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
Tamir Agmon and

Stefan Sjögren
Venture Capital and the Inventive Process
Tamir Agmon • Stefan Sjögren
Venture Capital and

the Inventive Process
VC Funds for Ideas-Led Growth
Tamir Agmon Stefan Sjögren
University of Gothenburg University of Gothenburg
Göteborg, Sweden Göteborg, Sweden
ISBN 978-1-137-53659-4 ISBN 978-1-137-53660-0 (eBook)

DOI 10.1057/978-1-137-53660-0
Library of Congress Control Number: 2016941484
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CONTENTS
1 A Comprehensive Economic Look at VC Funds 1

1.1 Introduction: The Purpose of This Book 1
1.2 Radical Ideas as Assets 3
1.3 The Need for Government Interventions as a Necessary
Condition for the Development of Radical, Innovative
Ideas in Technology 4
1.4 The Functional Role of VC Funds in Financing
Radical Ideas 4
1.5 The Narrative of the Book and Its Structure 5
References 10
2 The Size and the Characteristics of the Venture

Capital Industry 13
2.1 Introduction 13
2.2 The Structure of VC Funds 14
2.3 The Size of VC Funds 16
2.3.1 The Size of VC Funds in the Global World 16
2.3.2 The Size of VC Funds in the U.S. 17
2.3.3 The Number and the Nature of the Investment
Projects of VC Funds in the U.S. 19
2.3.4 The Dynamics of U.S. VC Funds 21
2.4 The Sources of Capital for U.S. VC Funds 21
2.5 Success and Failure in U.S. VC Funds 23
v
vi CONTENTS
2.6 Summary 24
References 25
3 VC Funds and the Semiconductor Industry: An Illustration 27

3.1 Introduction 27
3.2 The Development of the Idea of Semiconductors 28
3.2.1 The Early Stages of Semiconductors 28
3.2.2 From Ideas to Products 29
3.3 From Devices to Commercialized Products: VC Fund
Participation in Forming an Industry 29
3.4 Contribution of Semiconductor to Growth 31
3.5 Summary: The Role of VC Funds in the Semiconductor
Industry 34
References 35
4 A Macro Perspective on the Unique Role of VC Funds

in the Process from Ideas to Growth 37
4.1 Introduction 37
4.2 The Connection Between Ideas and Growth 38
4.3 The Role of Radical Ideas in the Growth Process 40
4.4 Incumbents and VC-Backed New Entrants 41
4.5 The Generation and the Development of Radical Ideas
in Technology 43
4.6 The VC Funds as a Part of the Technology “Trajectory” 44
4.7 Summary 46
References 46
5 Government Intervention to Promote Radical Ideas

and VC Funds as a Functional Form to Facilitate Their
Financing 49
5.1 Introduction 49
5.2 Types of Government Interventions 50
5.3 Why Government-Funded Research Is Necessary to
Promote the Generation of Ideas: The Public-Good
Characteristics of Radical Ideas 51
5.4 Temporary and Contestable Monopoly: Government
Intervention Through IP Laws 54
5.4.1 Competition, Monopoly and IP Laws 54
5.4.2 The Role of Patents in VC Funds 56
CONTENTS vii
5.5 Government Support of Institutional Savings 60

5.6 Summary: VC Funds, a Response to Incentives Provided by
Government Intervention in the Market for Radical Ideas
in Technology 62
References 63
6 How the Contracts Between the LPs, GPs,

and the Entrepreneurs Facilitate Investments in High-Risk
Radical Ideas 65
6.1 Introduction 65
6.2 VC Funds and the Role of Financial Intermediation 66
6.3 Radical Ideas Are Examples of High-Risk Assets 69
6.4 The Contracts That Forms VC Funds 70
6.4.1 The Contracts Between the LPs and the GP 70
6.4.2 The Contracts Between the GP and the Entrepreneurs 72
6.4.3 Assets, Liabilities and Contracts 73
6.5 Summary: The Unique Nature of VC Funds as Financial
Intermediaries 74
References 76
7 The Allocation of Savings to VC Funds, Consumers’

Surplus and Life-Cycle Savings Model 77
7.1 Introduction 77
7.2 The Life-Cycle Savings Model and High
Risk Investments 79
7.3 Asset allocation Model for Investments
in VC Funds 82
7.4 The Contribution of VC Funds
to Consumers’ Surplus 84
7.4.1 How VC Funds Generate Consumers’ Surplus 84
7.4.2 How VC Funds Increase Consumption Possibilities 87
7.5 Summary 91
References 92
8 Externalities, Consumers’ Surplus, and the Long-Term

Return on Investments by VC Funds 95
8.1 Introduction 95
8.2 The Controversy About the Return on Investment in
VC Funds 96
viii CONTENTS
8.3 The Specific Risk of Assets Based on Radical Ideas 98

8.4 The Risk Preferences of GPs, LPs and the Beneficiaries
of Institutional Investors 100
8.5 Direct and Indirect Considerations in Measuring the Return
on Investment by Institutional Investors in VC Funds 102
8.6 Summary: The Market Is Right 105
References 105
9 The Future of VC Funds: The Effects of Technology

and Globalization 107
9.1 Introduction 107
9.2 Knowledge Economy and VC Funds: Digital Platforms
and Crowd Financing 109
9.3 Globalization and VC Funds 110
9.4 Who Will Finance VC Funds, Savers or Taxpayers? 111
9.5 Summary: The Future of VC Funds 112
References 113
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
Fig. 2.1 VC fund actors and investment relations 14

Fig. 2.2 Venture capital investments in the US, between 1985 and
2014 ($ billions) 18
Fig. 5.1 Government interventions for promoting radical innovations
in the market for ideas 50
Fig. 5.2 Government spending on R&D as percentage of GNP, 2013,
for some OECD and non-OECD members 53
Fig. 5.3 A timeline over the development of institutional savings and
government intervention 61
Fig. 6.1 The role of financial intermediary—matching households’
preferences with the supply of real world projects 66
Fig. 7.1 The transformation of current savings to future consumption 80
xi
LIST OF TABLES
Table 2.1 Annual investment by VC funds from all countries (Money,

# of Deals) 16
Table 2.2 Geographical distribution of VC funds 2013 17
Table 2.3 The dimensions of the VC industry in the US 1994 and 2014 18
Table 2.4 Venture capital investment by stage (2014) US data 20
Table 2.5 Investment by U.S. VC funds by industry groups and stage of
investment in 2014 20
Table 2.6 The number of VC funds per year and capital raised 22
Table 2.7 Sources of capital for U.S. VC funds 2014 22
Table 2.8 Sources of capital for European VC funds 23
Table 2.9 Exits by IPOs and acquisitions for selected year 24
Table 3.1 Value of semiconductors consumed worldwide by end use
sector 1999, and 2013 32
Table 5.1 Economic balance sheet of a start-up 57
Table 5.2 Post-investment balance sheet of the VC fund 57
Table 5.3 Cash flow-probability correlation 58
Table 7.1 Balance sheet of the start up after investment round one 86
Table 7.2 Balance sheet of start up company after investment round two 87
Table 7.3 Changes in relative prices of selected durable goods 2009–2013 89
Table 7.4 Changes in the weights of clothing and footwear in the
non-durable basket 89
Table 7.5 Number of years that it took major GPTs and consumers’
goods to reach 50 % of the homes in the U.S. 90
Table 8.1 US VC funds pooled return compared to public market returns,
2014 96
xiii
xiv LIST OF TABLES
Table 8.2 Statistics of the distribution of success measures given exit,

1996–2005 99
Table 8.3 A comparison between VC backed new IPO and non-VC new
backed IPOs 1980–2012 100
Table 8.4 The volatility of VC backed 1st day return and 3 years BHR
by sub periods 1980–2012 100
CHAPTER 1
A Comprehensive Economic Look at VC

Funds
Abstract The inventive process by which innovative ideas in technology

are turned into economic growth is the most important economic process
of the last 200 years. The venture capital industry and the venture capi-
tal (VC) funds at its core are a small but important part of the inventive
process that leads from an innovative idea to both increased consumption
and an extension in consumption possibilities. The main proposition of
this book is that by discussing VC funds in the context of the inventive
process, we can better understand the venture capital industry and the way
that VC funds operate. Discussing VC funds in the context of the inven-
tive process requires bringing together different aspects of economics and
finance and weaving them into a complete picture.
Keywords VC funds • inventive process
1.1 INTRODUCTION: THE PURPOSE OF THIS BOOK

The inventive process that began at the end of the eighteenth century with
the first industrial revolution and continues to this day is the most impor-
tant single feature of the economic and the social growth of the world
in which we live. The main outcome of the inventive process has been a
continuous growth of world population, coupled with a growth of income
per capita. Beginning with the industrial revolution, a wide array of new
innovative ideas in technology have been expressed in new products. New
© The Editor(s) (if applicable) and The Author(s) 2016 1

T. Agmon, S. Sjögren, Venture Capital and the Inventive Process,
DOI 10.1057/978-1-137-53660-0_1
2 T. AGMON AND S. SJÖGREN
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
growth issues, we are able to better understand why VC funds are of

such general interest. Light is also shed on a multitude of sub-issues. For
instance, how do VC funds raise capital and why are institutional inves-
tors the main source of capital for VC funds? What is the rate of return
on the investment in VC funds from the point of view of the providers
of the capital? How does the government intervene in the market in
which VC funds operate? What is the contribution of VC funds to society
at large?
The book is motivated by three observations about VC funds. The
first observation is about developments in the market like the introduc-
tion of the Internet, or the development of semiconductors. The second
observation is about intellectual property (IP) laws, the growth of basic
research, and the development of institutional savings. The third observa-
tion is about the success of VC funds. The three observations are described
briefly below. The implications of the three observations on the venture
capital industry and on VC funds are discussed in detail through the book.
1.2 RADICAL IDEAS AS ASSETS

At any given point in time, there are a finite number of assets on the mar-
ket. These assets together form the universe of all possible investment pos-
sibilities that in combination construct the market portfolio. The market
portfolio is not static. There is a process by which new radical ideas are
turned into new assets that generate new current and future consumption
streams. Radical innovative ideas not represented by current assets are gen-
erated by people all the time. A small number of these ideas are selected
by researchers and are developed further. The selected number of radical
ideas are developed further by entrepreneurs, and a small fraction of those
are selected by VC funds that develop them even further, testing their
business viability and commercial potential. If successful, the investment
by VC funds in radical ideas makes them into assets that increase the value
of the market portfolio by adding new assets that were not part of the mar-
ket portfolio prior to the selection and development process by VC funds.
Adding new assets and thus extending consumption possibilities is the way
in which radical innovation contributes to growth, where some ideas will
be developed into commercial products and sold to consumers, and other
ideas will be formed into platforms for numerous amounts of other ideas.
There is a basic difference between the assets already in the market port-
folio and what might be called “assets in process”. When using standard
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.
1.3 THE NEED FOR GOVERNMENT INTERVENTIONS

AS A NECESSARY CONDITION FOR THE DEVELOPMENT
OF RADICAL, INNOVATIVE IDEAS IN TECHNOLOGY
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.
1.4 THE FUNCTIONAL ROLE OF VC FUNDS

IN FINANCING RADICAL IDEAS
VC funds have played an important part in financing the development,

testing, and early commercialization of radical innovative ideas in the ICT
and the pharma industry. The successful early-stage and later rounds of
investments financed by VC funds developed into major new assets in the
market portfolio. New industries like semiconductors and new compa-
nies like Microsoft, Facebook, and eBay are examples of the connection
between early investment by VC funds and major increases in consump-
tion possibilities later on. A large number of unsuccessful investment proj-

ects by VC funds disappeared and did not become new assets. Both the
successes and the failures are necessary parts in the process by which VC
funds finance radical ideas. In this book, we use different analytical frame-
works. One such framework is the functional and structural finance view
developed by Merton and Bodie (2005). Instead of viewing VC funds and
the general partners that manage them as atomistic actors in perfect mar-
kets, we analyze how the VC industry has evolved as a functional response
to institutional changes and monopolistic competition.
1.5 THE NARRATIVE OF THE BOOK AND ITS STRUCTURE

As was stated above, we adopt a comprehensive approach to the venture
capital industry and to VC funds, treating them as a small but important
link in the chain of individuals and organizations that generate, select,
develop, and commercialize radical innovative ideas in technology. This
process, plus the much bigger process of incremental innovation by
already existing firms and other organizations, is what drives the unprec-
edented economic growth since the beginning of the nineteenth century.
The narrative of the book focuses on the way that the main components
of the inventive process and the specific needs of the main actors that
drive this process form the venture capital industry and the structure and
mode of operations of VC funds. The focus of the current literature (see
Denis, 2014 and Lerner & Tåg, 2013 for an extensive overview of the
literature) is on the GP (see Kaiser & Westarp, 2010; Kaplan & Lerner,
2009), also known in the literature as a “Venture Capitalist”, as the initia-
tor of the investment by VC funds and claims that the structure and mode
of operations of VC funds are the result of unique characteristics of GPs.
The specific talents of GPs include but are not limited to the following:
low search costs (Chan, 1983), choosing and writing contracts with entre-
preneurs (Hellman, 1998; Hellman & Puri, 2002; Kaplan & Strömberg,
2002, 2004; Kaplan, Sensoy, & Strömberg, 2009), closely monitoring and
stage funding processes (Admati & Plfeider, 1994; Hellman, 1998), and
the ability to reduce the time to bring products to the market (Hellman
& Puri, 2000). The talents of the GPs are part of the special features
of VC funds that make VC an institution that spurs innovative activity
(Kortum & Lerner, 2000) and complements the traditional R&D activity
taking place within existing firms (Lerner, 2009). Our approach differs
from the central theme of the current literature on VC funds. Throughout
this book, the view is that the VC fund is as an institutional response to

the need to finance the process from radical ideas to consumption. This
narrative is expressed in the following eight chapters of the book.
Chapters 2 and 3 introduce and discuss the venture capital industry
and VC funds in two ways: in Chap. 2 we discuss the size of the indus-
try according to a number of measurements: the number and size of VC
funds, capital raised and assets under management, the number of people
employed by VC funds, total investment and number of investment proj-
ects, and the preferred industries for VC investment in different years. VC
funds are financial intermediaries. They receive capital from savers either
through institutional investors or directly and then transfer the capital to a
specific class of investments: early-stage, high-risk investments and follow-
up investments. VC funds are small relative to other financial intermediar-
ies. The size of the venture capital industry and the number and size of
the VC funds within it reflect the small share of “assets in process” (radical
ideas that if successful will become assets in the market portfolio) in the
total portfolio of the savers. The origin of VC funds was in the U.S., but
in recent years VC funds have become global. Still, most of the venture
capital industry is in the U.S. For that reason most of the discussion in
Chap. 2 and later on uses U.S. data.
In Chap. 3 we provide an illustration of the role of VC funds in the
process of turning ideas into assets that contribute to future consumption.
The purpose of the illustration is to show one well-known and important
complete process before discussing different aspects of the venture capital
industry and VC funds. The semiconductor industry was chosen for the
following reasons: it is relatively easy to trace the history of the indus-
try from an idea to products, it is possible to show the contribution of
VC funds to the development, testing, and early commercialization of the
radical ideas that were at the basis of the semiconductor industry, and it
is possible to measure the contribution of the semiconductor industry to
current and future consumption.
In the next five chapters, we discuss five related dimensions that
together comprise the environment in which VC funds operate, an envi-
ronment that determines the structure of VC funds and their mode of
operations. In Chap. 4 the focus is on the economic growth process in
general and on the ideas-led growth process in particular. The connection
between ideas and growth is discussed in this chapter, as well as the role of
radical ideas in the growth process. People and organizations are involved
in this process, and as it was illustrated in Chap. 3, it takes a long time to
move from an idea to concrete products, services, and production tech-

nologies that affect consumption. VC funds have a small but important
part in the growth process. Through their investments, VC funds connect
government-funded basic research in its early stages to capital markets and
large-scale production.
In Chap. 5 the focus is on the forms that government intervention
takes and in what way the structure of both the liabilities and the assets of
VC funds is a response to the intervention policy of governments in the
field of promoting radical innovative ideas in technology. Governments
intervene in the process of turning radical ideas in innovative technol-
ogy into consumption by funding basic research, by enforcing intellec-
tual property (IP) laws, and by encouraging and supporting long-term
institutional savings. The first form of intervention increases the supply of
radical ideas in innovative technology. The second form affects the value
of assets based on radical ideas if successful. The third form of intervention
makes it easier to finance VC funds by institutional investors. In this way,
government intervention affects both the liabilities and the assets of VC
funds. For example, the combined effect of the contract between Limited
Partners (LPs) and GPs in VC funds and the temporary and contestable
monopoly awarded to successful investment projects by VC funds as a
result of IP laws brings about investment decision rules for VC funds that
maximize the value of their investment projects conditional on success.
Chapter 6 is titled “How the Contracts between the Limited Partners
(LPs), the General Partners (GPs) and the Entrepreneurs Facilitate
Investments”. The focus of this chapter is on VC funds as firms. Although
VC funds are financial intermediaries, they operate like firms and their
structure is determined by a nexus of explicit and implicit contracts between
those who provide the necessary inputs to VC funds. Like any other firm, a
VC fund is comprised of assets and liabilities. VC funds are special-purpose
financial intermediaries that specialized in high risk “assets in process,”
which in turn are based on radical innovative ideas in technology. The flow
of funds moves from the sources of funds (the savers) to the uses of funds
(the investment projects). The investments by VC funds are limited by
how much capital the institutional investors and others like family offices
who provide the capital are willing to allocate for this purpose. As we have
pointed out in the brief discussion of “assets in process” above, the risk
of these assets is high and, more importantly, is different than the risk of
assets already in the market portfolio. The providers of the capital, i.e. the
investors in VC funds, control this risk by allocating a small part of their
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-
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
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.
Hellman, T. (1998). The allocation of control rights in venture capital contracts.

Rand Journal of Economics, 29, 57–76.
Hellman, T., & Puri, M. (2000). The interaction between product market and
financing strategy: The role of venture capital. The Review of Financial Studies,
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Hellman, T., & Puri, M. (2002). Venture capital and the professionalization of
start-up firms: Empirical evidence. Journal of Finance, 57(1), 169–197.
Kaiser, K., & Westarp, C. (2010). Value creation in the private equity and venture
capital industry (Faculty & Research Working Paper). Insead.
Kaplan, S. N., & Lerner, J. (2009). It ain’t broke: The past, present, and future of
venture capital. Journal of Applied Corporate Finance, 22(2), 36–47.
Kaplan, S., & Strömberg, P. (2002). Financial contracting theory meets the real
world: An empirical analysis of venture capital contracts. Review of Economic
Studies, 70(2), 81–315.
Kaplan, S., & Stromberg, P. (2004). Characteristics, Contracts, and Actions:
Evidence from Venture Capitalist Analyses. The Journal of Finance, vol. LIW,
no. 5, 2173–2206.
Kauffman Foundation. (2012, May). “WE HAVE MET THE ENEMY… AND
HE IS US” lessons from twenty years of the Kauffman foundation’s investments in
venture capital funds and the triumph of hope over experience (Kauffman Report).
Kortum, S., & Lerner, J. (2000). Assessing the contribution of venture capital to
innovation. The Rand Journal of Economics, 31(4), 674–92.
Lerner, J. (2009). Boulevard of broken dreams—why public efforts to boost entrepre-
neurship and venture capital have failed—and what to do about it. Princeton,
NJ: Princeton University Press.
Lerner, J., & Tåg, J. (2013). Institutions and venture capital. Industrial and
Corporate Change, 22(1), 153–182.
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thesis of function and structure. Journal of Investment Management, 3(1),
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Economy, 98(5, Part 2).
CHAPTER 2
The Size and the Characteristics

of the Venture Capital Industry
Abstract In this chapter, we discuss the size of the VC industry along

a number of dimensions: the number and size of VC funds, the amount
of capital raised and assets under management, the number of people
employed by VC funds, the total investment and number of investment
projects, and the preferred industries in different years. VC funds are
financial intermediaries. They receive capital from savers either through
institutional investors or directly, and then transfer that capital to a spe-
cific class of investments: early-stage, high-risk investments and follow-up
investments. VC funds are small relative to other financial intermediaries.
Yet, they fulfill an important function. The presentation of the venture
capital industry and VC funds in this chapter focuses on the U.S.
Keywords VC funds • VC industry
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

DOI 10.1057/978-1-137-53660-0_2
which VC funds invest capital become a part of already existing companies

by acquisition, or become new companies through IPOs. Some of the
ideas were developed in the context of basic research, others came directly
from entrepreneurs. In this chapter we aim to put a number on this tran-
sition from idea, to successful investment project, to new company. VC
funds extend the market portfolio and contribute to increased consump-
tion on a societal level. Comprised of VC funds, institutional investors,
and other intermediaries like family offices that provide high risk capital,
as well as entrepreneurs that propose investment projects based on radi-
cal ideas in innovative technology, the industry includes many different
but small actors relative to the actors and volumes on traditional financial
market. In this chapter, we discuss data on VC funds and related actors.
2.2 THE STRUCTURE OF VC FUNDS

VC funds are organized as limited partnerships with a finite and short
horizon compared to the infinite horizon of limited liability companies.
Figure 2.1 shows a schematic picture of the actors and their relationships
that together constitute the VC industry.
In the center is the VC fund, here illustrated by a T-account balance
sheet with assets, liabilities, and net worth. Like any limited partnerships,
General Partners (GP) Limted Partner (LP)

Retains legal liability. Investment Venture Capital Fund (VC) II Are protected against any losses
managers run a firm that serves beyond the original investment
as a general partner. Venture Capital Fund (VC) I t
Public Pension Funds
Provides management to The balance sheet Enodwmnets/Foundations
portfolio companies and small Corporate Pension Funds
Liabilities
amount of capital to the fund. Family Offices
Financial Institutions
Charge appr. 2% of invested Liabilities Others
Assets
capital as management fees.
worth
Net worth
Portfolio companies VC Fund I

II
A B C ... N
.. N
Entreprenures in Firm A, B, C .. N of VC Fund I
Fig. 2.1 VC fund actors and investment relations

THE SIZE AND THE CHARACTERISTICS OF THE VENTURE CAPITAL INDUSTRY 15
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.
It is useful to differentiate between actors who operate organizations

as a way to accomplish their goals and the organizations themselves. The
organizations (in this case VC funds) are a collection of contracts (the
nature of the contracts is discussed in Chap. 6). The actors are people,
often managers, who sign contracts that set up the organization. GPs,
the decision makers in institutional investors, other providers of capital
to VC funds, and entrepreneurs are all people. They may sign contracts
that comprise one VC fund, or they may create many VC funds. Decision
makers in institutional investors are involved in a number of VC funds. If
the institutional investor is large, for instance the New York State Pension
Fund, the decision makers probably were involved in setting up a large
number of VC funds. Successful GPs may be involved in a number of VC
funds. Matrix Partners, a well-established VC firm (a GP), set up nine VC
funds and raised a total of $2.4 billion. Some “serial entrepreneurs” were
involved in more than one VC fund.
2.3 THE SIZE OF VC FUNDS
2.3.1 The Size of VC Funds in the Global World

Table 2.1 shows the global annual investment and the number of deals
made by VC funds in the world in the period from 2008 to 2014. With
two exceptions, 2009 (the year of the global financial crisis) and 2014
(where VC funds made some mega-investments) total annual investment
was around $50 billion and the number of deals was between 5500 and
6500 per year. Total investment by the VC funds in the world in the years
Table 2.1 Annual investment

Years Total investment Number of
by VC funds from all countries ($ billion) deals
(Money, # of Deals)
2008 51.2 5500
2009 35.4 4813
2010 46.6 5438
2011 55.9 6040
2012 49.5 6085
2013 53.5 6551
2014 86.7 6507
Source: Pearce (2014)

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.
2.3.2 The Size of VC Funds in the U.S.

The data on annual capital investments of VC funds in the U.S shows that
the period between 1985 and 2014 can be divided roughly into the fol-
lowing four periods:first, an early-stage between 1985 and 1994, where
the annual capital invested in the U.S. were around $3 billion (Fig. 2.2).
Second, in the boom period in the late 1990s the amount grew quickly,
reaching $100 billion in 2000. Third, it went down sharply in the period
from 2002 to 2005 and increased to about $30 billion in 2006. Fourth,
Table 2.2 Geographical distribution of VC funds 2013

Region Amount invested ($ billion) Investment rounds % of activity
US 33.1 3480 68.2

Europe 7.4 1395 15.3
Canada 1.0 176 2.1
China 3.5 314 7.2
India 1.8 222 3.7
Israel 1.7 166 3.5
Source: Pearce (2014)

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
Number of VC Firms (GPs) 385 803 108

Number of VC Funds 635 1206 90
Number of professionals 3735 5680 52
Capital under Management ($ billion) 33.2 156.5 371
Source: NVCA (2015)
capital investment declined again during the crisis of 2008–2009. Since

2010 the annual capital investment has been around $25–$30 billion per
year. Capital investment went up in 2014 to about $30 similar to the 2001
level of investments. Agmon and Messica (2007) present data that con-
nects the changes in the amounts of capital raised by VC funds in the U.S.
to the changes in the price index of NASDAQ. As shown in Fig. 2.2, the
year 2000 was an exceptional peak year for VC funds, followed by a sharp
decline in capital raised that continued for 13 years.
In Table 2.3 we show the growth over the 20-year period in the
number of GPs’ firms (sometimes referred to as venture capitalists), the
number of active VC funds, the number of professionals employed by
the GPs firm and the capital under management by comparing the first
and the last year of data. As it is clear from the data presented below the
real jump was in capital under management close to five times. What was
in 1994 a budding industry became an important part of the inventive
process in the U.S.
Capital under management is an outcome of capital raised by VC funds
(Table 2.3). VC funds have a horizon of 10–12 years. The capital raised
by a VC fund at the time of its establishment is transmitted to the fund

as the investment process proceeds. At any given time, the capital com-
mitment of a specific fund is divided into three parts: one, capital invested
and returned to the investors (distributed capital), two, capital invested
in a company still held by the VC fund (capital under management), and
three, callable capital yet to be called by the GP of the VC fund in question
(dry powder). Dry powder is about one-half of assets under management.
Dry powder is a function of changes in capital commitment. If capital
commitment increases more than capital investments, as it did in the years
after 2001, dry powder will increase as well.
Although the U.S. venture capital industry and U.S. VC funds grew sub-
stantially in the 20 years from 1994 to 2014, it is still a small industry, and
VC funds are small financial intermediaries (Fig. 2.2). The closest financial
intermediaries to VC funds are private equity (PE) funds. PE funds are
also limited partnerships, and are organized in a similar way to VC funds.
Most institutional investors classify PE funds and VC funds as alterna-
tive investments (AIM). However, PE funds follow a different investment
model than VC funds. They invest in existing companies, which are usually
based on a specific business model that the GPs of the PE fund think has
a potential to increase the value of the target company. According to data
published by Perqin in 2014, there were at that point in time about 2200
operating PE funds in the world. They raised $465 billion in 2014, com-
pared to less than $90 billion raised by all VC funds in the world. In 2014,
PE funds in the world had more than $3.5 trillion under management,
compared to little more than $150 billion in capital under management by
U.S. VC funds. Other financial intermediaries like banks are much larger
in capital holdings and in the number of institutions and employees than
VC funds. As of 2014, Wells Fargo Bank, the largest bank in the U.S. in
terms of employees, had 228,000 employees and total assets of $1.7 tril-
lion. The banking sector in the U.S. employed 260,000 loan officers in
2014. U.S. VC funds employed less than 6000 professionals.
2.3.3 The Number and the Nature of the Investment Projects

of VC Funds in the U.S.
Investment in radical ideas is a dynamic process. All projects begin as either
seed or early-stage. Most VC funds do not invest in seed (that investment
is often financed by angel investors) but they do invest in early-stage. It
can be said that investment in early-stage is investment in “pure ideas,”
whereas investment in more advanced stages, known as “expansion” and

“later-stage” is investment in development and commercialization. In
2014, the total investment by U.S. VC funds was allocated as follows in
number of deals: 2 % to seed investment, 32 % to early-stage investments,
42 % to expansion stage (second and third rounds of investment), and 25 %
to later stages. VC funds usually focus on one or two industries at any
given point in time (Table 2.4).
In recent years the IT and Life Sciences sectors lead the investments by
VC funds. In earlier periods U.S. VC funds focused on other industries,
like semiconductors. In Table 2.5 we present data on the investment of
VC funds in the U.S. in initial stages and in all investments by industry
groups in 2014.
Average investment by U.S. VC funds in 2014 was almost $13.5 mil-
lion and average initial-stage investments were only $5.1 million (aver-
age investment in later stage investments were almost $19 million). This
reflects the increasing need of capital for VC backed firms when moving
to later stages.
Table 2.4 Venture capital investment by stage (2014) US data

Seed Early stage Expansion Later stage
2% 32 % 42 % 25 %
Source: NVCA (2015)
Table 2.5 Investment by U.S. VC funds by industry groups and stage of invest-
ment in 2014
Industry All investments Initial stage
Companies Deals Investment Companies Deals Investment

(numbers) (numbers) ($ billions) (numbers) (numbers) ($ billions)
IT 2611 3050 35.7 1059 1059 5.2

Life
Sciences 650 827 8.8 174 174 1.2
Non
Hi-Tech 404 484 4.8 177 177 0.9
Total 3655 4361 49.3 1410 1410 7.3
Source: NVCA (2015)

Unlike other financial intermediaries, the outcome investments by VC

funds are not standard and a number of them receive much attention.
The National Venture Capital Association in the U.S. presents the face of
the VC industry via a list of well-known new and innovative public com-
panies that were supported by VC investments in their early stages. The
list includes names like Microsoft, Starbucks Corporation, eBay, Apple
Inc., and Staples. The largest single VC investment in 2014 was in Uber
Technologies, Inc. that received two investments of $1.2 billion each in
later-stage rounds in June and December.
2.3.4 The Dynamics of U.S. VC Funds

VC funds are temporary financial intermediaries. As limited partnerships,
they have a given horizon and by the end of the period specified in the
contract between the VC fund and the LPs the fund ceases to exist. GPs
are usually organized as limited liabilities firms, in the industry known as
VC firms, and they do not have a specific horizon. Most GPs would like
to follow their first VC fund with consecutive funds. According to data
collected and based on an 8-year horizon 1938 GPs (venture capital firms)
raised funds and managed 4957 venture capital funds, for an average of
2.55 VC funds per GP. The number of first-time VC funds is small. In
1994 there were 25 first-time VC funds out of 136 VC funds that raised
capital in this year. The comparable numbers for 2014 were 36 first-timers
out of 263 VC funds that raised capital in that year. The percentage of
first-timers is quite stable at 15–20 per year. Most VC funds are small. In
2014, 538 out of the active 803 GPs manage less than $100 million. Only
31 GPs (4 %) manage more than $1 billion.
The total number of active VC funds in the U.S. does not change much
(Table 2.6). Some GPs are leaving the industry and new GPs raise new
funds, but one-time GPs often turn out to be unsuccessful and they then
cannot raise a second VC fund, but the industry as a whole is quite stable.
2.4 THE SOURCES OF CAPITAL FOR U.S. VC FUNDS

Asset allocation for high-risk investment in VC funds is a crucial part of
the venture capital industry. In Table 2.7 we show the contribution of dif-
ferent sources to the capital of VC funds.
Most if not all of the capital invested in VC funds comes from intermediar-
ies that manage money for different types of beneficiaries. The beneficiaries
Table 2.6 The number of VC funds

Year Number of Venture Capital
per year and capital raised funds ($ million)
2006 236 31,107.6

2007 235 29,993.7
2008 214 25,054.9
2009 162 16,103.8
2010 176 13,283.6
2011 192 19,080.5
2012 217 19,844.9
2013 208 17,702.0
2014 263 30,711.3
Source: NVCA (2015)
Table 2.7 Sources of capital

Source of capital Share of
for U.S. VC funds 2014 investment in
VC funds (%)
Public Pension Funds 20

Endowments/Foundations 17
Corporate Pension Funds 7
Insurance Companies 7
Family Offices 14
Financial Institutions 13
Others 22
Source: BloombergBusiness (2014)
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
Table 2.8 Sources of capital for European VC funds

Source of capital Share of investment in VC funds (%)
Government agencies 30.0

Pension funds 12.3
Financial institutions (Banks, Mutual funds,
Fund of funds, Sovereign funds) 11.5
Insurance companies 2.2
Corporate investors 10.7
Endowments, foundations and academic
institutions 6.1
Family offices and private individuals 11.2
Other 15.9
Source: EVCA (2015)
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.
2.5 SUCCESS AND FAILURE IN U.S. VC FUNDS

VC funds invest in risky investment projects. We discuss the specific
nature of the risk that VC funds deal with in later chapters. In this sec-
tion, we show how the inherent risk is expressed in the reported results of
U.S. VC funds. In its annual report of 2015, the National Venture Capital
Association (NVCA) published information about the outcome of 11,686
companies first funded by U.S. VC funds in the period from 1991 to
2000. Of these companies, 14 % made an exit through an IPO, 33 % were
acquired by other companies, 18 % are known to have failed, and the fate
of 35 % of the companies is unknown.1
Of the companies first funded by VC funds in this period, 47 % made an
exit. That seems like a high rate of success. However, the LPs who invest
in VC funds measure their return on the total amount invested. Successes
have to cover the losses of the 53 % of the companies funded by U.S. VC
funds that did not make an exit. In Table 2.9 we present data for selected
Table 2.9 Exits by IPOs and acquisitions for selected year

Year IPOs Total value at Acquisition Average value of
(number) IPOs ($ billion) (number) acquisition ($ billion)
1994 130 5 84 56
2000 230 25 245 326
2009 10 1 109 113
2014 115 12 459 350
Source: NVCA (2015)
years on VC backed IPOs and acquisitions. The data on the acquisition

includes all the acquisitions done in that year, but the average value is
based on the acquisitions of that year where the price was known. In 2014
about 30 % of the acquired companies reported the price of the acquisition.
The years in Table 2.9 represent four different periods in the history of
U.S. VC funds: 1994 is the infancy period of U.S. VC funds, 2000 is the
peak of the dot-com bubble, 2008-2009 are the financial crisis years, and
2014 seems to be a beginning of new growth for VC funds.
The aggregate numbers of the successes and failures reported in this sec-
tion tell only part of the picture. VC funds are looking for exceptional, high-
return investments. Examples for exits that brought VC funds extremely
large profits are Apple’s IPO, Nest’s acquisition by Google, Facebook’s
IPO, and the biggest IPO ever: Alibaba Group’s recent IPO at a value of
$25 billion. On the other hand, many IPOs, primarily VC-backed biotech
companies, end up with modest profits, as do many acquisitions.
2.6 SUMMARY
VC funds are unique financial intermediaries. They are small by any mea-
surement: annual investment, assets under management, number of VC
funds, or number of people employed by the venture capital firms, the
GPs. Unlike most financial intermediaries that are organized as limited
liabilities companies, VC funds are organized as limited partnerships with
a relatively short horizon. VC funds also have a unique business model
wherein they are looking for the rare early-stage investments that will have
exceptionally high profits at the exit and will ultimately develop into com-
panies like Apple, Facebook and Alibaba. Yet, VC funds and the venture
capital industry attract a lot of attention in the financial world, among
global policy makers, in the world of research, and in the public at large.
NOTE
1. Companies that were funded for the first time by VC funds before or at
2000 cannot be held by them 14 years later in 2014.
REFERENCES
Agmon, T., & Messica, A. (2007). Empirical evidence on supply driven venture
capital market in the U.S. International Journal of Techno Entrepreneurship,
1(2), 207–219.
BloombergBusiness (2014, September 23). Behind the venture capital boom: Public
pensions.
EVCA. (2015). 2014 European private equity activity statistics on fundraising,
investment & divestment. Retrieved from http://www.investeurope.eu/
media/385581/2014-european-private-equity-activity-final-v2.pdf
Pearce, B. (2014). Adapting and evolving: Global venture capital insights and
trends 2014. Retrieved from http://www.ey.com/Publication/vwLUAssets/
Global_venture_capital_insights_and_trends_2014/$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
VC Funds and the Semiconductor Industry:

An Illustration
Abstract In this chapter, we provide an example of the role of VC funds

in the process of turning ideas into assets that contribute to future con-
sumption. The example gives the reader a concrete illustration of what
VC funds actually do. The semiconductor industry was chosen for the
example for the following reasons: it is a modern industry based on an idea
that precedes the application by about 100 years. Further, it is an industry
that affects many industries; for instance, both the automotive industry
and new industries like mobile phones. VC funds financed some of the
industry leaders at the early stage and contributed to the development of
applications by second-generation innovative firms.
Keywords Radical ideas • Radical technologies • Semiconductor

industry • Venture capital
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 &

DOI 10.1057/978-1-137-53660-0_3
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.
3.2 THE DEVELOPMENT OF THE IDEA

OF SEMICONDUCTORS
The semiconductor is not an invention and no single individual invented

it. The base of the semiconductor industry was the discovery that some
material (e.g. silicon, germanium) has unique properties that in some
directions have lower resistance than in other directions. The electrical
conductivity of a semi-conductive material can be changed by altering
temperature (conductivity increases with temperature), or by “doping”
it via adding other material. The early work of combining knowledge of
electrons and quantum mechanics (electronics) prepared the semiconduc-
tor to be developed into diodes and transistors. These are perhaps the two
most important inventions necessary for our advancement in data process-
ing, communication, and lighting.
3.2.1 The Early Stages of Semiconductors

Lukasiak and Jakubowski (2010) discussed the history of the semiconduc-
tor. The germination period of the idea of semiconductors was long. The
term “semiconducting” was used for the first time by Alessandro Volta in
1782. It took 50 years until Michael Faraday came up with the first docu-
mented observation of a semiconductor effect. The first quantitative analy-
sis of semiconductors was published by Hittorf in 1851. Photoconductivity
in solids was discovered by Wiloughby Smith in 1873. The first working
solar cell was constructed by Fritts in 1873. The theory related to semi-
conductors was developed at an accelerated rate at the beginning of the
twentieth century. As the concepts and the theory behind semiconductors
VC FUNDS AND THE SEMICONDUCTOR INDUSTRY: AN ILLUSTRATION 29
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).
3.2.2 From Ideas to Products

In the first 50 years of the twentieth century, the idea of semiconductors
was turned into a procession of products. Many of these products were
built in laboratories and did not have any commercial value per se, but
they were steps towards the industry as we know it today. Most if not
all of this activity was done by physicists as a part of their research (some
of them were awarded the Nobel Prize for their research1). The Metal-
Oxide-Semiconductor-Field-Effect (MOSFET) transistor was developed
as early as 1930. The first germanium point contact transistor was built
by Bardeen and Brattain in 1947. The final step that was the forerunner
of the current semiconductor industry was the manufacturing of silicon
transistors by Gordon Teal. This made it possible to replace the vacuum-
tube technique that was both space- and electricity-consuming. In 1958,
the first integrated circuit was demonstrated by Kilby, allowing for the
distance between each transistor to be minimized. This started the minia-
turization of computers that has been exponential since 1970. The num-
ber of transistors in an integrated circuit follows the famous Moore’s law
and doubles every second year, while the size of the transistor is simulta-
neously minimized with nearly the opposite negative exponential speed.
Based on research and development done at the Bell Laboratories in the
1950s, radio transistors have been produced since 1954, and television,
radar, and light-emitting diodes (LEDs) have thereafter enriched society.
3.3 FROM DEVICES TO COMMERCIALIZED PRODUCTS:

VC FUND PARTICIPATION IN FORMING AN INDUSTRY
In 1955, Schockley, one of the inventors of the modern semiconductor,
founded Schockley Semiconductors Laboratory in Santa Clara, CA. He
recruited 12 scientists to work with him. Two years later, in 1957, eight
of the Schockley team, known as the “Traitorous Eight” left to start their
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
production costs of particular products, or both. In doing so, they con-

tributed to higher added value and higher consumers’ surplus to society.
Even VC-backed companies that fail contribute to society. They do so
by identifying which ideas do not work, and, perhaps more importantly,
by training engineers and other professionals to work in the innovative
processes.
Another important input for our analysis of the economics of VC funds
and the contribution of ideas to consumption is government interven-
tions. This will be further discussed in Chap. 6. One such intervention
is the strengthening of patent rights. In their study, Hall and Ziedonis
(2001) investigate the patent behavior of 95 firms in the semiconductor
industry. Between 1979 and 1995, the number of patent approvals per
invested dollar was higher in this industry compared to all other industries.
Hall & Ziedonis conclude that patent rights may have facilitated the entry
of specialized firms and vertical disintegration. However the authors are
careful not to posit only positive effects of stronger patent rights. The pat-
ent portfolio race which took place in the semiconductor industry at this
later stage, may also have had a dampening effect on exchanges of intellec-
tual property. The history of the development of the semiconductor and
the devices described above are examples where innovation is essentially
cumulative and therefore dependent on the diffusion of knowledge.
3.4 CONTRIBUTION OF SEMICONDUCTOR TO GROWTH

In a recent trade publication the author states, “The U.S. semiconductor
industry has been a major innovator among all U.S. industries: from 1960
to 2007 it accounts for 30.3 % of all economic growth due to innovation in
the U.S. and the industry contribution to real economic growth was more
than seven times its share in the nominal GDP” (Parpala, 2014, p. 1). The
importance of the semiconductor industry lies in providing new innova-
tive inputs, as well as in producing intermediate goods that allow a number
of new industries to grow. Further, semiconductors make old industries
more efficient and to provide new features, and to provide more advanced
inputs at lower prices every year. In Table 3.1, we show the proportion
of the output of the semiconductor industry that was bought by differ-
ent users of semiconductors divided into sectors. The data shows that the
computer and the communication sectors are the major buyers of the out-
put of the semiconductor industry. That output is an intermediate product
for final goods and services.
Table 3.1 Value of semiconductors

Sector Share of total
consumed worldwide by end use sec- consumption (in %)
tor 1999, and 2013
1999 2013
Computers 50 34
Communication 21 32.5
Consumer 14 14.3
Industrial & 9 9.7
Governments
Auto 6 9.5
Source: Aizcorbe (2002), Semiconductor Industry

Association (2014)
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.
Successful development and commercialization of radical ideas in tech-

nology generates three types of benefits: economic rents to the developers
and the financiers of the successful ideas, externalities to industries that
use the developed idea or its applications, and an increase in current and
future consumption that in turn increases consumers’ surplus in the soci-
ety as a whole. The first type of benefits comes first, the second benefits
takes longer, and the extension of consumption possibilities leading to the
consumers’ surplus is accrued over a long time.
As an illustration of how benefits are generated and distributed, con-
sider the case of Intel Corporation and the semiconductor industry as
a whole. Intel Corporation was the first new generation semiconduc-
tor company (Schockley Semiconductors Laboratory was more of a
research organization and Fairchild Semiconductor was an extension
of an existing company). Intel Corporation was founded in 1968 with
an investment of $2.5 million. The company went public in 1971 at a
value of $6.8 million. The initial investors as well as the founders (the
entrepreneurs) of Intel received a substantial producers’ surplus rela-
tive to the original investment. The total increase in the value of Intel
between 1968 and 1971 was $4.3 million (a cash-on-cash return of
2.72X). As we have shown earlier in the chapter, the semiconductor
industry brought about a decline in the relative prices of important sec-
tors in the U.S. economy, particularly computers and communication.
As the market for computers and communication devices is not perfect,
some of the benefits of the decline in the price of semiconductors went
to increased return on factors of production like capital and labor in
the industries affected by the semiconductor industry. The main con-
tribution of the semiconductor industry is to consumers’ surplus. If the
contribution of the semiconductor industry to the value added of the
information industry is expressed by a 10 % increase in its value, and
that the information sector is about 5 % of the U.S. GDP of $16.77 tril-
lion, the added contribution of the semiconductor industry is large by
any number. The semiconductor industry contributes to welfare by pro-
viding efficient inputs to many industries outside the information indus-
try. The economic rent to the successful developers and financiers of the
semiconductor industry like Noyce, Moore, and Rock is easily observed
and people can relate to it. The externalities to other industries and the
increase in current and future consumption is broadly spread and is hard
to measure. The real contribution of the semiconductor industry is in
the externalities and in the added consumers’ surplus, but the potential
high return (both financial and otherwise) to a small number of indi-

viduals, entrepreneurs, and financiers alike is what motivates the process
as a whole.
3.5 SUMMARY: THE ROLE OF VC FUNDS

IN THE SEMICONDUCTOR INDUSTRY
The development of the semiconductor industry provides a good exam-

ple of the long process of turning a radical innovative idea into a large
new industry that develops and supports the new information sector
and contributes to many other industries. Producers’ surpluses to those
involved in the development process and consumers’ surplus to con-
sumers at large were generated. VC funds took part in the development
and commercialization of the new industry by providing early-stage
financing and related services. A well-known example is the contribu-
tion of VC financing to Intel. When Intel was founded in 1968, VC
funds were at the embryonic stage. The initial financing was organized
by Arthur Rock who acted as a GP (including a small personal partici-
pation). As the industry developed, VC funds took part in its financ-
ing. In a study discussing the contribution of VC funds in the silicon
valley to the development of the semiconductor industry Ferary and
Granovetter (2009) state, “The presence of VC funds in an innovative
cluster opens specific potential interactions with other agents in which VC
funds have a specific function.” (p. 327). As the semiconductor industry
established itself, VC funds finance the development of ideas that were
the basis for the second generation of companies in the semiconductor
industry.
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.
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
A Macro Perspective on the Unique Role

of VC Funds in the Process from Ideas
to Growth
Abstract The ideas-led growth model is the macroeconomic framework

that describes the inventive process in which VC funds operate. The con-
nection between ideas and growth, and the role of radical ideas within that
connection, are discussed in this chapter. As was illustrated in Chap. 3, it
takes a long time to move from an idea to concrete products, services, and
production technologies that affect consumption. VC funds take a small
but important role in this process. VC funds operate in what is defined
in economic growth theory as the “technology push” within different
technology trajectories in different periods. GPs of VC funds select radical
ideas “pushed” by innovators, scientists, and entrepreneurs and turn them
into firms.
Keywords Radical ideas economic consumption • Technological change
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

DOI 10.1057/978-1-137-53660-0_4
(Maddison, 1995). The most important growth drivers in this period

were innovative ideas in technology. Not only did consumption per capita
increase but the quality of life increased as well. The consumption basket
has expanded in all facets, from transportation, to healthcare, to commu-
nication, to food products, to clothing, and to the many other goods and
services. The change in total consumption and in the components of the
consumption basket had far reaching social and cultural changes as well.
All this is the result of innovative ideas in technology. Most of the changes
in consumption affect the Western world, particularly the U.S. and the
E.U. countries.
Most of the growth in the world is a result of incremental innovation by
existing firms. Incremental innovation improves the quality and reduces
prices of existing goods and services. A parallel process of radical innova-
tion is a small but important part of the process that has driven economic
growth since the beginning of the eighteenth century. The development
of the semiconductor industry, discussed in Chap. 2, is an example of radi-
cal innovation and its impact on economic growth.
4.2 THE CONNECTION BETWEEN IDEAS AND GROWTH

The special role of ideas in economic growth is discussed by Jones (2005).
Jones has extended the classic Solow growth model and the Romer (1990)
models. The main two contributions of the ideas-led growth model as dis-
cussed by Jones are as follows: first, to place innovative ideas in technol-
ogy as important factors of production, and second, to show that given
the special nature of ideas, growth depends on government intervention.
Ideas are different factors of production than labor and capital. In what
Jones calls “The Ideas Diagram” he describes the specific characteristics of
ideas, and shows the links between ideas, non-rivalry of goods, increasing
returns to scale, and competitive equilibrium.
The two specific features of innovative ideas as growth drivers are non-
rivalry and increasing return to scale, where increasing return to scale
is measured by the number of applications (uses) per idea. Non-rivalry
means that once an innovative technology idea proves useful many can
use it and develop it to many applications. The repeated use does not
“waste” the idea. Technically that means that the marginal (alternative)
cost of using a specific idea for one more use is zero. If the idea is useful
and contributes to the production of more goods with zero marginal cost,
then more applications will increase the return of the idea. Hence, ideas
A MACRO PERSPECTIVE ON THE UNIQUE ROLE OF VC FUNDS IN THE … 39
have increasing return to scale. As Jones shows in such a model there is

a problem. Labor and capital will be paid their alternative costs, and the
ideas will be considered a free factor and not be paid. This is not a tenable
situation, as there is a need to invest time, labor, and capital to generate,
develop, test, and commercialize ideas so that that they become useful. To
encourage innovative technology ideas, high risk must be compensated by
high return in case of success. Non-rivalry of ideas means that it is easy to
copy an idea-based innovation once it is successful.
The aggregate macroeconomic model presented and discussed by
Jones has two important features: the first is the relationship between ideas
and economic growth. The generation and the development of innovative
ideas in technology and management over time is also known as the inven-
tive process. The inventive process and its relation to growth is supported
by data over the last 200 years and a large amount of supportive research
in economics, economic history, and the development of technology.
Measured in 1990 U.S. dollars, the GDP per capita in the U.S. grew sub-
stantially through the twentieth century. Measured in 1990 US dollars,
the GDP per capita was $2500 in 1900, $10,000 in 1960 and $25,000 in
2000. The second feature of the ideas-led growth model is that a necessary
condition for the inventive process is government intervention. The need
for government intervention in order to promote a higher rate of growth
was recognized early as is evidenced by the clause in the U.S. Constitution
that allows a monopoly, if such a monopoly is needed for economic prog-
ress. Article 1, Section 8 of the U.S. Constitution empowers the Congress
“To promote the Progress of Science and useful Arts by securing for Limited
Times to Authors and Inventors the exclusive Rights to their respective
Writings and Discoveries”. The cost of government intervention is small
relative to the high rate of growth of consumption per capita since the
beginning of the nineteenth century. Unlike other cases of imperfect mar-
kets, the imperfection and the resulting monopoly power in this case is not
a case of market failure. It is a planned market intervention. It is the way
to maximize welfare over time (the way in which governments intervene
in the market is discussed in Chap. 5).
Jones relates the generation process of ideas to the proportion of
researchers out of the working force. This is sufficient for his macroeco-
nomic approach. In reality, the process from an idea to increase in per capita
consumption is complex. Many people and organizations are involved. Parts
of the process are funded directly by the government in the form of funded
research. Other parts are funded by donors, and still other parts are financed
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.
4.3 THE ROLE OF RADICAL IDEAS IN THE GROWTH

PROCESS
In the Jones model of ideas-led growth, all ideas are treated the same way
and research-based innovation is the engine for growth. In the real world
there are many different types of innovation. Many individuals, institutions,
government agencies and business firms are involved in innovation. A rel-

evant distinction for our purposes is the difference between incremental
innovation and radical innovation. Incremental innovation deals primar-
ily with improving existing production processes, goods and services.
Incremental innovation is relatively simple: it is a systematic process, and
for most part it is done within R&D divisions as a part of the management
process of incumbent firms. Radical innovation deals with new production
processes, goods, and services. It is unstructured, and it requires entrepre-
neurial individuals and organizations. The idea of the internal combustion
engine and its implementation in the automobile is an example of radical
innovation; contrastingly, the change to robotic gears in cars is an example
of incremental innovation.
The distinction between different types of ideas is a subject of much
research. There is a whole body of literature in economics and manage-
ment on incremental and radical innovation (sometimes referred to as
evolutionary and revolutionary innovation). Garcia and Calantone (2002)
provide a thorough literature review of the typology of innovation and
the terminology of innovativeness. Norman and Verganti (2012) discuss
the difference and the relations between radical (revolutionary) and incre-
mental (evolutionary) innovation. They define incremental innovation as
changes in the design that lead to improvements of existing objects and
processes. Radical innovation changes either the technology, or the mean-
ing of goods, services and technology processes. There is a basic difference
in the risk of incremental innovation and the risk of radical innovation. In
probabilistic terms, the difference is between risks within a known distri-
bution of probable results to a risk of not knowing. This type of risk and
uncertainty is discussed in the literature under the term “ambiguity” (e.g.
Epstein & Ji, 2014).
4.4 INCUMBENTS AND VC-BACKED NEW ENTRANTS

In the following section we focus on radical innovation. Schumpeter
(1934) coined the term “creative destruction” to describe radical innova-
tion as a situation where new technology replaces (destroys) the current
technology. Arrow (1962) discusses similar process under the heading of
“drastic innovation”. Successful radical innovative ideas in technology
and management may replace a product that now is the standard in the
market, or they may replace a production technology with another new
approach. The process of replacing incumbent technology is risky and it
may take a long time. It involves technological and commercialization

issues as well as the resistance of the incumbents to new, radical ideas.
Fudenberg and Tirole (1984) discuss the way in which monopoly rents
are moving from incumbents to new entrants. Even when the incumbents
expect new and radical changes in the technology, they are not adept at
developing it and therefore they prefer to try and prevent the radical new
ideas from becoming the new standard. The difficulties of incumbents
in adapting to radical changes are discussed in the management litera-
ture. Christensen and Rosenbloom (1995) show that “attackers” have the
upper hand in developing and commercializing new radical technologies.
This is because the “attackers” have no commitments to current stake-
holders that may not benefit from the introduction of radical innovation.
An example is the dairy industry. Pasteurization is a central process in
the production of dairy products. For a number of years there has been
a competing process to traditional pasteurization, based on nanotechnol-
ogy. Many argue that the new process is better and more efficient, yet the
dairy industry continues to resist the change (Ramsden, 2013). Given
the resistance of incumbents to radical innovation, and the large potential
of radical innovative ideas in technology if successful, there is a need for
new coordination between a developer of ideas, a manager of the process
of development testing and commercialization, and a financier of radical
ideas. One way for an incumbent to resist developing new radical prod-
ucts is to avoid buying the idea from the entrepreneur, or to buy it and
then not develop it. This is possible in a monopolistic market with one
incumbent. In an oligopolistic market, where incumbents are threatened
by losses in assets in place if a rival incumbent buys and develops the new
technology, the incumbents can either choose to bid against each other
or not start the bidding process at all in a tacit collusion. If you outbid
your rival incumbent, the price will not stop at the value of the idea, but
rather increase to cover the loss in the rival incumbent’s existing assets.
Whenever the bidding process starts, the existing firms will have a race to
the bottom. No actor is thus willing to start the bidding process and the
idea will not be developed. Norbäck and Persson (2009) show that in such
as case the presence of a venture capitalist the price of new ideas increases.
A venture capitalist is always willing to start the bidding process. Agmon,
Gangopadhyay, and Sjögren (2014) show that patent trusts, which share
the cost of protecting themselves from the development of new technolo-
gies by banding together to buy radical ideas from entrepreneurs, actually
can be welfare enhancing. Once they have bought the idea by outbidding
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.
4.5 THE GENERATION AND THE DEVELOPMENT

OF RADICALIDEAS IN TECHNOLOGY
Successful radical innovative ideas are specific and their growth conse-
quences are expressed in flows of goods and services and in actual price
reductions in the market. The radical change in economic growth since
the end of the eighteenth century is explained by a small number of
life-changing concrete innovations like steam power, electric power, the
telephone, and the internal combustion engine. These major ideas (inven-
tions) have changed the life of all the people in the world. The changes
in the quality of life came through the introduction of infrastructure ser-
vices like indoor plumbing, running water, and in-house electric power,
as well as transportation, telephone services, and the Internet. They also
came through appliances like washing machines1 and air conditioners, and
through cars and jet planes. Gordon (2012) describes the growth that the
world has enjoyed since the end of the eighteenth century as a result of
three industrial revolutions, each of which centers on an initial paradigm-
changing, metamorphic innovative idea in technology. The first industrial
revolution took place in the period from 1750 to 1830 with the inventions
of the steam engine, railroads, and cotton spinning machines. The second
industrial revolution took place in the period from 1870 to 1900 with
the invention of available and useful electric power, the internal combus-
tion engine, and running water (combined with indoor plumbing). The
second industrial revolution is still present in many aspects of our daily life
like cars, air-conditioning, refrigeration, artificial light, and many of the
technologies at the base of most of what we consume. The third industrial
revolution took place in the period from 1960 to 1990 with the inven-
tion of computers and the Internet. The third industrial revolution is still
with us. The number of applications of the Internet is increasing in a rapid
pace. Computers are everywhere and affect far-away fields like healthcare,
agriculture, communication, and industrial production.
Radical ideas begin in the minds of people and they are often con-
nected to particular individuals. In the early part of the inventive process
that has created accelerated growth in the Western developed countries,
a small group of individuals made substantial changes to society. In the
1880s three individuals, Thomas Edison, Charles Brush, and Werner von
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.
4.6 THE VC FUNDS AS A PART OF THE TECHNOLOGY

“TRAJECTORY”
The annual investment of U.S. VC funds in 2013 was about $20 billion,
which represents a little less than 10 % of the investment in the develop-
ment of ideas, which is where VC funds are located in the ideas chain.
Although it is small, investment by VC funds is important because it pro-
vides a link between radical innovative ideas that often begin with research
and consumption of goods and services. Dosi (1982) discusses two alter-
native models that explain the relationship between technological change
and economic growth: “demand pull” and “technology push”. A possi-
ble interpretation of the analysis developed by Dosi is to relate “demand
pull” technological changes to incremental innovation and “technology
push” changes to radical innovation. VC funds are part of the “technol-
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
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).
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Transaction Publishers.
CHAPTER 5
Government Intervention to Promote

Radical Ideas and VC Funds as a Functional
Form to Facilitate Their Financing
Abstract Firms are defined by their nexus of contracts. Although VC

funds are financial intermediaries, their structure and their mode of opera-
tions is determined by a nexus of explicit and implicit contracts between
those who provide the necessary inputs to VC funds. Like any other firms,
VC funds are comprised of assets and liabilities. The liabilities of VC funds
are equity transferred from savers through LPs; the assets are investments
in young companies based on radical ideas in technology. Three basic con-
tracts define how much capital VC funds invest, in what type of projects
they invest, and how the return on the investment is allocated between
entrepreneurs, GPs and LPs. These three contracts are the contract that
defines the VC fund, the contract between the VC fund (the GP) and the
entrepreneurs, and the contract between the LPs and the GP.
Keywords Explicit and Implicit Contracts • temporary monopoly •

IP laws
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

DOI 10.1057/978-1-137-53660-0_5
Government interventions
Institutional
Research
IP Laws
Funded
savings
The Market for ldeas
Fig. 5.1 Government interventions for promoting radical innovations in the

market for ideas
of the “market for ideas” to summarize the markets and actors involved in
developing, transferring and commercializing ideas into products.
5.2 TYPES OF GOVERNMENT INTERVENTIONS

Merton and Bodie (2005) develop what they have defined as functional
and structural finance (FSF). FSF describes situations where due to specific
transaction costs, behavioral considerations, and other such market imper-
fections atomistic markets cannot provide the necessary financing solu-
tions. In such cases, institutions become an endogenous part of financing
solutions. The case of financing investment in the development and early
commercialization of radical ideas in technology is such a case. As was
discussed in Chap. 4, and is discussed in more detail in this chapter, the
development of radical ideas requires government intervention in three
ways. First, the developers and financiers of radical ideas must be allowed
to appropriate some of the benefits of the idea to themselves if the idea
turns out to be successful. As is discussed in Sect. 5.5 below, this is done
by granting successful developers and financiers of radical ideas temporary
monopoly power.
Second, government must subsidize the generation of radical ideas
through funded research. This will be discussed in Sect. 5.3. Third,
government must make it easy for middle class savers to allocate small
percentage of their savings to finance high-risk radical ideas through insti-
GOVERNMENT INTERVENTION TO PROMOTE RADICAL IDEAS … 51
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.
5.3 WHY GOVERNMENT-FUNDED RESEARCH IS

NECESSARY TO PROMOTE THE GENERATION OF IDEAS:
THE PUBLIC-GOOD CHARACTERISTICS OF RADICAL IDEAS
There is a common saying defining the non-rivalrous nature of ideas as a
public good as, “If you have one apple and I have one apple and we exchange
these apples then you and I still each have one apple. But if you have an idea
and I have an idea and we exchange these ideas, then each of us will have two
ideas”. A more common definition of a public good in economics is that
it does not diminish in consumption. All of this means that the alternative
cost of ideas is zero. As was discussed in Chap. 4 in the context of Jones,
if radical innovative ideas in technology were to become public goods, no
one will be willing to invest time, effort, and capital to develop such ideas
as an economic investment. One way to resolve the issue of public good
is to have the government itself invest in public goods. For many years,
governments have invested in and supplied public goods. Defense is a
prime example of a good that is supplied by local authorities and paid for
by taxes collected from the public. Fireworks provide another, marginal
example. In recent years there has been a move for the participation of
the private sector in the production of public goods. Besley and Ghatak
(2001) discuss the process of production of public goods by private sector
firms. The main implication of their study is that in case of public goods
(non-rivalrous and non-excludable) the party with the higher valuation
should be the owner.
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
United Kingdom 0.44

China 0.44
Spain 0.52
Canada 0.57
Japan 0.6
Netherlands 0.66
United Stated 0.76
Norway 0.76
Russia 0.76
Germany 0.85
Finland 0.86
Denmark 0.89
Sweden 0.93
Korea 0.95
Austria 1.09
0 0.2 0.4 0.6 0.8 1 1.2
Fig. 5.2 Government spending on R&D as percentage of GNP, 2013, for some
OECD and non-OECD members. Source: OECD.Stat
VC funds in healthcare benefited from earlier funded research by the NIH

and other research organizations.
In 1945, Vannevar Bush wrote a letter to the president titled, “Science –
the Endless Frontier,” asking, “what can the Government do now and in
the future to aid research activities by public and private organizations?”
(https://www.nsf.gov/od/lpa/nsf50/vbush1945.htm). Federal support
of American academic institutions increased rapidly up to 1970. This
increase was accompanied by less industrial support for research funding
(Atkinson & Blanpied, 2008). Government- supported inventions were
made available via nonexclusive licenses, resulting in less incentives for
companies to co-fund projects in universities. The Bah-Dole act (Patent
and Trademark Law Amendments Act, 1980) allows universities to claim
legal rights of their inventions, even if those inventions were funded by
government support. Since the introduction of this act, universities have
developed technology transfer offices (TTO) with the express purpose of
commercializing innovations. Industry funding of R&D at universities and
colleges increased from a level of $400 million per year in 1980 to $2000
million per year in 2005 (Litan, Mitchell, & Reedy, 2007). The com-
mercialization activity within university transfer offices has also increased
the number of VC-backed spin-offs where the TTO is part of the selec-
tion process, as well as part of early-stage nurturing (Wright, Lockett,
Clarysse, & Binks, 2006).
5.4 TEMPORARY AND CONTESTABLE MONOPOLY:

GOVERNMENT INTERVENTION THROUGH IP LAWS
5.4.1 Competition, Monopoly and IP Laws
Competition is considered the most important factor in productivity,
growth, and consumers’ welfare. In the U.S. and in other Western coun-
tries competition is equated to liberty. Therefore, the well-established
intervention of the U.S. government, as well as many other governments
in the market for innovation through intellectual property (IP) laws has
raised much scholarly, legal and policy discussion. In the introduction
to a book titled, “Creation without Restraint: Promoting Liberty and
Rivalry in Innovation”, Bohannan and Hovenkamp (2012) state, “The
Constitution (of the U.S.) IP clause, with its requirement that patent and
copyright law ‘promote the progress’ of their fields by creating rights for ‘lim-
ited times’, establishes a rationale for IP that is based on economic incen-
tives rather than some alternative theory such as natural rights” (Ibid p1).
Later in the introduction they say, “An innovation policy based on private
incentives requires balancing of two offsetting rights. One is the right to
compete by innovating new things; the other is the right to appropriate part
of the value of innovation’s results” (p.2). The same principle is discussed
in the economic literature. Darby and Zucker (2006) state, “The world’s
leading economies are characterized by national innovation systems which
encourage development of embryonic inventions into successful commercial
innovations that reduce costs or improve the qualities of existing products
or create new entirely new products. Innovation is driven by appropriable
opportunity” (p.1).
Competition and monopoly are two important and necessary condi-
tions for the generation, testing, and development of innovative ideas
in technology. Competition is a key concept in the legal structure of
the US, the EU and other countries. Comparing the legal expression of
the concept of competition in the US as expressed by the Sherman Act
to that of the EU as it is expressed by the Treaty of Rome and related
agreements (Graham & Richardson, 1997) the U.S. competition relates
to a basic idea of individual liberty and the EU competition is seen as a
necessary condition in the process of European integration. Monopoly
is seen as a necessity to overcome the public-good nature of ideas and to
create an incentive to invest time, effort, and capital in the development
and commercialization of ideas. Schumpeter (1942) argued that monop-
oly is necessary to develop radical destructive ideas. Arrow (1962) has

argued that the monopoly power should be given to new entrants if
successful, as the incumbent monopolistic industry is less likely to inno-
vate. The monopolists would not feel the need to carry the fixed cost
and the risk of new innovation. Therefore, only the competitive pres-
sure of new entrants will bring innovation. The new entrants should
get monopoly power if they are successful, thus justifying the high risk
of investing in new ideas. This is a dynamic process. Successful radical
ideas are turned into innovative technology through exits to new incum-
bents and these incumbents are in turn challenged by new entrants. The
short-term horizon of VC funds as limited partnerships makes them an
efficient vehicle to develop challenging radical ideas that if successful
will replace incumbents. This is so as the limited horizon prevents VC
funds to become incumbents. Microsoft and Intel are examples for VC
backed young companies that over time developed into incumbents. The
potential of gaining monopoly rents for investments in radical ideas in
technology is a driving force for entrepreneurs and GPs alike. It is also
part of the motivation of institutional investors and other managers of
savings which allocate capital to VC funds. Competition among GPs is
also an important factor in investment decisions by VC funds. The con-
tract between LPs and GPs in VC funds drives GPs to try and generate
high profits. The success of one VC fund in a given investment makes
other VC funds try harder to replicate this success. One way to do that
is to find a better radical idea that will replace the now successful one.
A similar approach is found in the legal literature on IP laws. In an
article titled, “A New Balance Between IP and Antitrust” (Lemley, 2007)
the author summarizes his view as follows: “The cyclical nature of the
IP-antitrust interface is understandable, given the fact that the interests that
drive the strengthening of one law push toward weakening the other” (p. 17).
But it is not desirable. The goal of both IP and antitrust as regulatory poli-
cies should be to balance the need to incentivize innovation against the
need for robust competition.
The practice is a synthesis between competition and monopoly. IP laws
grant a temporary and contestable monopoly through patents. On the
legal side, a patent is defined as “a limited monopoly granted by the govern-
ment for the term period of the patent” (US Legal Definitions, p. 1). On
the financial side, the limited time horizon of VC funds and the incentives
of GPs to search for the next big success keep patent-based monopolies
short-term and constantly contestable.
There is also the fundamental idea that IP systems should promote

the diffusion of new technology by encouraging inventors to share their
inventions. What is called the patent puzzle (Hall & Harhoff, 2012) is
that too strong IP laws, instead of supporting the possibility of combin-
ing innovations, impede diffusion. Under strong IP laws, companies have
developed IP strategies that directly counteract the idea of openness and
are used to extract monopoly rents. Lerner (2002) finds evidence that
wealthier countries and countries with democratic institutions have stron-
ger patent protection. He also finds that legal tradition affects the patent
regime. What is also pointed out in the study by Lerner is that the patent
regimes are shaped by those actors that are in power. Pushed forward by
countries with strong patent regimes, global agreements have been intro-
duced. The PCT (Patent Cooperation Treaty) was introduced in 1970
between member states with the purpose of having a unified filing system.
A more debated agreement is the TRIP (Agreement on Trade-Related
Aspects of Intellectual Property Rights). This agreement was introduced
in 1995 within WTO members and ensures that member states provide
strong intellectual property rights. The market for patents is now global
and it includes different types of patent “aggregators” (Wang, 2008), shar-
ing the same purpose of creating monopoly by obstructing others to use
patented innovations. It is argued by Boldrin and Levine (2005), among
others, that patents are necessary in some industries and not in others.
The authors use the pharmaceutical industry with its high R&D costs as
an exception that needs patents to encourage financing. In Chap. 9 we
discuss briefly the idea of digital cooperative platforms that are one way
to make radical innovation more cooperative. Yet, VC funds did operate
and they are still operating in the current environment of strong IP laws.
5.4.2 The Role of Patents in VC Funds

Patents are a way to insure economic rent for the successful development
of radical ideas in technology. As such they affect the value of early stage
new companies that are based on radical ideas. Shares in such companies
are assets of VC funds. The effect of patents on the assets and therefore on
the value of VC funds is illustrated by the following example.
Assume that a group of entrepreneurs approach a venture capital fund
with an innovative technology idea. Assume further that by the time of
the approach the entrepreneurs already register a patent on their idea.
The VC fund decides to invest 100 in a new early stage company based
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
Table 5.1 Economic

Assets Liabilities and net worth
balance sheet of a start-up
Cash 100 Liabilities to labor 100
Idea 250 Equity of entrepreneurs 150
Equity of VC fund 100
Total 350 Total 350
Table 5.2 Post-investment bal-

Assets Liabilities and
ance sheet of the VC fund net worth
Equity of 100 Liabilities to LP 100

start up and GPs
Total 100 Total 100
Table 5.3 Cash flow-probability

Cash flows Probability
correlation
0 0.95
10,000 (=4000 + 6000) 0.05
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.
The lack of interest can be understood by examining the data presented

in the example above. Let us examine the return on the investment in
the start-up described above. There is a 5 % probability of success. Once
success is achieved the rate of return on the investment of $100 in devel-
oping the idea is extremely high. In cash-on-cash terms the investment
achieved a multiplier of 100× (the value is 10,000 if successful with a
patent). Realizing such a high rate of return (multiplier) can be only the
result of a monopolistic position of the start-up company given the suc-
cess. A monopolistic position that yields such high profits can be main-
tained only if it is legally protected by a patent. Going back to the HIV
test example, suppose that the development and the commercialization
of the new test turns out to be successful and the new start-up set up for
the development and commercialization of the new test. Assume further
that potential consumers are willing to pay $100 per unit where the cost
of production is $10. The new company will be very profitable (hence the
high return). However, if the new idea is not protected, competitors will
enter the market and the price will get down to $10 where the producer’s
surplus is zero. As was discussed in earlier chapters, GPs of VC funds do
not invest in projects that do not yield a substantial producers’ surplus if
they are successful.
Geronikolaou and Papachristou (2008) have discussed and tested the
relationship between patents and VC investment. Based on the literature
in the field, they have presented two hypotheses about patents and VC
funds. The first hypothesis is that an arrival of new technology (result-
ing in increased number of patents) increases demand for VC capital by
driving new firm start-ups. This hypothesis was specified by Hirukawa &
Ueda, (2011). The second hypothesis is based on the irreversibility-delay
proposition of Dixit and Pindyck (1994), which claims that the decision
to invest may be deterred in the presence of uncertainty over future cash
flows. Geronikolaou and Papachristou test the hypothesis that because
of information asymmetries and irreversibility considerations, patents
generate VC activity. Their test, based on European data in 15 countries
obtained from the EVCA, supports their hypothesis. In accordance with
these results Mina & Lahr (2013) show that VC investors use patents
as a signal of know-how and commercial viability, saying that the patent
has a selection function. Our analysis supports the positive relationship
between patents and VC investment, but the reason is not a reduction in
uncertainty in the selection process, but rather an increase in value, given
success.
5.5 GOVERNMENT SUPPORT OF INSTITUTIONAL SAVINGS

Eighty-five percent of the capital committed to VC funds in the U.S. is
coming from institutional investors that invest and manage money for sav-
ers, who are primarily middle-class and lower-middle-class workers. The
other 15 % is invested by family offices and wealthy individuals. Out of
the institutional investors, U.S. pension funds provide about 40 % of the
capital for VC funds. Public U.S. pension funds provide more than half of
this amount. The EVCA (2014) has reported that 25 % of all the money
that went into European private equity funds and venture capital funds
came from pension funds (see Table 2.8). A 2012 report published by
the U.S. Government Accountability Office (GAO) indicated that in the
period from 2001 to 2010 about 70 % of all large Defined Benefits Plans in
the U.S. invested capital in private equity and venture capital funds. This
is a new phenomenon, and it is very different from the way that radical
ideas in technology were financed in earlier periods. The Bell telephone
company, and later AT&T, were financed by a small group of wealthy
individuals. One of them, Hubbard, was a lawyer and the father-in-law of
Alexander Graham Bell. The parallel processes of a change in the source
of radical ideas from individuals to research institutions and the growth of
middle-class savings as a source for investment has shifted the financing
of radical ideas from individuals to institutions. This would not have hap-
pened without the active intervention of the U.S. government.
The major role of the institutional savings of middle-class and lower-
middle-class workers in the U.S. as the main suppliers of capital for invest-
ment is a relatively new phenomenon. The following brief timeline of the
evolution of institutional savings in the U.S. and major government inter-
ventions shows how this process came about.
The timeline, Fig. 5.3, demonstrates two related processes: a rapid
increase in institutional savings in the U.S., and a parallel increase in gov-
ernment involvement in making institutional savings more attractive to
U.S. workers. Pension payments by employers became tax deductible in
1914. As early as 1940 15 % of the workers in the private sector and all the
workers in the public sector in the U.S. were covered by pension plans. The
government intervened in the management of pension funds through the
1947 Labor Management Relations Act and, in a more thorough way, in
the Employee Retirement Security Act (ERISA) of 1974. By the end of the
twentieth century most of the workers in the U.S. were covered by either a
contributing or by a defined benefits pension plan. This development made
1875 1914 1919

1899
American Express The IRS rules that pension 300 Private pension plans
There are 13 private pension
establishes the first private paid to rerees is deducble coering 15% of salaried
plans in the US.
pension fund ato the employers as wages workers in teh private sector
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
1945 1947 1970 1974

75% of the naon pays The Labor-Management Almost 9 million workers in ERISA (Employment
income tax (up to 6% in Relaon Act established the the private sector (25%) are Rerement Security Act) was
1939) operaons of pension funds covered by pension plan enacted
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.
from DB to DC plans. As it is shown in Agmon, Gangopadhyay, and

Sjögren (2014) DB plans are a main source for capital for VC funds. Most
of the asset allocation of public pension funds in the U.S. is coming from
DB plans.
The position of the U.S. government towards the commitments of
the employers that fund DB plans is expressed in ERISA and by the
establishment of the Public Benefits Guarantee Corporation (PBGC), an
insurance facility specifically for DB plans. In addition, due to political
considerations, the federal government provides an implicit underwriting
of all public-sector DB plans. This policy creates an incentive for the pen-
sion funds that manage DB pans to follow a high-risk investment policy
that includes investment in VC funds. The interest of the employers is
to minimize their contribution to the plan. The interest of the managers
of the DB plans within the pension fund is to generate high return. The
payments to the beneficiaries of the DB plans are not dependent on the
return on the investment by the DB plans and they know that to a large
extent they are insured by the federal government. The implicit and the
explicit contracts between the U.S. government and the DB plans reflect
political and policy consideration of the U.S. government, but as a result
of these considerations DB plans have become a major source of capital
for VC funds.
5.6 SUMMARY: VC FUNDS, A RESPONSE TO INCENTIVES

PROVIDED BY GOVERNMENT INTERVENTION
IN THE MARKET FOR RADICAL IDEAS IN TECHNOLOGY
Government intervention in the market for radical ideas is an old policy.

In 1474, the “Venitian Statute on Industrial Brevets” was declared to
protect the citizens of Venice from persons with the purpose of copying
and infringing on innovations. One effect of the Statute was to attract
innovators from other parts of Europe to settle in Venice (David, 1993).
In the U.S. the policy has survived for more than 250 years. For most
of this period, government intervention in the market for ideas was
expressed through IP laws and their legal interpretation. Since the begin-
ning of the twentieth century, governments in general and the U.S. gov-
ernment in particular intervenes in the process of generating radical ideas
in two additional ways: first, by funding basic research, and second, by
creating a new, large, and less personal source for financing radical ideas
through VC funds. VC funds respond to all three types of government
intervention. Assets of VC funds are impacted by the granting of tempo-

rary and contestable monopolies to successful developers and their finan-
ciers. The liabilities of VC funds are coming primarily from the savings
of households through institutional investors. The flow of radical ideas
in technology out of which GPs of VC funds select their investments is
affected by basic research that is funded in part by the government.
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CHAPTER 6
How the Contracts Between the LPs, GPs,

and the Entrepreneurs Facilitate Investments
in High-Risk Radical Ideas
Abstract As is recognized by the U.S. Constitution, government inter-

vention is a necessary condition for promoting radical ideas. This is due
to the non-rivalrous and increasing return to scale (public-good features)
of radical ideas. Governments intervene in the process of turning radi-
cal ideas in innovative technology into consumption by funding basic
research, through intellectual property (IP) laws, and by encouraging and
supporting long-term institutional savings. The first form of intervention
increases the supply of radical ideas in innovative technology. The second
affects the value of assets based on radical ideas if successful, and the third
makes it easier to finance VC funds by institutional investors. Government
intervention creates economic rents. It is shown in the chapter that in
the market for ideas, temporary and contestable monopolies are welfare
increasing.
Keywords Contract • VC • Limited partners • general partners • radical

ideas
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

DOI 10.1057/978-1-137-53660-0_6
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.
6.2 VC FUNDS AND THE ROLE OF FINANCIAL

INTERMEDIATION
Households, savers, and investors will maximize their utility by giving up
some consumption today and use that for investing in projects to secure
future consumption. Households, being risk-averse, have a preference for
low-risk investment. For the same reason, households will prefer smaller
projects, or parts of projects, which allow for diversification and better match
the generally lower amount which they commit for investment (Fig. 6.1).
On the opposite side of the picture is the producing sector, whose proj-
ects often have a long duration (and hence low liquidity). These projects
The producing sector – user of capital
High risk Low liquidity Large
Financial intermediary
Low risk High liquidity Small
The households – provider of capital
Fig. 6.1 The role of financial intermediary—matching households’ preferences

with the supply of real world projects
HOW THE CONTRACTS BETWEEN THE LPS, GPS, AND THE ENTREPRENEURS … 67
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-
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
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.
6.3 RADICAL IDEAS ARE EXAMPLES OF HIGH-RISK

ASSETS
The high risk of the assets in which VC funds invests arises from the nature
of radical innovation. Radical innovative ideas can be either successful or
unsuccessful there is no middle ground. The time constraints built into VC
funds as limited partnerships means that GPs have “one shot”. In Chap. 8
below we discuss the risk distribution of assets based on radical ideas in
the context of valuation of VC funds. The examples of well-known suc-
cesses and failures of investments by VC funds illustrate the “all or noth-
ing” character of investments in radical ideas. AllAdvantage an internet
advertising agency was established in 1999 by three entrepreneurs; Pohle,
Anderson and Brock. The company was funded by $200 million invest-
ments by a number of VC funds. For example, in 2000 AllAdvantage
completed $100 million investment round led by SOFTBANK Capital
Partners that invested $70 million and led a group of other VC funds
that together invested $30 million. Early in 2001 AllAdvantage closed
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.
6.4 THE CONTRACTS THAT FORMS VC FUNDS
6.4.1 The Contracts Between the LPs and the GP

In a well-known study Holmstrom and Milgrom (1991) discuss the prob-
lem of compensation systems that deal with allocation of risk and reward-
ing productive work. DeMarzo and Kaniel (2015) extend the conceptual
model of Holmstrom and Milgrom to a case of contracts between one
principal and many agents where the performance of the agents is mea-
sured relative to their peers. Holmstrom and Milgrom and DeMarzo and
Kaniel are discussing in their studies different markets and different situa-
tions, but their models contribute to better understanding of the contract
between LPs and GPs. Large institutional investors divide their allocation
for high risk assets based on radical ideas to a number of VC funds they
also decide how much capital is allocated to what investment projects. VC
funds act as instruments for institutional investors to invest the capital that
they have allocated for investment in projects based on radical innovative
ideas. The institutional investors are represented by the LPs in the VC
funds that provide the capital and direct the investment through the con-
tracts between the LPs and the GPs.
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
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.
6.4.2 The Contracts Between the GP and the Entrepreneurs

Kaplan and Strömberg (2002) conducted a thorough empirical study of
contracts between VC funds in the U.S. and the entrepreneurs that pro-
vide the ideas and manage the companies in which the VC funds invest.
The main findings of the study were that there is a distinction between
cash-flow rights and control rights; moreover, the VC funds, indeed, the
GPs of the VC funds, control the major decisions through the board. The
analysis of the dynamics of the cash and control rights show that over
time(i.e. in later financing rounds) the “founders’” rights decline in favor
of the rights of theVC funds. If the company was doing less well than
expected at the time of the investment, the power of the GP increases.
The findings of Kaplan and Stromberg are congruent with the financial
contracting theory as it is discussed by Hart (2001). Their findings are
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.
6.4.3 Assets, Liabilities and Contracts

VC funds operate under capital constraints. The allocation of capital to
VC funds is determined by institutional investors and other managers
of savings, given the obligations to their beneficiaries and the market
conditions (a low interest rate environment may increase the allocation
to VC funds). Agmon and Messica (2007) provide analysis and empiri-
cal support to show that VC funds are supply-driven. GPs of VC funds
begin with a fixed amount of capital and, given that, they are looking
for assets that fit their objectives and the constraints set by the contract
between the VC fund and the GP. This is the opposite direction than
what is assumed in financial economics. In their seminal paper on the
cost of capital, Modigliani and Miller (1958) present a model of the
firm using an economic version of the balance sheet. Modigliani and
Miller define assets as the current value of the risk-adjusted future cash
flows to be generated by the firm. The liabilities (including net worth)

are defined as the risk adjusted current value of all the payments paid
to providers of capital. As in any balance sheet, the current value of the
assets is identically equal to the current value of the liabilities (including
net worth). The current value of assets and liabilities in the Modigliani
Miller is an expectation, taking risk into consideration. As time passes,
actual cash flows are generated and they are paid to liabilities holders
according to the contracts that define the liabilities. Modigliani and
Miller discuss business firms and they see the assets as creating the value,
and the liabilities as a list of how the generated value is paid to those who
provide capital, labor, and other inputs to the firm. VC funds are finan-
cial intermediaries and although the Modigliani Miller model is relevant
for them it works in a different way. As was pointed out earlier, financial
intermediation goes from the liabilities to the assets. As is discussed in
Chap. 7, an institutional investor like a public pension funds allocates
assets(the savings of its beneficiaries) among different asset classes. The
contract between the providers of the capital, LPs, and the VC fund
determines the investment by VC funds. As was discussed in Sect. 5.4.1
above, the contract between the GP and the LPs determines the actual
selection of assets by the GP as well as the management of the invest-
ment. The liabilities and the assets of VC funds are expressions of the
contracts between the LPs, the VC fund, and the GP. The assets are
chosen based on the contract between the LPs and the VC fund and they
reflect the payoff of the GP.
6.5 SUMMARY: THE UNIQUE NATURE OF VC FUNDS

AS FINANCIAL INTERMEDIARIES
In Chap. 4, the distinction between incremental and radical innovation

was discussed. Most of the growth of the world comes from incremen-
tal innovation, which improves current production. Companies invest in
increasing future cash flows all the time. This process increases the cur-
rent risk-adjusted value of the assets. The ongoing investment of the cur-
rent companies requires capital. The capital is raised by issuing liabilities
(including net worth). Financial intermediaries like portfolio managers
of public pension funds invest in incremental innovation by investing in
equity issued by existing companies. Almost all financial intermediaries
transfer capital (savings) from their beneficiaries (households) to invest-
ment projects that reflect incremental innovation. The assets “lead” the
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).
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CHAPTER 7
The Allocation of Savings to VC Funds,

Consumers’ Surplus and Life-Cycle Savings
Model
Abstract The venture capital industry is supply determined. Capital

allocation is what makes VC funds work. The focus of this chapter is on
the main source of capital to VC funds (institutional investors) and on
the question, why do institutional investors allocate capital to VC funds?
Pension funds have fiduciary obligations to their beneficiaries. We show
in the chapter that allocating a small fraction of the savings of the benefi-
ciaries to “lottery-like” investments that, if successful, will change future
consumption in a substantial way is congruent with long-term maximiza-
tion of the utility of consumption of the savers. Successful, innovative,
VC-backed companies increase consumption possibilities both by chang-
ing relative prices and by introducing new goods and services.
Keywords Institutional investors • life-cycle savings
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,

DOI 10.1057/978-1-137-53660-0_7
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
tutional investor, contribute to secure future consumption by allocating

some of their capital to high-risk VC fund investments. Another purpose
of this chapter is to illustrate how VC funds, as a firm, create consumer
surplus and to give some evidence of changes in consumer baskets as a
result of VC activity.
7.2 THE LIFE-CYCLE SAVINGS MODEL AND HIGH RISK

INVESTMENTS
The main motivation for savings is to provide for future consumption.
The life-cycle savings model provides insights into the motivation of
households to save part of their income. As most of the savings in the
U.S. are done through institutional investors and institutional investors
have fiduciary obligation to their beneficiaries( the saving households),
asset allocation of institutional investors should reflect the preferences of
their beneficiaries. Bodie, Treussard, and Willen (2007) present the three
principles of savings according to the life-cycle savings model. The three
principles are:
• Focus on future consumption and not on the financial plan.

• Financial assets are vehicles of moving consumption from the present
to a future period.
• The value of a dollar in return for savers depends on the consump-
tion that the dollar commands in the future.
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-
tion of goods and services by different organizations like corporations,

financial institutions, professional service providers, and government
agencies. Buying the securities issued by these organizations is the equiv-
alent to buying rights to their future production streams. The transfor-
mation of current savings by households to actual flows of goods and
services in the future through the process of financial intermediation by
institutional investors is demonstrated in Fig. 7.1 below. This figure is
similar to Fig. 6.1. However, the focus in Fig. 7.1 is on how households
secure their future consumption, while Fig. 6.1 illustrates the need of a
financial intermediary to match households’ preferences with the charac-
teristics of real assets.
Institutional investors collect savings from households and invest the
money into different classes of assets like fixed income, equity, real estate,
and what is called “'Alternative Investment”'. The investment is expressed
by buying securities, liabilities of corporations and other business organiza-
tions by the institutional investors. The securities held by the institutional
investors (bonds and equity) are claims against assets of the organizations
Households
“Savers”
Future consumption Savings
Today’s existing assets Facilitate future

consumption
Today’s innovations in
radical ideas
Expected Institutional investors

future consumption
Balance Sheet Asset allocation:
Fixed income
Representing cash Existing EquityReal estate
flows from future sales Bonds Alternative investments:
assets
of goods and services -Private equity
Ideas Equity -Venture capital
Fig. 7.1 The transformation of current savings to future consumption

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
successful, will change the life of the household in a substantial manner.

Friedman and Savage explain this behavior by assuming that such changes
affect the utility of the households and make the utility-adjusted expected
value of the lottery (if successful) positive. In the following section, we
show this by a simple asset allocation model that explains why such invest-
ment is congruent with what one would expect based on the life-cycle
savings model.
This explains why we buy into a lottery, but it does not explain why we
buy all the lottery tickets in the lottery. What explains the investment of
institutional investors in all the VC funds in the face of what seems to be
insufficient risk adjusted returns is that the reported returned documented
in Chap. 8 is just a part of the total financial return to the institutional
investors. In Chap. 8 it is shown that successful investment in VC-backed
radical ideas has externalities to the pre-investment market portfolio. In
Sect. 7.4, we show that the effects of successful investments by VC funds
contribute to the long-term welfare of the beneficiaries of institutional
investors who dominate current and future consumption.
7.3 ASSET ALLOCATION MODEL FOR INVESTMENTS

IN VC FUNDS
Conceptually, asset allocation of institutional investors that manage savings

for their beneficiaries should reflect their preferences according to the life-
cycle savings model. In the following, we assume that this is the case. The
model is an abstraction of reality and it is based on simple assumptions.
Assume an economy in which there is one person. There are two periods:
present (period 1) and future (period 2). The person generates income from
labor in period 1 and retires to live on savings in period 2. At the beginning
of period 1, the person has to make the following related decisions:
• How much income to consume in period 1, and as a result of that

decision, how much income to save and invest for consumption in
period 2?
• How to allocate his or her savings among existing assets?
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
distribution of variance. Asset number three is a specific “metamorphic

asset” with a binominal distribution of success with some probability of
success of p and a probability of failure of 1 - p .
The three assets represent two alternative production choices: ongoing
production is represented by a riskless assets (bonds) and risky assets that
represent current production (an equity or a portfolio of stocks like the
market portfolio). The third asset represents potential future production
possibilities due to radical innovative ideas in technology. If successful,
such ideas may substantially increase the value of production (and con-
sumption). The probability of success of such investments is low. This is
reflected in the high risk of the third asset.
The allocation of the savings (investment) to assets one and two is an
abstraction of the debt and the equity components in the asset allocation
of pension funds. Investment in asset three, the “metamorphic asset”, is
an abstraction of investing in a VC funds. The real world is much more
complex than the simple model presented above; yet, the model helps in
understanding the asset allocation of US institutional investors in general
and of U.S. public pension funds in particular. U.S. public pension funds
are lead investors in VC funds. Other investors often make their decision
whether to invest in new VC funds by following the investment decisions
of large public pension funds. The data presented below suggests that
investment in the “metamorphic asset” by households is very small. The
big promise of a substantial increase in future consumption is tempered by
a low probability of success of each project.
CalPERS, the State of California public pension fund, is the largest
single investor in the world in VC funds. By the end of 2014, CalPERS
held about $2 billion in VC assets under management in its portfolio. This
is about two-thirds of one per cent of the total portfolio. Pension funds
provide about a third of the $200 billion of assets under management by
VC funds in the U.S. Total assets managed by U.S. pension funds in 2012
were $17,000 billion. That means that about 0.4 % of the total portfolio of
U.S. pension funds is invested in VC funds. Public pension funds allocate
more than the average to VC funds. CalPERS holds 0.7 % of its portfolio
in VC funds. Indiana State (INPRS) is the pension fund that invests the
highest percentage of its total portfolio in VC funds, with an investment
of about 1.5 % of its total portfolio. With $66 billion invested out of the
total of $200 billion assets under management, pension funds are critical
for VC funds. Yet, with about 0.7 % of the total portfolio, VC funds are
not critical to pension funds. The objective of most pension funds is speci-
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.
7.4 VC FUNDS PRODUCERS’ AND CONSUMERS’ SURPLUS
7.4.1 Production and Surpluses in VC Funds

VC funds are organizations that employ factors of production to gener-
ate output. They pay the factors of production that they employ and they
sell the output that they produce. VC funds employ labor and capital and
they produce a special type of intermediate goods that we have defined in
earlier chapters as “assets in process”. In this respect they operate in the
same basic way as all firms do. In practice VC funds sell firms either to the
market as IPOs or to other firms as acquisitions. The operations of VC
funds can be discussed in the context of what is called in the strategic man-
agement literature “resource-based view of the firm (RBV)”. The RBV
is a particular version of a world of monopolistic competition. In such a

world some providers of factors of production can and do realize an eco-
nomic rent attributed to the resources that they control. Entrepreneurs
are the sources of ideas. VC funds control to some extent high risk capital
allocated by institutional investors and the GP of VC fund has discretion
which radical idea to finance out of very large flow of radical ideas (busi-
ness proposals submitted to VC funds). As was discussed in chapter five
the monopoly position granted to radical ideas by IP laws. The objec-
tive of VC funds is to maximize producer’s surplus, and in doing so they
contribute to consumer’s surplus as well. Producers’ surplus is measured
by economic rent (excess return) gained by the providers of factors of
production like capital and labor. Consumers’ surplus is the outcome of
reduced prices or increased quality (or both) of a particular output.
Producer’s surplus and consumer’s surplus in the VC industry can be
measured using a model developed by Lieberman and Balsasubramanian
(2007). Lieberman and Balasubramanian developed a RBV approach to
measure producer’s surplus and consumer’s surplus using firm level data
appearing on annual financial reports. We apply this model to a VC fund
to gain better understanding of the way that single VC funds contrib-
ute to consumers’ surplus. VC funds hire specific labor and raise sector
specific high risk capital. ‘Sector specific high risk capital’ is defined as
capital that institutional investors allocate for investment projects with
binomial distribution. The investors will receive very high return if the
investment project is successful, but they are willing to lose all the capital
if the investment project is unsuccessful. Armed with this capital the VC
funds are looking for projects that are congruent with the incentives in
the contract between the GP and the LPs. These projects are coming
from entrepreneurs. Once the GP select an idea for an investment the VC
fund and the entrepreneurs establish a start-up firm.
Given the two basic factors of production (labor and high risk capital)
and the intermediate output the venture capital fund generate its final out-
put which extends future consumption possibilities for consumers. The
value of the production of VC funds is the market value for the startup
companies in the portfolio of the VC fund. The higher is the potential
value of the portfolio companies the higher is the return to the factors of
production employed by VC funds. As was pointed out above the value of
an exit depends on the expected value of the production of the post-exit
VC backed firm which in itself depends on the added value of this company.
Table 7.1 Balance sheet of the start up after investment round one

Idea 250 Equity 250
Total 350 Total 350
Successful VC-backed investment projects generate very high return at

the time of the exit. This excess return (economic rent) is allocated as pro-
ducers’ surplus between capital (LPs returns) and labor (GPs and entre-
preneurs return). In the below we use a numerical example to show the
development of the value of portfolio companies of venture capital funds
over time. This is expressed by what is known as “investment rounds” allow
measurement of the incremental value as it is valued by the market. Exit is
the final stage in the life of VC backed companies. Consider the following
illustration of the change in value following investment rounds (Table 7.1).
The current value of the innovative idea of the portfolio company
(start-up) of the venture capital fund at investment round one is $250 (a
result from a negotiation between the entrepreneur and the VC fund).
This value is divided between the entrepreneurs (60 %) and the VC fund
(40 %). The venture capital fund invested $100 in labor service in order
to acquire more information about the value of the innovative idea of
the start-up given success. Assume that the information acquired by the
start-up was positive. As a result, there is a need for an additional invest-
ment of $300. This is called a second-round investment. After the second-
round investment the current (expected) value of the future cash flows
went up, from $250 to $1200. The new value of $1200 represents higher
expectations. Assume that the venture capital fund has raised an additional
investment of $300 from another venture capital fund at the new value
of $1200. Both the value of the start-up at investment round two and its
allocation among the entrepreneurs, the first venture capital fund (VC I),
and the second venture capital fund (VC II) is presented in the balance
sheet post-investment round two below (Table 7.2).
The new value of the startup is $1200. The new investors, VC II, invest
$300 at a value of $1200 and they own 25 % of equity (the cash and the
liabilities to labor cancel each other). The rest of the equity (75 %) is allo-
cated at a ratio of 40/60 between VC I and the entrepreneur ($1200 ×
0.75 ×0.4 = $360 and $1200 × 0.75 ×0.6 = $540 respectively). Therefore,
the equity is allocated as it is presented in the balance sheet after the second
Table 7.2 Balance sheet of start up company after investment round two

Idea 1200 Equity of VC I 360
Equity of entrepreneurs 540
Equity of VC II 300
Total 1600 Total 1500
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.
7.4.2 How VC Funds Increase Consumption Possibilities

In earlier chapters we have shown that it takes time for the potential
expected increase in consumers’ surplus to turn into actual additional
consumption. In this section, we provide some evidence on the process
of turning successful radical ideas into actual consumption. The most
important effect of radical ideas in technology is their reduction of the
production costs of a large array of goods and services. Changes in relative
prices affect consumption. A decrease in the price of a good included in
the consumption basket of a consumer contributes to an increase in real
consumption, through both a substitution effect and an income effect. A
great part of the effect of innovative ideas in technology on both current
and future consumption comes through changes in relative prices. The
combined substitution and income effect is greater if the good in question

is an input used in the production of many items. Microelectronics, ICT,
composite materials, and biotechnology are major areas that have expe-
rienced radical changes that introduced new goods and services and new
inputs that changed the relative prices of many existing products and ser-
vices. Yet, the process of translating innovative radical ideas into changes
in relative prices of goods and services is complex and it takes a long time.
David (1990) invoking Solow’s famous quip from 1987 about the com-
puters, notes, “We see the computers everywhere but in the productivity
statistics”. David argues that there is an increasing return to time for new
technologies but that it takes a long time to have a substantial effect. As
time goes by the rate of diffusion of new technology, the increases and
the relative price changes generated by new technologies are felt more
and more. Doms and Lewis (2006) discuss the diffusion of PCs across
U.S. businesses. In 1984, there were approximately 20 million PCs in use
in the U.S. and the U.K. The number of PCs in use reached 1 billion by
2005. The contribution to productivity and the share of PC services in
the consumption basket grew accordingly. A major input in PCs as well as
in other IT related industries are semiconductors. The discussion of the
semiconductor industry in Chap. 3 provides insights into the long process
of generating idea-based changes to the relative prices of existing products
and of simultaneously introducing many new goods and services.
In the following section we provide anecdotal evidence collected from
various sources to demonstrate the nature and the size of the potential
contribution of VC-backed firms to future consumption. One of the few
attempts to measure this contribution directly is a study of the contri-
bution of two specific digital data storage (DDS) technologies to future
consumption (Austin & MacAulay, 2000). Austin and Macauley develop
a model to estimate welfare gains from introduction of new technologies.
The model provides a rigorous approach to forecast future benefits for
consumers. In their research, they estimate the current value of the prob-
able future benefits to U.S. consumers of the two technologies at more
than $3.5 billion.
In a recent study titled “Should Low Inflation be a Concern” Papanyan
and Fraser (2014) report a decline in relative prices of durable goods and
decline in the proportion of clothing and footwear in the non-durable
basket of goods of consumers, Tables 7.3 and 7.4.
Papanyan and Fraser conclude, “Continuous innovation and growth
in the information technology sector resulted in lower prices along with
Table 7.3 Changes in relative prices of selected durable goods 2009–2013

Durable goods Relative price changes (%)
Video and audio equipment 6.8

Photography equipment 6.5
Information processing equipment 5.9
Telephone and facsimile 4.4
Clocks, lamps and lighting fixtures 4.6
Source: Papanyan and Fraser (2014)
Table 7.4 Changes in the weights

Years Weights in basket (%)
of clothing and footwear in the non-
durable basket 1964–1974 48
1984–1994 19
2004–2014 5
Source: Papanyan and Fraser (2014)
simultaneous increase in the quality of high-tech products”. They con-

tinue to say that most of the benefits of this process have accrued to the
consumers in the form of consumers’ surplus, and only a small portion
went to those who developed, commercialized, and financed the innova-
tive process in the form of economic rent.
In the presentation and the discussion of the ideas-led growth model
Jones (2005) has argued that ideas are non-rivalrous and therefore have
increasing returns to scale, but the increasing returns to scale are based
on an increasing number of users. As innovative production technology,
when an innovative product or an innovative service becomes available
they are not adopted immediately. There is a process over time where the
innovative idea and its applications are adopted. In a study of the psychol-
ogy of novelty-seeking behavior Schweizer (2006) says, “Innovation is not
‘something new’, but more appropriately referred to as ‘something that is
judged to be new”. This observation means that the value of an innova-
tion depends on the number of users. As the number of users grows, the
value of the innovation increases. In Table 7.5 below we show data on
the length of time that it has taken for major innovative technologies to
reach 50 % of the homes in the U.S. The data is divided into two types
of innovations: General Purpose Technologies (GPT) that are used in a
broad spectrum of applications as a part of the production process of many
goods and services, and innovative consumers’ products.
Table 7.5 Number of years that

Innovation Number of years
it took major GPTs and consum-
ers’ goods to reach 50 % of the General purpose technologies
homes in the U.S. Telephone 71
Electricity 52
PCs 19
Cell phones 14
Internet 10
Consumer goods
Radios 28
Color TVs 18
VCR 12
DVD players 7
MP3 players 3
Source: Census Bureau, Consumers Electronics Association

and Theirer (2000)
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
billion. The potential value (increasing return to scale) of Nest’s application

can be deduced from a recent report published by McKinsey & Company
titled, “Unlocking the potential of Internet of Things”, (McKinsey Global
Institute, 2015). The total value of the Internet of Things in 2025 is esti-
mated by McKinsey & Company to be in the range of $4–$11 trillion U.S.
dollars and the range of the value for home applications (the market in
which Nest is operating) is estimated to be in the range of $200–$300 bil-
lion. Given these numbers, a 2014 price tag of $3.2 billion seems to be rea-
sonable. Most of this value, if and when it takes place, will go to consumers
in the form of consumers’ surplus. The extremely high return of KPCB
on their initial investment in Nest, ($400 million on an investment of $20
million in three years) is a function of how much of the increased value for
society generated by Nest as a part of Google in the next 10 years or so
can be captured as producer surplus, and how much of that will fall out as
consumers’ surplus. In general, the allocation of the value added gener-
ated by an innovative idea in technology between producers’ surplus and
consumers’ surplus is a function of the scale of the use (number of users).
As the scale of an innovative idea in technology increases (measured by the
number of users), a larger share of the added value generated by the idea
goes to consumers and not to the producers. Such investments generate
high economic rent for VC funds. An example is what is known as ubiq-
uitous broadband. Crandall, Jackson, and Singer (2003) have estimated
the future consumers’ surplus in the U.S. of ubiquitous broadband in the
range of $230–350 billion. In a more recent study, Saunders, McClure,
and Mandel (2012) indicated that telehealth is one of the most promis-
ing applications of ubiquitous broadband. In 2013, Forbes published an
estimate that the telehealth market in the U.S. will grow from $240 mil-
lion to $1.9 billion by 2018. CNBC has reported that VC investment in
Health-IT early-stage companies went up from $1.9 billion in 2013 to
$2.4 billion in 2014. This investment is an indication of the effect of a
growth in the expected value of future consumers’ on current investment
by VC funds.
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
management through the private equity industry. The OECD proposed

investment policies are:
• More patient capital that acts in a counter-cyclical manner

• An ongoing, direct engagement as shareholder
• A more active role in the financing of long-term, productive activi-
ties that support sustainable growth such as cleaner energy, infra-
structure projects, and venture capital.
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.
REFERENCES
Austin, D., & MacAulay, M. (2000). Estimating future consumers welfare gains
from innovation: The case of digital data storage. Washington, DC: Resources
for the Future.
Bodie, Z., Treussard, J., & Willen, P. (2007). The theory of life-cycle saving and
investing. Boston: Federal Reserve Bank of Boston.
Crandall, R. W., Jackson, C. L., & Singer, H. J. (2003). The effects of ubiquitous
broadband adoption on investment, jobs, and the U.S. economy. Washington, DC:
Criterion Economics.
David, P. A. (1990, May). The dynamo and the computer: An historical perspective
on the modern productivity paradox. AEA Papers and Proceedings.
Doms, M., & Lewis, E. (2006). Labor supply and personal computer adoption. San
Francisco: Federal Reserve Bank of Philadelphia Working Paper No. 06-10.
Gans, J. S., Hsu, D. H., & Stern, S. (2002). When does start-up innovation spur
the gale of creative destruction? RAND Journal of Economics, 33(4),
571–586.
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No. 7471). National Bureau of Economic Research.
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Handbook of economic growth (Vol. B, pp. 1065–1111). Amsterdam: Elsevier.
Lamoreaux, N. L., Levenstein, M., & Sokoloff, K. L. (2006). Finance innovation
during the second industrial revolution: Cleveland, Ohio 1870–1890.
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its distribution among stakeholders of the firm (Mimeo). Los Angeles, CA:
Anderson School of Management, UCLA.
Lundvall, B.-Å. (2009). Innovation as an interactive process: From user-producer
interaction to the national system of innovation. African Journal of Science,
Technology, Innovation and Development, 1(2–3).
McKinsey Global Institute. (2015). Unlocking the potential of internet of things.
McKinsey & Company.
Papanyan, S., & Fraser, K. (2014, March 20). Should low inflation be a concern? A
comprehensive explanation for the current lack of inflationary pressures.
U.S. Economic Watch.
Rogers, E. R. (1983). Diffusion of innovations. London: The Free Press, Collier
Macmillan Publishers.
Saunders, J. D., McClure C. R., & Mandel, L. H. (2012). Broadband applica-
tions: Categories, requirements, and future frameworks. First Monday, 17(5).
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tion: Neurocognitive aspects within a work-psychological perspective. Creativity
and Innovation Management, 15(2), 164–172.
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computers-are-filling-the-digital-divide
CHAPTER 8
Externalities, Consumers’ Surplus,

and the Long-Term Return on Investments
by VC Funds
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.
Keywords Return on investment externalities
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

DOI 10.1057/978-1-137-53660-0_8
Table 8.1 US VC funds pooled return compared to public market returns, 2014
Index 5 years 15 years 20 years
US VC funds 16.07 4.84 35.44

S&P 500 15.34 6.21 9.36
NASDAQ 16.97 5.85 10.85
Source: Cambridge Associates (2014)
VC funds, this is often practiced by comparing the measured return

on a sample of VC funds to the return on an equity index like the S&P
500 for the same period. A recent example is provided by Cambridge
Associates (2014). The data compiled and published by Cambridge
Associates compares the pooled return of U.S. VC funds over various
length periods to the return on S&P 500 and NASDAQ over the same
periods. Table 8.1 below presents the commuted returns for durations
of 5, 15, and 20 years.
In a different study of the return on investment by about 1500 VC
funds over the period 1996–2005, Smith, Pedace, and Sathe (2010)
reported an average return on the total investment of 13.7 % with a stan-
dard deviation of 37 %. The data suggests a high risk on the investment in
VC funds by institutional investors and others represented by LPs in VC
funds. Moreover, unlike the measurement of the return on other asset
classes like equity which is done on the basis of short period, the relevant
horizon of VC funds is measured in years in which there are inflows and
outflows of capital. As was discussed in earlier chapters, VC funds are the
financial market’s response to specific planned intervention by the govern-
ment, with the purpose of promoting radical ideas in technology.
8.2 THE CONTROVERSY ABOUT THE RETURN

ON INVESTMENT IN VC FUNDS
In a publication titled, “Venture Capital Outperformed Major Stock Indices

during Third Quarter of 2014” (January 30th 2015), Bobby Franklin,
President and CEWO of NVCA, states, “Driven by a strong exit market
for VC backed companies on the cutting edge of innovation, venture capital
continues to prove its worth as investible and strong performing asset class”
(p. 1). In a Harvard Business Review (2013), Diane Mulcahy, one of the
authors of the Kauffman Foundation report on VC funds says, “Although
EXTERNALITIES, CONSUMERS’ SURPLUS, AND THE LONG-TERM RETURN ON … 97
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
the investment in VC funds is that the measurement of the return to the

capital invested in VC funds as the return to the LPs is incomplete. The
missing return is the result of externalities that accrue to the institutional
investors, but not directly to the LPs in the VC funds. The externalities
come from the specific and different nature of the assets in which VC
funds invest. The nature of the assets and how they affect the valuation of
VC funds is discussed in the next section.
8.3 THE SPECIFIC RISK OF ASSETS BASED ON RADICAL

IDEAS
In earlier chapters, we referred to investments by VC funds as invest-
ments in “assets in process”. Sudarsanam, Sorwar, and Marr (2003)
present a map of what they call “knowledge assets”. They distinguish
between “structural resources” and “stakeholders’ resources” where the
former reflects the intellectual assets of the organization and the latter
reflects the intellectual assets owned by individuals. Sudarsanam et al.
argue that in the knowledge economy there is a process whereby the
“stakeholders resources” are becoming “structural resources”. A pos-
sible way to interpret this model is that ideas are becoming assets, similar
to “assets in process”. In almost all asset classes, institutional investors
and other managers of savings (including foundations) select assets out
of existing asset “inventory”. VC funds invest in import new assets to
the market by making new radical stakeholders’ assets into structural
assets. The addition of new assets to the market by IPOs of VC backed
company is small relative to the stock of existing assets. However, over
the years the number of assets in the market portfolio that began as VC
backed IPOs is growing. An example is the NASDAQ with a total value
of $6.5 trillion in 2104. The added value from IPO that year was about
$22 billion.
The difference in the process of investment between assets based on
radical ideas and assets already traded in the market is expressed by a
different probability distribution of the future cash flows to be gen-
erated by them. Financial intermediaries that manage investment for
households (savers) act as if they hold a well-diversified portfolio and
they measure risk relative to the market portfolio. The market portfolio
and therefore the measured risk (defined in the finance literature as sys-
tematic risk) represents the existing portfolio. The assets in which VC
funds invest are different. The process of turning radical ideas into assets
Table 8.2 Statistics of the distribution of success measures given exit, 1996–2005
Measure Mean Median Skew
Internal rate of return (IRR) (%) 13.7 9.6 5.7

Cash on cash (multiple) 1.79 1.29 8.48
Source: Smith et al. (2010)
traded in the market can be described by a binomial probability distribu-

tion. There are two stages in the process: first, the investment is either
successful or not. Successful investment by VC funds ends with an exit
(either an IPO or an acquisition). Unsuccessful investment ends with no
exit. Data presented in Chap. 2 shows that a substantial proportion of
investment projects by VC funds end with no exit. Given an exit, there
is a distribution of value generated by the exit. Unlike the return on the
already existing assets in the capital market, the probability distribution
of value generated by exits of VC funds is not symmetric. Smith et al.
(2010) estimated the distribution of outcomes given exit for a sample
of 1258 VC funds for IRR and 1438 for cash on cash ratio1 or invest-
ment multiples at the time of the exit. In Table 8.2 below, we present
the statistics for the distribution of the measures of success given exit in
the Smith et al. study.
The distribution reported by Smith et al. continues in later years. In
2012 the value of the top 38 VC- backed IPOs was slightly more than
$100 billion. The range of the values of this group was between $56.9
billion (Facebook) and $45 million (Envivio). The mean value was $2.64
billion and the median was $798 million: a highly skewed distribution.
In the following section, we will see that the nature of the distribution
of value, given success, is functional and it is the result of the contract
between the GPs and the LPs of VC funds. Once the “new assets” join
the market portfolio the probability distribution of the returns become
congruent with the common risk-return relations in the market. In terms
of asset class, successful IPOs are no longer part of VC funds’ asset classes
and become part of the equity market.
Ritter (2014) reports price behavior of shares issued by new companies
through IPOs relative to price behavior of shares of comparable compa-
nies who have been listed on public stock exchanges in the U.S. for at
least five years. In Table 8.3 below, we bring Ritter’s data on a comparison
between the 1st day return of the new IPOs and the three-year buy and
hold return (BHR) on the new IPOs that survived for three years relative
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
VC backed 2773 24.8 0.6

Non-VC backed 4927 12.6 (11.6)
Source: Ritter (2014)
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
Number of IPOs 518 1258 517 480

First day return (%) 8.5 17.4 81.4 16.2
3 years BHR
Comparable return (%) 14.9 25.8 (61.7) (14.0)
Source: Ritter (2014)
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.
8.4 THE RISK PREFERENCES OF GPS, LPS

AND THE BENEFICIARIES OF INSTITUTIONAL INVESTORS
A common assumption in economics is that the welfare of the individual
is the objective of the economic system. Intermediaries in institutional
investors and instruments of institutional investors like VC funds are sup-
posed to serve this goal. Yet, managers of financial institutions like pension
funds and specific financial intermediaries like VC funds are individuals,
and individuals may and do have different preferences. The preferences

of households (savers) were discussed in Chap. 7 in the context of the
life-cycle savings model. In general, it is assumed in economics and finance
that individuals behave as if they are risk-averse. Yet, there are dynamic
situations where allocating small portion of savings for investment in a
risk-loving fashion is congruent with a long-term maximization of utility.
Friedman and Savage (1948) discuss such behavior in the context of lot-
teries. Under contracts with payoffs that encourage risk taking, risk-averse
individuals may make investment decisions resembling a risk loving behav-
ior. VC funds in high-risk projects with a binomial probability distribu-
tion of success (e.g., either no success or a skewed probability distribution
given success) is an example of the behavior described and discussed by
Friedman and Savage. In this case the motivation of GPs to select projects
for investment on the basis of maximizing return conditional on success is
an outcome of their contract with the LPs in the framework of VC funds.
This point was discussed in Chap. 6.
The preferences of the managers of institutional investors and other
managers of savings reflect their fiduciary obligations to their beneficia-
ries and, in case of public pension funds, they have obligations to society
at large as well. CalPERS, the largest pension fund in the U.S. publishes
its investment objectives. We use CalPERS, an example for risk prefer-
ences and investment policies for all institutional investors. CalPERS is
the largest pension fund in the U.S. and the largest single investor in
VC funds in the U.S. and the global markets. The Board of CalPERS
states that: “The overall objective of CalPERS investment program is to
generate returns at an appropriate level of risk to provide members and
beneficiaries with benefits as required by law” (CalPERS, 2015, p. 3). The
risk and the return are measured in terms of the portfolio of all the assets.
Large institutional investors like CalPERS used to say that due to their
size (CalPERS’ portfolio exceeds $300 billion) they mimic the market.
Yet, CalPERS considers the long-term implications of current invest-
ment decisions. In an appendix titled, “Investment Beliefs” the Board of
CalPERS states that the investment policy of CalPERS is long-term and
that the fund “considers the impact of its actions on future generations of
members and taxpayers” (CalPERS, 2015, Appendix 3). One can say that
large institutional investors act as risk-averse investors in the context of
the current market portfolio, but they are willing to invest in higher risks
to increase the welfare of future generations. They do that by investing
in VC funds. We will see in the next section that the long horizon and
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.
8.5 DIRECT AND INDIRECT CONSIDERATIONS

IN MEASURING THE RETURN ON INVESTMENT BY
INSTITUTIONAL INVESTORS IN VC FUNDS
The most important difference in measuring the return on the invest-
ment of VC funds from the point of view of the partners of VC funds and
providers of capital to VC funds is the length of the horizon. Limited
partners and general partners of VC funds are contractually bound by
the horizon of the funds. There is a difference between the GPs and
the LPs in VC funds. GPs (also referred to as Venture Capitalists) are
usually organized as limited liabilities companies. Most if not all GPs
want to raise a number of consecutive VC funds. Sequoia, the biggest
GP firm (VC firm) in the U.S. has raised more than $6 billion over the
years since its foundation in 1972 and has managed many VC funds in
the U.S. and globally. Therefore GPs (VC firms) have no limited hori-
zon. LPs in VC funds are legal structures set up as instruments to invest
money and they do not have any objectives different than the objectives
of the institutional investors that set them up. Institutional investors
have long horizons congruent with the average duration of their obli-
gations to their beneficiaries. The difference in the horizon makes the
measurement of the return on investment in VC funds different for the
providers of the capital (represented in VC funds by LPs) and the GPs
of VC funds. Consider the following simple example: assume a two-
period world. Investment takes place in the first period. The outcomes
of the investment are received in the second period. There is one insti-
tutional investor that manages savings for all consumers and one VC
fund. The VC fund raised $1000 from the institutional investor and
invests it all in one start-up with a probability of success p. If successful
the start-up will go public at a market value of $3000. The GP of the
VC fund will receive 20 % of the profits of the VC fund. The existing

companies in the economy issue equity. The institutional investor holds
equity in all the companies relative to their weight in the market port-
folio. After the IPO the startup become a part of the market portfolio
and it is traded in fair market price relative to its expected return and
its systematic risk. Assume further that the new company is based on a
radical idea that contributes to economic growth. From the point of
view of the economy the success of the VC-backed start-up is similar
to a successful R&D operation by the economy. Nadiri (1993) summa-
rizes the literature on the return on investment in R&D by incumbent
companies and on the spillover of R&D in one industry on the profits
of other unrelated industries. Nadiri reports that the spillovers are sub-
stantial and range from 20 % to 110 % with an average of about 50 %
relative to the contribution of the R&D to the industry that invests in
the R&D. Assume that the new start-up after successful IPO generates
spillover value equal to 10 % of its value at the IPO. Given this assump-
tion, it is possible to compute the return on the successful investment
to the GP of the VC fund and to the provider of the capital the institu-
tional investor.
• The return to the LPs:

Given the simplifying assumption of the example above the LPs
invest $1000 and realize value of $3000 one year later. The LP paid
the GP a carryover of 20 % of their profits: ($2000) × 20 % = $400.
The after carry over profits of the LP was $1600, an annual IRR of
160 %, or cash-on-cash of $2600/$1000 = 2.6X.
• The return to the institutional investor:
As was discussed above, the LPs are an instrument of the institu-
tional investor and the profit of $1600 go to the institutional investor.
However, the institutional investor holds the market portfolio. The IPO
of the successful investment of the VC fund was added to the market
portfolio. The new addition to the market portfolio increases its value
by 10 % of the increase in the value of the VC fund, $2000 × 0.1 = 200.
This value is part of the return on the investment of the institutional
investor on its investment in the VC fund. The total return on the
investment of the institutional investor in the VC funds is equal to the
direct return accrued to the LP after fees plus the externalities (spill-
over effect) of the success of the investment by the VC fund. In the
example this is equal to: $2000 – ($2000 × 0.2) + ($2000 × 0.1) = $1800
• The return to the GP:

Given our simple two period model the GP can raise only one fund.
Therefore its return is directly related to the profits of the VC funds
without the externality. In the example described above the payment
to the GP is 2000 × 0.2 = 400.
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.
8.6 SUMMARY: THE MARKET IS RIGHT

The major thesis of this book is that by investing in assets based on radical
ideas, VC funds fulfill an important role in the process from idea to con-
sumption, a process that drives economic growth. Given the contribution of
VC funds to economic growth, one would expect that those who manage,
finance, and support VC funds will be compensated for their effort. Given
the specific high risk of assets based on radical ideas as discussed in Sect. 8.3,
one expects high returns for capital and for labor employed in VC funds. The
literature on the return of investment in VC funds is inconclusive at best. A
number of researchers and industry analysts claim that the return to capital
allocated to VC funds is insufficient and that the return to GPs is too high.
In Chap. 6 we show that the payment structure and the level of payments to
GPs are welfare-increasing. In this chapter, we have shown that if correctly
identified and measured, the return to the providers of the capital over the
long horizon is substantially higher than the partial return to LPs discussed
in most research. The post-exit measurement including externalities is con-
gruent with the measurement of consumers’ surplus discussed in Chap. 7.
The payments to GPs, the return on the capital allocation of institutional
investors over their long horizon, the real return to the beneficiaries of the
institutional investors that allocate capital for VC funds, as well as the interest
of the taxpayers that pay for the government support of VC funds through
IP laws, funding basic research, and tab benefits to institutional savings all
play a role in making VC funds a useful instrument of economic growth.
NOTE
1. Cash on cash is the amount the VC receives at exits divided by the amount
of total investment.
REFERENCES
CalPERS. (2015, July). Total fund investment policy.
Cambridge Associates. (2014, December). U.S. venture capital index® and selected
benchmark statistics.
Hall, B. H., & Lerner, J. (2009). The financing of R&D and innovation. In
Handbook of the economics of innovation (Vol. 1, pp. 609–639).
Harris, R. M., Jenkinson, T., & Kaplan, S. N. (2014). Private equity performance:
What do we know? Journal of Finance, 69(5), 1851–1852.
Kaiser, K., & Westarp, C. (2010). Value creation in the private equity and venture
capital industry (Faculty & Research Working Paper). Insead.
Kauffman Foundation. (2012, May). “WE HAVE MET THE ENEMY… AND
HE IS US” lessons from twenty years of the Kauffman foundation’s investments in
venture capital funds and the triumph of hope over experience (Kauffman Report).
Mulcahy, D. (2013, May). Six myths about venture capitalist. Harvard Business
Review.
Nadiri, I. M. (1993). Innovations and technological spillovers (Working Paper
Series, No. 4423). National Bureau of Economic Research.
Ritter, J. (2014). Home page for Jay Ritter. Warrington College of Business,
University of Florida. IPO data. Retrieved from https://site.warrington.ufl.
edu/ritter
Smith, R., Pedace, R., & Sathe, V. (2010). Venture capital fund performance: The
effects of exits, abandonment, persistence, experience, and reputation (Working
Paper). Retrieved from http://ssrn.com/abstract=1432858
Sudarsanam, S., Sorwar, G., & Marr, B. (2003, October 1–2). Valuation of intel-
lectual capital and real option models. In Proceeds from PMA Intellectual
Capital Symposium, Cranfield University.
CHAPTER 9
The Future of VC Funds: The Effects

of Technology and Globalization
Abstract Radical innovation and specific financial arrangements have

gone hand-in-hand since the beginning of the inventive process in the
West. VC funds are a specific form of financing radical innovation that
depends on the nature of the technology and the organization of the
capital markets. Changes in technology and globalization are changing
the world now. Digital platforms are the up-and-coming form of business
organizations. Globalization and the growth of China, India, Brazil and a
host of small countries are changing the geopolitical and economic map of
the world. People will continue to generate radical ideas, regardless of the
form that the market takes. Financing will continue to be necessary. VC
funds may change the way they operate, but their function will continue
in one form or other.
Keywords VC funds • digital platforms • globalization
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

DOI 10.1057/978-1-137-53660-0_9
research. His argument is that technology is “…an autonomous, evolv-

ing entity that continuous to progress whoever is in charge”. Technological
change is a spontaneous phenomenon and should not be explained by
single, heroic inventors. The electric light bulb would most likely have
been discovered even without Thomas Edison. At least 23 other inventors
were working on the same idea and contributed to versions of the bulb.
The same can be said for many other innovations, such as the thermometer
(six inventors), vaccination (four inventors), and photography (four inven-
tors).1 Technological change should rather be seen as a chain of parallel
activities.
The story of our book is not one of the entrepreneur or the innovator.
The history of the development of the semiconductor, which we discussed
in Chap. 3 confirms the notion of innovation as a combined tinkering
with ideas already ‘in the air’, leading to technological breakthroughs and
technology as an unstoppable, evolving system that picks its inventors, as
described by Ridley. Also, patents can be questioned as tools to spur diffu-
sion of ideas. Even without patents, technology will find its way. Whatever
process technology is, this process needs financing to develop and commer-
cialize ideas to be enjoyed by society in large. In this book, we show that
government intervention supporting institutional savings, direct funding
of basic research (public goods), and IP laws (patents) increases the prob-
ability of getting ideas funded. We also show in this book that the VC as a
construct is a response to market needs to fund technological change. The
VC fund is a tool for encompassing the incumbents’ resistance to techno-
logical change rendering old technology obsolete. This resistance is satis-
fied with the limited time horizon of the VC fund. The VC fund is a tool
for bridging the gap between households’ savings and households’ desire
to increase future consumption. The shaping of institutional investors, the
pension funds in particular, has allowed technology to be financed without
reliance on few rich individuals, and instead has pooled the savings from
middle class households. This has mitigated the free-rider problem of the
non-rivalrous characteristics of ideas, and contributed to a more efficient
process of combining the inventive drive of individuals with the engine of
basic research, fueled by the average person’s desire for a better life. This
combination has led to an efficient, continuous increase in the consump-
tion per capita.
In a study of the inventive process in the early twentieth century in
the U.S. Lamoreaux, Sokoloff, and Sutthiphisal (2009) discuss the dual
process of innovation in the Midwest and the East Coast in the U.S. at the
THE FUTURE OF VC FUNDS: THE EFFECTS OF TECHNOLOGY AND GLOBALIZATION 109
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.
9.2 KNOWLEDGE ECONOMY AND VC FUNDS: DIGITAL

PLATFORMS AND CROWD FINANCING
Digital platforms are a form of technology-based organization that is
changing the way business develops via new production technologies,
goods, services, and experiences. Accenture (2015) published a report
of the effects of digital platforms on business. According to the report,
digital platforms blur the boundaries between industries. They make the
distinction between incumbents and attackers, as well as the differentiation
between incremental and radical innovation, less important. The process
of turning stakeholders’ intellectual capital into organizational intellectual
capital that is now the specific province of VC funds may become part of
the normal daily activity of new, diffused digital platforms. The develop-
ment of digital platforms affects patents as well. Google announced an
Open Patent Non-Assertion (OPN) system related to specific patents. It is
too early to assess the precise changes in IP laws as a result of the develop-
ment of digital platforms, but it is clear that changes will occur. All this is
likely to change the mode of operations of VC funds. Today, the focus of
GPs of VC funds is on exits. Exits take place either through acquisitions
or through an IPO. Either way, a precondition for the exit is forming an
independent firm, a start-up which later becomes the basis for the IPO or
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.
9.3 GLOBALIZATION AND VC FUNDS

The discussion in the book focuses on VC funds in the U.S. In recent
years, the VC industry has become more global. This is shown by the
number of VC funds located outside the U.S., by the number of invest-
ment projects funded outside the U.S., and by the globalization of the
sources of capital for VC funds. The biggest non-US market for VC funds
is China. Venture capital funding in China grew from $4 to $6 billion a
year to an almost bubble level of more than $15 billion in 2014. The VC
market in India is growing as well and VC investment rose to more than
$1 billion in India in 2013–2014. The real globalization of the venture
capital industry and of VC funds is expressed in international trade in
radical ideas, in high-risk financing, and in commercialization. Two cases
in point are Israel and China. Israel is a small country. From a global
perspective, it has a tiny domestic market and small institutional savings.
Israel also has an implicit comparative advantage in the development of
radical ideas in technology. The comparative advantage is implicit as Israel
needs a substantial import of high-risk sector specific capital to make the

implicit comparative advantage explicit. In the case of Israel, this was done
through a government intervention in the market in a program called
Yozma (in Hebrew ‘Enterprise’). The program was launched in 1994 with
a goal of setting up 10 VC funds that will raise $30 million from foreign
sources (plus $30 million each from the Israeli government and from local
investors). In the 20 years that passed from the initiation of the Yozma
program, more than $24 billion was raised by Israeli and US VC funds in
Israel, with the result of building a strong VC sector in Israel with more
than 80 VC funds and about 50,000 employees in VC-backed start-ups.
However, what Israel does is produce radical ideas, develop them, and
export them to the U.S. and other parts of the world. Israel is an outsourc-
ing center for radical innovative ideas in technology. The development of
R&D centers of major multinational enterprises in Israel is strengthening
this process. China is a different case. The comparative advantage of China
is enormous, and its growing domestic market produces a large demand
for new products and production technologies. The increase in venture
capital funding in China to more than $15 billion in 2014 is explained
by a strong demand for mobile phones and their applications. China is
also a source of capital for the venture capital industry as evident by a
$6.5 billion seed-stage VC fund financed by the Chinese government. The
globalization of the venture capital industry and of VC funds changes the
nature of the industry. VC funds will have to adjust themselves to different
business cultures and learn to operate in a multi-government world with
many different regulatory environments.
9.4 WHO WILL FINANCE VC FUNDS, SAVERS OR

TAXPAYERS?
The U.S. model of VC funds is based on financing them through the sav-
ings of households. The savings are not invested directly by households.
In most cases, capital for VC funds is allocated by financial institutions and
intermediaries. Public pension funds are an example of the first group and
family offices are an example of the second group. However, this is not
the case in other parts of the world. Most of the capital for VC funds in
China is coming from the government and from wealthy individuals. In
Europe where VC funds have been operating for many years, government
is still the single largest source of capital. According to the EVCA (2014),
the share of governments in financing VC funds in Europe in 2014 was
35 %. The share of pension funds in 2014 was 14 %. The answer to the

question of which sector in the economy finances VC funds—the govern-
ment, or savers through institutional investors—has implications for the
way that VC funds operate. In the U.S., the globalization of the portfolio
of large institutional investors contributes to the globalization of U.S. VC
funds. Matrix Partners a well-established U.S. VC fund that traced its ori-
gin to 1977. In the period 1982–2014 Matrix Partners managed 9 VC
funds with capital of $2.4 billion. Two of them were in India (2006) and
in China (2008). Institutional investors in the U.S. are major sources of
capital for Matrix Partners. Where governments are a main source of capi-
tal for VC funds the focus is more limited. The new Chinese VC funds
financed by the government are aimed at Chinese seed-level investment
projects. In Sweden, the government saw VC funds and the VC industry
as a way to develop Swedish SME (Karaomerlioglu & Jacobsson, 2000).
In a recent Statement of Opinion on a new model for financing innova-
tions (Statens Offentliga Utredningar, SOU 2015: 64), commissioned by
the Ministry of Enterprise and Innovation, the remit and focus of the
inquiry was to propose how state financial support to SMEs should be
efficiently structured. One starting point was to strengthen the “financial
eco system” and to stimulate Swedish start-ups and companies to grow.
The Swedish state financial support should complement capital markets
and support high-risk growth enterprises by using a fund structure. As the
venture capital industry becomes more global, and governments of major
countries like China, India, and Brazil are becoming important actors in
the global VC industry, the nature of the industry and the role of VC
funds as it has developed in the U.S. may change.
9.5 SUMMARY: THE FUTURE OF VC FUNDS

The combination of new innovative technology with the economic growth
processes in many countries, particularly in Asia, in South America, and
elsewhere is changing the arena for the development and financing of radi-
cal innovative ideas in technology. The combination of VC funds with
capital allocated from institutional investors that was the common model
for the last 25 years or so may change due to globalization and changes in
technology. Changes in technology and the role of the government in the
U.S. help VC funds to replace other forms of financing radical innovation
in years past. The need to provide finance to innovative entrepreneurs
with no money is independent of the organization structure of the capital
market and from IP laws. Providing such entrepreneurs with capital is

welfare increasing. Rapid changes in technology and the political and eco-
nomic implications of globalization may change the way that VC funds
operate and may change their legal structure, but the important role that
they fulfill in the process from ideas to consumption makes it certain that
in one form or another they will continue to operate for many years to
come.
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.
REFERENCES
Accenture. (2015). Digital business era: Stretch your boundaries. Business
Technology Trends 2015. Accenture.
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.
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.
Karaomerlioglu, C. D., & Jacobsson, S. (2000). The Swedish venture capital
industry—an infant, adolescent or grown-up? Venture Capital: An International
Journal of Entrepreneurial Finance, 2(1).
Lamoreaux, N., Sokoloff, K. L., & Sutthiphisal, D. (2009). The reorganization of
inventive activity in the U.S. during the early 20th century (Working Paper No
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Ridley, M. (2015). The evolution of everything: How new ideas emerge. New York:
Harper Collins Publishers.
Statens Offentliga Utredningar, SOU 2015:64. En fondstruktur för innovation
och tillväxt.
AFTERWORD
In this book we discuss how radical innovative ideas that contribute to

economic growth are financed. The process of financing radical innovative
ideas that turn technology into increasing consumption is complex and
there are a number of actors. The following is a list of the main points
discussed in the book. The list is divided into four parts:
• The objective and the process at large

• The objective of consumers/households is to maximize the utility of
long term consumption including intergenerational transfers. This
is expressed by an increase in the consumption per capita. The main
drivers of this process are ideas.
• The main actors
• The main actors are households that save money that is transferred to
investment. Institutional investors who allocate some of the savings
of households to finance radical ideas, and the government, which
intervenes in the market to allow for investing in non-rivalrous ideas
with increasing return to scale, subsidize institutional savings and
fund basic research.
• The facilitators
• VC funds are special-purpose financial intermediaries that are the
response of the capital market to the specific nature of radical ideas
as investments. The contracts between LPs that provide the capital
and GPs who manage the funds create an incentive to GPs to make

DOI 10.1057/978-1-137-53660-0
116 AFTERWORD
investment decisions aimed at maximizing return given success,

where the probability of success is low and the return given success is
very high. VC funds provide an outlet for entrepreneurs and innova-
tors who do not fit with the business strategy of incumbents and thus
VC funds encourage Schumpeterian “destructive creativity”.
• The return on investment
• Returns in radical ideas are realized over the long term, beyond the
horizon of VC funds. In measuring returns, one has to take into
account the externalities to the market portfolio caused by spillover
effects and by the long-term increase in consumption due to increase
in consumers’ surpluses. Once returns are measured in this way,
there is congruence between the general macroeconomic statement
that radical ideas contribute substantially to economic growth and
the actual returns on investments by VC funds as a group of financial
intermediaries.
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Lerner, J. (1995). Venture capitalists and the oversight of private firms. The Journal
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McKinsey Global Institute. (2015, June). The internet of things: Mapping the value
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Economy, 94, 1002–1037.
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Financial Studies, 27(7), 1977–2021.
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DOI 10.1057/978-1-137-53660-0
INDEX
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

DOI 10.1057/978-1-137-53660-0
120 INDEX
commercialization, 4, 6, 10, 20, 33, F

34, 42, 45, 50, 53, 54, 59, 68, Fairchild Semiconductors,
81, 109, 110 30, 33
computer sector, 28, 32 financial assets, 79
consumers’ surplus, 8, 9, 31, 33, 34, financial contracting, 77
78, 85, 91, 92, 105, 116 financial ecosystem, 112
contracts, 5, 7, 8, 15, 16, 62, 65, 66, financial intermediation, 21, 24,
68, 70–4, 101, 115 66–9, 110
creative destruction, 41 role in VC funds, 66–9
Crowd financing/funding, 110 financial market, 67
crowd-sourced application, 45 financiers, 77
cutting tools, 78 first venture capital fund
(VC I), 86
functional and structural finance
D (FSF), 50, 75
defined benefits (DB) plans, 60–2
defined contribution (DC) plans,
61, 62 G
digital platforms, 109–10 GDP per capita, 39
diodes, 28 general partners (GPs), 2, 7, 8, 15,
domestic market, 110, 111 66, 69
drastic innovation, 41 General Purpose Technologies
dry powder, 19 (GPT), 89
durable goods, 88–9 germanium, 28, 29
global annual investment, 16
global financial crisis, 16
E globalization, 10, 109–12
eBay, 4, 21 Google, 45, 70
“Economic Dynamics”, 52 Governments interventions,
economic rent, 4, 33, 56, 58, 85, 86, 49, 50
89, 91 Bah-Dole act, 53
Edison General Electric Company, 44 competition, monopoly and IP laws,
Edison, Thomas, 43, 108 54–6
electrical conductivity, 28 role of patents in VC funds, 56–9
electric light bulb, 108 types of, 50
electric power industries, 44 GP firm, 102
Employee Retirement Security Act
(ERISA), 60
entrepreneur, 15, 57, 58, 66, 68, H
71, 77, 84 high-risk investment policy, 10, 21,
Entrepreneurs Facilitate 62, 79–82
Investments, 7 households, 66–8
INDEX 121
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
P rate of growth of consumption per

pasteurization, 42 capita, 37–9
patent, 55, 108 R&D statistics, U.S. GDP, 40
rights, 31 resource-based view of the firm
role in VC funds, 56–9 (RBV), 84–5
trusts, 42 Return on investment externalities, in
Patent Cooperation Treaty (PCT), 56 VC funds, 96–8
pension funds, 8, 22, 78, 83 risk-free interest rate, 82–3
pension payments, 60 Rock, Arthur, 30
performance fee, 15 Romer growth model, 38
Perqin, 19
pessimistic investors, 68
photoconductivity in solids, 28 S
portfolio managers, 74 Schockley Semiconductors Laboratory,
Post-investment balance sheet, 57 29, 33
pre-money valuation, 2 second-round investment, 86
price behavior of shares, 99 second venture capital fund
price index, 18 (VC II), 86
private equity (PE) funds, 19 Sector specific high risk capital, 85
probability of failure of 1-p, 83 securities, 80, 81
probability of success of p, 83 semi-conductive material, 28
producers’ surplus, 85 semiconductor industry, 4, 27–8
Public Benefits Guarantee Corporation early stages of, 28–9
(PBGC), 62 from ideas to products, 29
public investment, 52 Sequoia, 2, 102
public market equivalent (PME), 97 serial entrepreneurs, 16
public market returns, 96 shares, 2, 56–8, 71, 90, 99
public pension funds, 68, 74, 111–12 Sherman Act, 54
public stock exchanges, 99 silicon, 28–30, 40
puzzle solving activity, 45 Silicon Valley, 34
Solow, 38
stakeholders’ resources, 98
Q Starbucks Corporation, 21
quantum mechanics (electronics), 28 stock market, 84, 109
structural resources, 98
survivorship bias, 67
R
radical ideas, 27, 50, 56
high risk assets, 69–70 T
public-good characteristics of, technological change phenomenon, 108
51–3 technological trajectory, 45
radio transistors, 29 technology push, 44–5
INDEX 123
technology transfer offices (TTO), 53 assets, liabilities and

telephone industry, 44 contracts, 73–4
The Ideas Diagram, 38 consumption possibilities, 87–91
Traitorous Eight, 29 contracts between GP and
transistors, 28, 29 entrepreneurs, 72–3
Treaty of Rome, 54 contracts between the LPs and GP,
70–2
digital platforms and crowd
U financing, 109–10
Uber Technologies, Inc., 21 financial intermediation, role of,
ubiquitous broadband, 91 66–9
“Unlocking the potential of Internet future of, 112–13
of Things”, 91 and globalizations, 110–11
unloved products, 45 production and surpluses, 84–7
U.S. Constitution, 4, 39 public pension funds, 111
U.S. Government Accountability size of, 16–23
Office (GAO), 60 structure of, 14–16
U.S. venture capital industry and success and failure in U.S., 23–4
VC funds technology trajectory, 44–6
capital sources, 21–3 U.S. model of, 111
dynamics of, 21 venture capital (VC) industry, 2, 13,
investment projects, 19–21 18, 27
size of, 17–19 venture capital investments, 18
sucess and failure, 23–4 venture capitalist, 5, 18, 42, 102
V Y
VantagePoint Venture, 30 Yozma program, 111
venture capital (VC) funds, 2–3, 5,
6, 7, 13, 27, 51, 65, 108–9

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VENTURE CAPITAL AND

Tamir Agmon and

Venture Capital and

ISBN 978-1-137-53659-4 ISBN 978-1-137-53660-0 (eBook)

Library of Congress Control Number: 2016941484

© The Editor(s) (if applicable) and The Author(s) 2016

Printed on acid-free paper

This Palgrave Pivot imprint is published by Springer Nature

1 A Comprehensive Economic Look at VC Funds 1

2 The Size and the Characteristics of the Venture

3 VC Funds and the Semiconductor Industry: An Illustration 27

4 A Macro Perspective on the Unique Role of VC Funds

5 Government Intervention to Promote Radical Ideas

5.5 Government Support of Institutional Savings 60

6 How the Contracts Between the LPs, GPs,

7 The Allocation of Savings to VC Funds, Consumers’

8 Externalities, Consumers’ Surplus, and the Long-Term

8.3 The Specific Risk of Assets Based on Radical Ideas 98

9 The Future of VC Funds: The Effects of Technology

Fig. 2.1 VC fund actors and investment relations 14

Table 2.1 Annual investment by VC funds from all countries (Money,

Table 8.2 Statistics of the distribution of success measures given exit,

A Comprehensive Economic Look at VC

Abstract The inventive process by which innovative ideas in technology

Keywords VC funds • inventive process

1.1 INTRODUCTION: THE PURPOSE OF THIS BOOK

© The Editor(s) (if applicable) and The Author(s) 2016 1

growth issues, we are able to better understand why VC funds are of

1.2 RADICAL IDEAS AS ASSETS

1.3 THE NEED FOR GOVERNMENT INTERVENTIONS

1.4 THE FUNCTIONAL ROLE OF VC FUNDS

VC funds have played an important part in financing the development,

tion possibilities later on. A large number of unsuccessful investment proj-

1.5 THE NARRATIVE OF THE BOOK AND ITS STRUCTURE

this book, the view is that the VC fund is as an institutional response to

move from an idea to concrete products, services, and production tech-

Hellman, T. (1998). The allocation of control rights in venture capital contracts.

The Size and the Characteristics

Abstract In this chapter, we discuss the size of the VC industry along

Keywords VC funds • VC industry

© The Editor(s) (if applicable) and The Author(s) 2016 13

which VC funds invest capital become a part of already existing companies

2.2 THE STRUCTURE OF VC FUNDS

General Partners (GP) Limted Partner (LP)

Portfolio companies VC Fund I

Entreprenures in Firm A, B, C .. N of VC Fund I

Fig. 2.1 VC fund actors and investment relations

It is useful to differentiate between actors who operate organizations

2.3 THE SIZE OF VC FUNDS

2.3.1 The Size of VC Funds in the Global World

Table 2.1 Annual investment

Source: Pearce (2014)

2.3.2 The Size of VC Funds in the U.S.

Table 2.2 Geographical distribution of VC funds 2013

US 33.1 3480 68.2

Source: Pearce (2014)

Number of VC Firms (GPs) 385 803 108

Source: NVCA (2015)

capital investment declined again during the crisis of 2008–2009. Since

by a VC fund at the time of its establishment is transmitted to the fund

2.3.3 The Number and the Nature of the Investment Projects

whereas investment in more advanced stages, known as “expansion” and

Table 2.4 Venture capital investment by stage (2014) US data