Sect. 7.1, appropriate
financing was a necessary condition for the success of such radical ideas
and their applications. The initial financing of such ideas is small.
To explain why it may be rational to invest some of the savings in radi-
cal high risk ideas we adopt a model developed by Friedman and Savage
(1948). Their model explains why risk-averse households invest small
amounts of money in a lottery that has a very high return if successful,
but the household’s expected value is negative. Their explanation is that
individuals may be risk averse in making investment decisions in general,
but at the same time may be willing to take on risk in lottery that, if
82 T. AGMON AND S. SJÖGREN
There are three assets in the economy and the person has to allocate
the savings (investment) between the three assets: asset number one is a
riskless asset with a risk-free interest rate, asset number two a risky asset
with an expected return above the risk-free rate, with an assumed normal
THE ALLOCATION OF SAVINGS TO VC FUNDS, CONSUMERS’ SURPLUS … 83
fied in terms of long-term return on the total portfolio. The target return
reflects the “appetite for risk” of the pension fund. Due to the small alloca-
tion, the financial return on the investment in VC funds hardly affects the
return on the total portfolio. It is an interesting question, then—why do
pension funds in general and public pension funds in particular contribute
a substantial part of the capital for VC funds where it affects neither the
return nor the risk of their portfolio? In Chap. 6, it has been shown that
the contract between the LPs who represent the institutional investors
and the GPs who manage VC funds pushes GPs to aim at “metamorphic
assets”, the third asset in the asset allocation model described above, with
the highest value if successful (even if the probability of success is small).
Asset allocation by institutional investors for radical ideas through VC
funds differs from other asset classes. In most other asset classes institutional
investors buy assets in a market like the stock market. VC funds negotiate
transactions with entrepreneurs. The negotiation is dynamic, as is evident
from the discussion of the GP-entrepreneur contract in Chap. 6 above.
Gans and Stern (2010) discuss the nature of transacting in the market for
radical ideas. Based on the literature of market design and the market for
technology they conclude that due to the specific characteristic of ideas like
complementarity across ideas and user reproducibility, radical ideas need
personal care. In an earlier study, Gans, Hsu, and Stern (2002) show that
VC funds provide such care and that they act as nurseries for ideas that
may create a storm of creative destruction. The small share of investment
in assets based on radical ideas makes the outsourcing of the selection and
management of such investments to VC funds an efficient solution.
Table 7.1 Balance sheet of the start up after investment round one
Assets Liabilities and net worth
Table 7.2 Balance sheet of start up company after investment round two
Assets Liabilities and net worth
round. As more capital is needed, the balance between labor and capital is
changing and therefore in second, third, and later investment rounds the
share of the entrepreneurs is declining. The balance sheet above describes
how the accumulated potential value of the start-up company is allocated
between the VC funds that invested in the two rounds and the entrepre-
neurs. Given the contract between the LPs and the GPs in the VC funds
that have invested in round one and round two it is possible to calculate
the expected value as of the end of the second round of the payments
to the GPs. The value of the VC-backed company is represented by the
equity in the balance sheet. The equity is allocated between the entrepre-
neurs and the LPs in the first round and the LPs in the second round. The
accumulation of value (equity) is the expected value to the providers of
capital (LPs), and to providers of labor (GPs) in VC funds. Actual produc-
ers’ surplus and actual consumers’ surplus depend on exit. The RBV based
analysis presented above makes it possible to measure the development of
the value of the VC backed company over the investment rounds and to
allocate it between producers’ surplus and consumers’ surplus.
The data presented above show that the adaptation time shortens rela-
tive to how recently the technology was created; for example, the Internet
took only ten years to become ubiquitous. The rate of adoption of innova-
tive ideas is often described as an s-curve. In one of the best well-known
studies on the adoption of innovation, Rogers (1983) found that the
potential users of any given innovation can be divided into five groups by
the time that it takes them to adopt an innovative product, service, or pro-
duction technology. The first group is the innovators and they are about
2.5 % of the potential users. They are followed by early adopters (13.5 %
of potential users), then come the early majority (34 %), the late majority
(34 %), and lastly the laggards (16 % of potential users).
A case in point is the development of Nest, which we described in earlier
in the book. Nest develops an application of the Internet. The application
is an expression of a radical innovative idea to use Internet for communi-
cation with ‘Things’ rather than communication with people. However,
when Nest started its operation there were few users, if any. The value was
small in this initial stage. The full potential of the idea was perhaps not yet
fully revealed. The success of Nest did also depend on competition from
other firms aiming for market shares in communicating with ‘Things’. This
is evident from the small investment that KPCB and Shasta Partners made
in 2010. When Google acquired Nest in 2014 the number of users had
increased and this affected the value of Nest, which is in part based on the
current and expected number of users. Google has acquired Nest for $3.2
THE ALLOCATION OF SAVINGS TO VC FUNDS, CONSUMERS’ SURPLUS … 91
7.5 SUMMARY
In a 2011 publication, the OECD proposed what they call more responsi-
ble and longer-term investment policies for pension funds and other insti-
tutional investors. These proposed investment policies explain the lead
role of pension funds in investing in innovative ideas in technology and in
92 T. AGMON AND S. SJÖGREN
The proposed policies by the OECD for institutional investors are con-
gruent with the role of such investors in providing financing for radical
innovative ideas through VC funds. GPs of VC funds play an active role
in the portfolio companies of VC funds. VC funds invest in illiquid, high
risk investments that may provide substantial consumers’ surplus over the
long-run. It takes large, well-diversified institutional investors to interme-
diate between the individual saver’s preference for short term, low-risk
and liquid investments and the societal requirements as specified in the
OECD proposed policies. The progress of institutional savings in the U.S.
and in other OECD countries contributes to more radical innovation,
which in turns increases consumers’ value. The partnership between entre-
preneurs and institutional investors expressed by VC funds remains an
important development in extending the inventive process and its growth
implications into the twenty-first century.
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computers-are-filling-the-digital-divide
CHAPTER 8
Abstract All the literature that deals with the definition of the measure-
ment of the return on the investment in VC funds measures the return to
the LPs over the relevant horizon of VC funds. Most measurements show
insufficient risk-adjusted return. We show that this is an incomplete mea-
surement. A complete measurement should take into account externalities
due to spillovers that increase the return on the total portfolio held by
institutional investors that allocate capital to VC funds. There is a differ-
ence between the return to the LPs in a VC fund and the returns to the
institutional investors that invested the capital through the LP. The total
long-term return to the institutional investors is congruent with the total
return to the beneficiaries, in terms of their long-term consumption.
8.1 INTRODUCTION
The modern valuation model is derived on the basis of a complete and
perfect market. The main assumption is that investors are holding a well-
diversified portfolio, called the market portfolio. The return and the risk
of any given financial asset is measured relative to the risk and return
relation of the market portfolio. The well-known capital asset pricing
model (CAPM) is an example of the measurement of the risk and return
of specific assets relative to the market. In the case of the return on
Table 8.1 US VC funds pooled return compared to public market returns, 2014
Index 5 years 15 years 20 years
investors in VC funds take on high fees, illiquidity and high risk, they rarely
reap the reward of high returns” (p. 1). The two quotes demonstrate the
controversy about the return on investment in VC funds by the providers
of the capital, the LPs of the VC funds. The academic literature on the val-
uation of VC funds based on the return to capital invested in VC funds is
inconclusive. Harris, Jenkinson, and Kaplan (2014) conducted a thorough
study on the return on the investment in PE funds and in VC funds. They
reported that investment in the top one-half of VC funds since the 1990s
yielded appropriate return relative to the relevant public market equivalent
(PME). They also reported that the investment in VC funds in the 1990s
yielded above PME returns whereas investment in VC funds in the 2000s
yielded below PME return. As the authors of the study say, institutional
investors have no ability to choose the better-performing VC funds as this
is determined at the end of the life of the funds. Therefore, the appropri-
ate measure for the evaluation of the return on the capital invested in VC
funds is the average return over all funds over their horizons. Kaiser and
Westarp (2010) provide an analysis of the distribution of the returns on
investment of LPs in VC funds. Kaiser and Westarp show that unlike the
bell-shape distribution of returns on capital assets at large, the return on
the capital invested in VC funds by LPs is highly skewed. The pooled
average annual return in their sample is 15.9 %, but more than half of the
VC funds in the sample report return between 0 % and (–100 %), about
10 % of the VC funds in this period have reported returns of more than
40 % and about 5 % of the VC funds in the sample reported annual return
of more than 100 %. This data is also consistent with the data reported in
the Kauffman Report (Kauffman Foundation, 2012). The authors of the
Kauffman Report used the data of the Kauffman Foundation, an inves-
tor in VC funds in the U.S. The Kauffman Report is based on a sample
of 100 VC funds. Only 20 of the 100 VC funds in the sample reported
return that exceeds the relevant PME by 3 % or more. 10 of these funds
were founded before 1995. (This is consistent with data reported from a
bigger sample by Harris et al., 2014). 62 of the VC funds in the Kauffman
Report sample reported return below the relevant PME. In the sample,
30 VC funds were large VC funds, above $400 million. Only four of these
VC funds yielded return above the return on the small-cap common stock
index for the same period.
Yet, even in the face of what seems to be less than expected return
considering the risk and the illiquidity and what look like negative senti-
ment institutional investors continue to invest in VC funds. The reason for
98 T. AGMON AND S. SJÖGREN
Table 8.2 Statistics of the distribution of success measures given exit, 1996–2005
Measure Mean Median Skew
Table 8.3 A comparison between VC backed new IPO and non-VC new backed
IPOs 1980–2012
Company IPO (number of) Average first day return Buy-and-hold return
3 Years comparable
Table 8.4 The volatility of VC backed 1st day return and 3 years BHR by sub
periods 1980–2012
1980–1989 1990–1998 1999–2000 2001–2012
to comparable already listed companies that were listed for at least 5 years.
The comparison is done based on market cap and book-to-market ratio.
VC-backed returns were volatile. In periods of high exit return as
measured by the average first day return, the comparable three-year
BHR was low. The comparable three-year BHR of non-VC- backed new
IPOs behaves in an opposite manner. This data is presented in Table 8.4
below.
The data presented in Table 8.4 show great volatility in the first-day
return and the return over time (three-year holding period). High first day
return was adjusted by a decline over the longer holding period return.
the potential additions to the market portfolio affect the return on their
investments in VC funds.
The preferences of GPs of VC funds are different. As was discussed in
Chap. 6, the contract between GPs and LPs is aimed at creating payoff
for the GPs, a payoff that will make GPs looking for the highest potential
return give success of a project almost regarding of the probability of suc-
cess. GPs are looking for projects that, if successful, will yield IPO value
like Facebook and not like Envivo even if the expected value of Envivo
prior to the investment was higher than that of Facebook.
Measuring only the direct return to the LPs after fees as the total return
to the providers of the capital is incomplete measurement. This is so as the
institutional investor realizes additional return through the spillover effect
over the measured return by the LPs in the VC fund. All the literature on
the return on investment in VC funds focuses on the direct return to the
LPs after management fees and carries over payments to GPs. There is an
incongruity between insufficient risk-adjusted return over long periods
of time like those reported by Harris et al. (2014), Smith et al. (2010),
and the Kauffman Report (Kauffman Foundation, 2012) and further dis-
cussed in Hall and Lerner (2009) and the continuous investments in VC
funds. The reported return on total investment by institutional investors
in all VC funds is not high enough to pay for the risk. Institutional inves-
tors continue to allocate capital to VC funds by mimicking the market and
reducing the free rider problem. Moreover, the continuous investment
by institutional investors in VC funds is explained by the added indirect
return due to positive externalities.
Required return is specified in terms of risk and return by measures
like risk-adjusted return. Successful investment by VC funds may change
the risk as well as the return in the market. The risk and the return effect
relates to the transition of the asset from the “outside” to the “inside”
of the market. Before the exit, there is still a high probability (1 − p) that
the investment of the VC funds will end with a loss of the capital invested
by the institutional investor (a return of minus 100 %). In this case, there
is no change in the market portfolio. Given success of the investment
project of the VC fund the start-up will go public and the new company
will join the market portfolio. Both the return and the risk of the market
portfolio will change as the result of the addition. The discussion of the
semiconductor industry in Chap. 3 and the contribution of companies like
Microsoft, Apple, Facebook and eBay as well as many other innovative
companies discussed briefly in Chap. 2 are specific and concrete examples
to the contribution of VC backed IPOs to the return of institutional inves-
tors through externalities.
EXTERNALITIES, CONSUMERS’ SURPLUS, AND THE LONG-TERM RETURN ON … 105
NOTE
1. Cash on cash is the amount the VC receives at exits divided by the amount
of total investment.
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CHAPTER 9
9.1 INTRODUCTION
The inventive process and its financing depends on the nature of technology
and on specific institutional arrangements at different times. What remains
constant is the dual process of incremental and radical innovation. In his
recent book, “The Evolution of Everything: How New Ideas Emerge”
Ridley (2015), questions the role government can play in funding basic
beginning of the twentieth century. Some innovation was done in the con-
text of R&D in large companies, primarily in the Midwest. This activity
was financed by banks and by the stock market. At the same time, smaller
entrepreneurial early-stage firms on the East Coast developed innovative
ideas and financed them through local sources. VC funds are an expression
of the conditions at the end of the twentieth century and the beginning
of the twenty-first century. They provide appropriate financial solutions
for the developing and commercialization of radical ideas in technology in
our time. In Chap. 5we discuss VC funds as a part of structural and func-
tional finance. As the world changes it is likely that VC funds will devel-
oped into new forms, but the need for financing the more radical “out
of the box” innovative ideas in technology will continue. In this chapter,
we provide some early thoughts about the likely effects of major trends in
the world of today on the future of VC funds. We focus on three major
changes that may affect the future form of VC funds: changes in technol-
ogy, globalization, and the increased role of government funding of VC
funds, particularly in emerging markets.
the target for the acquisition. In new digital platforms, the innovation will
be applied directly to all users and partners without the intermediation of
the organizational form of a firm. Such a change, if and when it occurs
may change the mode of operations of VC funds.
VC funds are financial intermediaries. As we have discussed in Chaps. 5
and 7, VC funds are a long-arm of institutional investors and other man-
agers of savings. VC funds are a part of the flow of funds where savings
of households are transferred to intermediaries that transfer the savings
to particular investments. Financial intermediation is a function of the
cost of collecting and processing information and other transaction costs
including the intangible trust related costs. Digital platforms reduce these
costs substantially. One expression of the cost reduction is the develop-
ment of crowd financing. Crowd financing (also called crowdfunding) is
defined by Wikipedia as a practice of funding a venture by raising mon-
etary contribution directly from a large number of people. According to
Wikipedia, more than $5 billion was raised by crowd funding in 2013.
Today there are more than 1000 platforms for crowd funding, some of
them are specific for early stage investments in radical innovative ideas
in technology. Crowd financing is not perceived in the VC industry as a
threat to VC funds; yet, it is likely that it will change the way that capital
is raised by VC funds.
NOTE
1. Ridley’s book continues the discussion of the basic issues of “demand pull”
and “technology push” nature of innovation discussed by Dosi (1982),
referred to in Chap. 4 above.
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A Bell Laboratories, 29
Accenture, 109 bidding process, 42
aggregators, 56 binomial probability distribution,
Agreement on Trade-Related Aspects 99, 101
of Intellectual Property Rights bonds and equity, 81
(TRIPS), 56 book-to-market ratio, 100
alternative investments (AIM), 19, 80 broadband, 52, 91
annual capital investments, 17 buy and hold return (BHR),
annual management fee, 71 99, 100
asset allocation model, 21, 81
for investments in VC funds, 82–4
assets in process, 3–4, 6, 8, 9, 57, 63, C
67, 73–4, 84, 98 CalPERS, State of California public
automotive sector, 32 pension fund, 9, 83–4, 101
average annual return, 97 Cambridge Associates, 96
average initial-stage investments, 20 capital asset pricing model (CAPM),
95
capital markets, 7, 10, 40, 112
B carried interest, 15
Bah-Dole act (Patent and Cash flow-probability correlation,
Trademark Law Amendments 57–8
Act, 1980), 53 cash flows, 79–80
balance sheet, 57, 73, 81 cash-on-cash terms, 59, 105
I M
ideas-led growth model, 40–1, 49 management fee, 15, 69, 71, 104
income and wealth distribution, 49 market cap, 100
income per capita, 1 market failures, 49
increasing return to scale, 38 market for ideas, 50
Indiana State (INPRS), 83 market portfolio, 95, 98, 103
industrial revolution, 1, 43 market value, 2, 85, 102
Initial public offer (IPO), 9 Matrix Partners, 112
innovative ideas in technology, 38 McKinsey & Company, 91
innovative production Metal-Oxide-Semiconductor-Field-
technology, 89 Effect (MOSFET) transistor, 29
institutional investors, metamorphic asset, 83, 84
22, 79–81, 85 Microsoft, 4, 21, 55
institutional savings, government middle class savers, 50, 78
support, 60–2 Miller, & Modigliani model, 74
integrated circuits (IC), 32 MobilEye, 75
Intel Corporation, 30, 33, monopolistic market, 42
34, 55 monopolists, 55
intellectual assets, 98 monopoly power, 54–5
intellectual property (IP) laws, 3, 7, Moore’s law, 29
54–6
Internet of Things, 44
inventive process, 1, 39 N
investment rounds, 86 NASDAQ, 18
IPO, 30 National Institute of Health
irreversibility-delay proposition, 59 (NIH), 52
National Venture Capital Association
(NVCA), 21, 23
K Nest, 45–6, 70, 90–1
Kauffman Foundation net present value, 57
report, 9, 96–7, 104 new assets, 3–5, 98, 99
knowledge assets, 98 Newton, 78
nitroglycerin, 40
Nobel Prize, 29
L non-durable goods, 88–9
Labor Management Relations Act, 60 Non-rivalry of ideas, 38, 39
liabilities, 57, 73–4, 81
life-cycle savings model, 79–82
light-emitting diodes (LEDs), 29 O
limited partners (LPs), 7–9, 15, oligopolistic market, 42
66, 69 Open Patent Non-Assertion (OPN)
low-risk strategy, 71 system, 109
122 INDEX
V Y
VantagePoint Venture, 30 Yozma program, 111
venture capital (VC) funds, 2–3, 5,
6, 7, 13, 27, 51, 65, 108–9