Boom and Bust in the Venture Capital Industry and the Impact on Innovation

Abstract:     
The past year has seen a dramatic decline in venture capital activity. Investment activity and fundraising by venture capital organizations have fallen sharply, and few observers expect a revival anytime soon.

This paper seeks to understand the implications of the recent collapse in venture activity on innovation. It argues that the situation may not be as grim as it initially appears. While there are many reasons for believing that on average venture capital has a powerful impact on innovation, the impact is far from uniform. In particular, during boom periods, the prevalence of over-funding of particular sectors can lead to a sharp decline in terms of the effectiveness of venture funds. While prolonged downturns may eventually lead to good companies going unfunded, many of the dire predictions seem overstated.

I proceed in three parts. First, I consider the cyclical nature of the venture industry. I explore why shifts in opportunities often do not rapidly translate into increase fundraising. I also highlight the tendency for the supply of venture capital, when it does finally adjust to shifts in demand, to react in an excessively dramatic manner. I explore how the structure of the venture funds themselves and the information lags in the venture investment process may lead to this "over-shooting" phenomenon. Similarly, I discuss the determinants of "busts," such as the industry is experiencing today.

I then consider the implications of these shifts on innovation. I review the more general evidence that suggests that venture capitalists have a powerful impact on innovation. I then consider both field-based and statistical evidence that the effects of venture investment on innovation are not uniform. I argue that the impact of these funds on innovation during period of rapid growth, or booms, is attenuated. At the same time, I consider the implications of prolonged troughs, such as the venture industry experienced in the 1970s, and highlight the apparently detrimental consequences of such events.

In the conclusion, I consider some of the implications for public policy. My analysis suggests that, while the rise of venture capital has been an important contributor to technological innovation and economic prosperity, an effective policy agenda going forward will not simply seek to spur much venture financing. I highlight the fact that many of the steps that policymakers have pursued have had the consequence of throwing "gasoline on the fire": i.e., they have exacerbated the cyclical nature of venture funding. Instead, the environment for venture capital investment can be substantially improved by government policies that encourage private investment and address "gaps" in the private funding process, such as industrial segments that have not historically captured the attention of venture financiers. In short, I argue that policymakers have to view efforts to assist young firms within the context of the changing private sector environment.

Keywords: Financing, Technological Change, Cycles

JEL Classifications: G24, O30

Working Paper Series