Enhancing the Innovative Capacity of Venture Capital

Abstract

How can law help translate great ideas into great innovations? Venture capital (VC) markets play an increasingly important role in funding innovation, and they have benefitted from substantial public support. While venture capital is almost synonymous with innovation, the ability of VC markets to catalyze innovations is often overstated. This Article examines the innovation limitations of VC and the role of law and policy in enhancing its innovative capacity. It draws upon academic commentary and original interviews with thirty-two early-stage investors, entrepreneurs, lawyers, and other innovation professionals in Northern California.

This Article explores, in an integrated fashion, three mutually reinforcing features that limit the capacity of VC markets to fund a wide range of socially valuable innovations. First, social ties are critical to connecting entrepreneurs and venture capital. This phenomenon shrinks the pool of entrepreneurs with a realistic chance of obtaining funding and distorts capital allocations in favor of those with greater social capital. Second, VCs exhibit a surprising degree of herd mentality, investing in trendy technologies while shying away from truly radical innovations. Finally, the VC business model favors innovations that promise large returns in a medium time frame with minimal risk. Such criteria necessarily deprioritize large swaths of socially valuable innovations with longer, riskier development timelines. While such practices are privately expedient in many contexts, they may leave significant profits unrealized. At a societal level, such practices are problematic to the extent that policymakers support VC markets to help effectuate innovation policy objectives.

This Article argues that law and policy have an important role to play in addressing these structural deficiencies and enhancing the innovative capacity of venture capital. It proposes a holistic suite of prescriptions to increase diversity and inclusiveness within the VC-startup ecosystem and to nudge VCs toward greater funding of certain technologies of high social value.

Keywords: venture capital, innovation policy, empirical, qualitative, interviews, lawyers, entrepreneurs, startups, Silicon Valley, federal funding, discrimination, software, biotech, cleantech, social connections, herd mentality, research and development, implicit bias, science policy, financial markets

JEL Classification: G24, M13, O16, O31, O32, O34, O38