The tenuous relationship of venture capital and innovation

Masako Ueda, Masayuki Hirukawa

30 January 2009



In the 1980s, German and Japanese auto and electronics companies were extending their global market shares at the expense of US companies. Economists and policymakers often attributed this disparity in economic performance to differences in financial systems. One argument was that German and Japanese banks provide patient capital and allow firms to focus on long-term objectives, whereas in the US, where stock markets are the major provider of long-term capital, firms are obsessed with maintaining their stock prices and too myopic to invest in R&D (e.g. Law, 1986).

In the 1990s, young US firms were expanding in new markets created by the advancement of computer and communication technology, whereas both Germany and Japan were experiencing near zero economic growth. Again, economists and policymakers found a culprit in financial differences. In the US, venture capital (VC) provided the opportunity for unproven technology to be tested out, whereas in Germany and Japan, such risk capital was negligible.

Does fixing the financial system fix the economic problem? This is an old question, but it persists due to the difficulty of establishing causality between finance and economic performance (e.g. Goldsmith, 1969). On the one hand, the supply of funds may allow productive opportunities to be exploited; on the other, new opportunities may demand funds.

Similarly, the causal relationship between venture capital and innovation is not clear. Venture capital may spur innovation by relaxing financing constraints that innovative firms face due to asymmetric information and moral hazard problems. This is the VC-first hypothesis, but the reverse – the innovation-first hypothesis – is also plausible. When innovation opportunities arise, innovating firms may demand venture capital investments and, as a consequence, venture capital markets grow. Zucker, Darby, and Brewer (1998) pioneered study of the causal direction by using the historical venture capital market size to study biotechnology start-ups. Interestingly, they found that, controlling for the presence of local star scientists, the size of the venture capital market negatively affected the rate of new biotechnology firms.

Does venture capital stimulate patents?

Kortum and Lerner (2000) study the impact of VC investment on industries’ patents by examining a 1979 change to the Employee Retirement Income Security Act that encouraged US pension funds to invest in venture capital and boosted the amount of funds available for US venture capitalists. They find that VC investment increases patent counts more strongly than industrial R&D expenditure, which appears to lend strong support to the VC-first hypothesis.

Nevertheless, follow-up studies have indicated that venture capital investment is not necessarily used to generate patented innovations. Studying a sample of German firms, Engel and Keilbach (2007) find that VC-funded firms register more patents than comparable firms lacking venture capital before receiving VC investments, whereas this tendency disappears after the investment is made. This suggests that patents stimulate venture capital investment but not the other way around. Studying firms that went public on the Italian Stock Exchange between 1995 and 2004, Caselli, Gatti and Perrini (2008) find the same result as Engel and Keilbach. These results are consistent with Stuck and Weingarten (2005), who contend that venture capitalists thwart innovation and force their portfolio firms to become more business-oriented, as venture capital general partners often possess advanced business degrees but not science degrees.

The aforementioned firm-level evidence that VC converts a science-oriented firm to a business orientation does not necessarily contradict Kortum and Lerner’s finding that VC positively impacts patent counts at the industry-level. If entrepreneurs expect abundant venture capital funds to aid them in commercialising their patents, they may be more willing to innovate, therefore raising patent counts. Nevertheless, using commercialisation of patents as a measure of innovation, Katila and Shane (2005) suggest that a positive relation between VC investment and innovation may merely be a spurious correlation. In their study of licensed MIT patents, they find that these patents are more likely to be commercialised if the licensee firms are in an industry with high VC investment. However, puzzlingly they find that this effect exists only for established firms and not for new firms that are likely to be recipients of VC investment.

Does venture capital stimulate productivity growth?

The impact of venture capital investment on innovation has also been studied using productivity growth as the measure of innovation. Romain and van Pottelsberghe (2004) and Tang and Chyi (2008) use cross-country data and Taiwanese data, respectively, and both find that VC investment enhances productivity growth. US evidence is weak, however. Despite using the same regression model as Kortum and Lerner (2000), Ueda and Hirukawa (2008) do not find that VC investment significantly affects total factor productivity growth. They do find that VC investment positively affects labour productivity growth, but this is due to technological substitution using more energy and material and less labour in VC-intensive industries.

Further, using a panel autoregression as well as industry-by-industry autoregressions, we find that total factor productivity growth is often positively and significantly related with future VC investment, which is consistent with the innovation-first hypothesis (Hirukawa and Ueda 2008). More surprisingly, we find that one-year lagged VC investments are often negatively and significantly related with productivity growth (and patent count as well). This negative relation between lagged VC investment and productivity growth is consistent with a bubbles and crashes theory that economic booms trigger subsequent collapses (e.g. Abreu and Brunnermeier, 2003). As VC investments often increase during economic booms and productivity growth slows down during crashes due to low capacity utilisation, the bubbles and crashes theory predicts that VC investment boom leads slow-down in TFP growth.


The current financial crisis has shut off venture capitalists’ opportunities to cash in their investments by bringing their portfolio firms to public stock markets. As a consequence, they are currently hesitant to invest in young firms in the first place. However, taken together, the evidence supporting the positive impact of VC on innovation is weak at best. Some innovations, especially less profitable ones, may take more time to be commercialised, but innovation is likely to persist even during this downtime, thanks to scientific curiosity and enthusiasm.


Abreu, D., and M.K. Brunnermeier, 2003, “Bubbles and Crashes,” Econometrica 71, 173-204.

Caselli, S., S. Gatti and F. Perrini, 2008, “Are Venture Capitalists a Catalyst for Innovation?European Financial Management, forthcoming.

Engel, D. and Keilbach, M, 2007, "Firm Level Implications of Early Stage Venture Capital Investment - An Empirical Investigation,” Journal of Empirical Finance 14(2), 150-167.

Goldsmith, R. W. 1969, Financial Structure and Development, Yale University Press, New Haven.

Jaffe, A. B. and J.Lerner, 2004, Innovation and Its Discontents: How Our Broken Patent System is Endangering Innovation and Progress, and What to Do About It, Princeton University Press.

Katila, R. and S. Shane, 2005, “When does Lack of Resources Make New Firms Innovative?Academy of Management Journal 48(5), 814-829.

Kortum, S. and J. Lerner, 2000, “Assessing the impact of venture capital on innovationRand Journal of Economics 31, 4, 674-692.

Law, W. A. 1986, "A Corporation Is More Than Its Stock," Harvard Business Review May/June 1986, 80-83.

Hirukawa, M. and M.Ueda, 2008, “Venture capital and innovation: Which is first?” CEPR Discussion Paper 7090.

Romain, A. and B. van Pottelsberghe, 2004 “The Economic Impact of Venture Capital,” Deutsch Bundes Bank.

Stuck, B. and M. Weingarten, 2005, “How Venture Capital Thwarts Innovation,” IEEE Spectrum, April 2005, 50-55.

Tang, M.-C., and Y.-L. Chyi, 2008, “Legal Environments, Venture Capital, and Total Factor Productivity,” Contemporary Economic Policy 26, 468-481.

Ueda, M. and M. Hirukawa, 2008, “Venture capital and Industrial “Innovation”,” CEPR Discussion Paper 7089.

Zucker, L. G., M.R. Darby, and M.B. Brewer, 1998, “Intellectual Human Capital and the Birth of US Biotechnology EnterprisesAmerican Economic Review 88, 290-306.



Topics:  Productivity and Innovation

Tags:  innovation, venture capital, reverse causality

Assistant Professor at the School of Business and Principal Faculty of INSITE (Initiatives for Technology Entrepreneurship), University of Wisconsin-Madison

Assistant Professor of Economics, Northern Illinois University