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 important 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 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 centers, 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 consumption possibilities. The important role of VC funds and the VC industry 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 radical 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 radical 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 context 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 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 investors 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 introduction 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 observation 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 market. These assets together form the universe of all possible investment possibilities 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 generated 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 market 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 portfolio 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 disappear and will not become a part of the market portfolio, and the investment 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 appropriate 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 companies like Microsoft, Facebook, and eBay are examples of the connection between early investment by VC funds and major increases in consumption possibilities later on. A large number of unsuccessful investment projects 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 frameworks. 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 markets, 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 unprecedented 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 initiator 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 entrepreneurs (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 industry 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 projects, 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 intermediaries. 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 th...