The Magic Of U.S. Venture Capital

Research probes its potent effects

There's no question that U.S. venture capitalists have made big bucks in recent years. But just how effective is venture capital in fostering innovation in the economy? In light of the link between America's economic performance and its technological prowess, this issue is receiving increasing attention from both economists and investors.

For one thing, the venture-capital business itself is exploding. PricewaterhouseCoopers, which tracks the industry, reports that venture-capital investment in the second quarter of this year surged to a new high of $7.67 billion. That's 76% above the previous quarter and more than double the year-earlier level (chart). Further, 992 companies received such funding, a new record.

The impact of this torrent of cash on America's technological lead could be considerable. A recent study of some 20 U.S. manufacturing industries from 1965 to 1992 by Samuel S. Kortum of Boston University and Josh Lerner of Harvard University found that venture capital produces six times as many patents as a similar amount of traditional corporate research and development spending.

After new rules in 1979 allowed pension funds to invest in higher-risk assets, Kortum and Lerner note, venture-capital investment exploded, rising tenfold by 1986--and patenting activity took off. Although venture capital on average has accounted for less than 3% of corporate R&D in recent years, they estimate that it has generated as much as 15% of U.S. industrial innovations.

Supplying cash, however, is only part of the venture-capital story. Just as important, say Thomas F. Hellmann and Manju Puri of Stanford University Graduate School of Business, is providing focus and guidance. In a study of some 170 emerging companies in Silicon Valley from the mid-1980s to the mid-1990s, the two professors found that companies pursuing an "innovator" strategy--aimed at being first in their markets with a new product--are more likely to get venture financing than those developing a product that has existing competition.

What's more, Hellmann and Puri report that among all "innovators," those with venture capital brought their product to market far faster than those without it. Among "imitator" companies, by contrast, the presence of venture backing had little or no impact on a product's launch time.

In short, the evidence indicates that venture capital has been especially beneficial to innovative startups. "Particularly through their active participation on company boards, venture capitalists provide critical guidance and help recruit key managers," says Hellmann.

"The big question," he adds, "is whether the mega venture funds that have sprouted up in recent years will be spreading themselves too thin to provide that kind of hands-on support."

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