The Venture Capitalist’s Gamble
Making private capital available to researchers to finance their work and its diffusion, promotes innovation and therefore fuels the modern day economy
Mario Calderini & Dario Moncalvo
Artistic Bill Board in Langa, Cape Town. Photo Edgar Pieterse.
An entrepreneur who goes to the bank to apply for a loan for a numeric controlled machine will more than likely go back to the office with the necessary resources for the investment. It is hard to imagine a young research worker going to the same teller asking for a loan in order to continue promising research on the synthesis of a new protein having the same luck.
Why is this?
First of all, the difference resides in the intangible nature of the subject the young researcher works on. Important economic implications derive from this characteristic. To start with the bank employee suffers from a significant informational asymmetry: his expertise lies in evaluating the value of tangible goods, whereas the quantification of the potential economic value associated with research requires specialized knowledge that is not readily available in the credit sector.
The growth of venture capitalism is one of the primary objectives in the strategies for scientific and technological development outlined by the European Union at the Lisbon Conference
Added to this is the fact that the same employee is able to base his decision on a broad case history of financing for numeric controlled machines whereas for investments in a highly innovative industry it is more difficult to have terms of comparison and contrast. Secondly, if the business performed with the numeric controlled machine falls through, the bank can count on the physical capital to recuperate its investment, for example reselling the goods on the secondary market for second-hand numeric controlled machines. On the other hand research that proves fruitless doesn’t produce any goods for a market where at least a part for the investment can be recuperated.
Thirdly, an investment in innovation has one unusual characteristic: most investments yield little or sometimes even nothing at all, but the few that have positive results are typically characterized by very high yields. This characteristic gives innovation investments a high-risk profile. The risk is often so high that the credit market doesn’t grant financing.
Many of the considerations above also apply to the capital equity market. It, too, finds it difficult to support very high-risk innovative activities. To summarize, in financing innovative business, the market fails: market forces do not guarantee the balance between supply and demand of capital for innovative business. The third route, however, that of self-financing, is difficult for new “high tech” companies, during the “seed” and “start up” phases of the new entrepreneurial business, often only have one distinctive asset, a new idea.
Aside from the traditional recourse of government support, the answer to this problem can be found, in a particular institutional system called venture capital.
An institutional system such as this is able to overcome some of the problems mentioned above through two fundamental mechanisms: a portfolio made up of a high number of high-risk projects, and a high level of specialization by field. The former allows for the diversification of risk: a few successful projects will more than pay the venture capitalist back for the numerous projects that do not produce good results. On the other hand, the latter considerably reduces the informational asymmetry between the financing and the financed party through specialization of knowledge: being different from other financing parties, venture capitalists boast specialized technological knowledge for evaluating entrepreneurial plans in the most advanced technological fields and experience in selecting and collaborating with the companies that they eventually commit to.
The venture capitalists’ field of activity is not actually limited to a simple evaluation and selection of the best emerging technological business opportunities but, due to common interests with the financed companies, it also extends to the management of industrial development plans. In this way, the knowledge of entrepreneurs and their work groups, often focused more on technological aspects than economic aspects, is combined with the managerial competence necessary for achieving the profit potential.
In exchange for this support, the venture capitalists set, according to contract, various obligations for the entrepreneurs of start-up technologies, that range from the distribution of business management and tools to the use of the technological results developed within the venture-backed companies, including the assignment of rights for patents of new inventions.
These obligations, which characterize the close relationship between the financed parties and the financing agents, represent a kind of quality certification for the entrepreneurial initiative, which enables the upcoming company to, in subsequent phases of development, access traditional capital markets, increasing its probability of success.
Operational risk | Capital demand
Growth patterns of innovative enterprises
The association between the financed companies and the venture capitalists is usually brief: it ends with the cancellation of the latter from the company’s capital (write-off), or with the sale of its quotas to another financing party (trade) or by accompanying the company in its stock market listing through IPO (initial public offering).
In a moment in time when the state system is unable, with its resources alone, to support research and its transfer to the industrial system, the availability of private capital for promoting innovation represents a key factor in the development of the modern economy. This is the reason why the European Union at the Lisbon Conference indicated venture capitalist business as a priority in the strategies for scientific and technological development. In particular, bridging the gap that separates Europe from the United States appears to be an absolute priority for defining industrial policies in the near future.
