Innovation between Risk and Reward Set
coordinated by
Bernard Guilhon and Sandra Montchaud
Volume 6
First published 2020 in Great Britain and the United States by ISTE Ltd and John Wiley & Sons, Inc.
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Library of Congress Control Number: 2019952874
British Library Cataloguing-in-Publication Data
A CIP record for this book is available from the British Library
ISBN 978-1-78630-069-0
For Elizabeth. This book is dedicated to her, though it may have turned out to be the opposite of what her concerns were. She is all the more deserving of this dedication for having read and reread it, and in having suggested changes and improvements, in the form of simpler sentences and less sophisticated turns of phrase. The material does not exactly make for a page turner and is perhaps a bit arid, which is yet another reason for segments that sounded strange and possibly in need of a bit of fine tuning. A special thank you goes to her.
For Alice, always quick to make space for my insatiable urge to write and to provide me with all the means to achieve it. And once more, through SKEMA, she provided the logistical infrastructure and opened its doors wide to give me the warmest welcome.
For Stéphane, whose taste for reading does not go so far as to include economics, and who prefers real economic games to reflections on economic issues.
For Matilde, whose future choices remain to be seen, in hopes that this book will serve as an inspiration to her to reflect and research.
For Arseniy, who always seems to be out of balance, in hopes that he will put his very real abilities to use.
“Really, what is analyzing, if not choosing and deferring?”
[ALA 10, p. 174]
The works carried out on the subject of venture capital analyze this financing mechanism in terms of the stages of intervention, the players involved, the actions and innovative practices they implement. They also focus on the institutional arrangements that govern them, as well as on the performance of innovation and growth of the company, the sector in which it operates, and the economy as a whole.
What economists refer to as innovation implies novelty, but it is not novelty in itself that constitutes innovation. A new product, service, or process concept may be filed away and never brought into use. What matters is how this concept is implemented in economic practice so that the new feature introduced changes previously established practices and, in turn, the ways in which certain types of problems are addressed. The idea of innovation therefore implicitly refers to methods of producing, consuming or financing, that is to an existing routine that is an accepted way of dealing with a recurring problem. We will use the definition proposed by Vanberg [VAN 92]: “An innovation can be considered as a routine that purports to be new and potentially superior with regard to the accepted way of dealing with a given problem”.
The phasing out of existing routines is a concept that comes directly from Schumpeterian analysis. In his book Capitalism, Socialism and Democracy [SCH 51], Schumpeter points out that capitalism is infinitely malleable, whose capability is not to manage existing structures but, by applying “disjointed pushes”, to create new ones and then destroy them [SCH 51, pp. 122–123]. He refutes the thesis of the exhaustion of technological progress, because capitalism is inherently subjected to an evolutionary process whose fundamental impulse is innovation. The creative destruction process takes place over the long term and transforms the economic structure from within “by eliminating outdated elements and continually creating new ones” [SCH 51, p. 122]. This is the essential source of productivity gains. The appearance of a new product, more modern equipment, or a new type of organization is, above all else, an internal phenomenon within a company that has the effect of modifying the forms of competition on the market through the effect it has on quality and costs. This process should not be reduced to a simple phenomenon of competition through pricing, since creative destruction calls into question “the very foundations and existence... of existing firms” [SCH 51, p. 124].
However, the Schumpeterian dynamic can only be understood if both the real and financial dimensions of the act of innovation are taken into account. Entrepreneurs who create innovations are faced with the need to finance their projects in order to achieve new discoveries, which means giving a primary role to financing mechanisms in the desired level of economic activity. In his own historic period, Schumpeter favored financing through banks, which over time, came to be seen as very limited in its ability to support innovative projects.
Over the past 40 years, the relationship between industrial structures and financing structures has changed profoundly. The forms of competition, including all institutions and organizations involved with competition in the markets, are the dominant institutional structure. Some institutional structures (deregulated labor markets, the mobility of skilled labor, more open and diversified financing, intellectual property rights, etc.) encourage the emergence of new companies capable of creating marketable technological knowledge. The emergence of venture capital is a by-product of the need to develop forms of innovation in financing, allowing new technological paths that have proliferated in many activities, particularly high-tech ones, to be explored. At the same time, the deregulation of financial systems favors marked-based systems and threatens the stability of bank-based systems. This has profound implications for how financing is provided to companies, as well as for the opportunities made available from private savings. Venture capital funds are multiplying: as professionally managed organizations, they constitute venture capital (VC) firms, they gather financing resources and they invest in companies that pass through a formative period for a limited period of time (5 to 8 years).
In an earlier paper [GUI 08], we defined venture capital as a financing mechanism for the early stages of a company’s life, and proposed to analyze it as a two-tiered structure of intermediation.
Figure I.1. The simplified intermediation structure
(source: [GUI 08, p. 9])
A venture capital fund is first and foremost an innovative project management structure, firmly rooted in a legal and institutional context that expresses the incentives and constraints defined by public authorities (taxation, legal rules, control mechanisms, etc.). Using this as a basis, the financing players, constituted mainly in Europe by banks and in the United States by pension funds, insurance companies, retirement funds, etc., become involved. In addition to these players, scientific, technological and industrial experts also take part, whose participation is often required to assess the market prospects of the projects that are presented.
The second level of intermediation involves projects that are more specifically technology-intensive. In recent years, institutions specializing in technological intermediation have emerged as agents acting as interfaces between venture capital and new technological developments. Particularly in the United States, many of these intermediaries have taken the form of Internet service providers that provide information on the quality of technology projects and growth opportunities. In addition, many technology companies in the start-up phase, initially financed on an individual basis, are knowledge producers seeking complementary financing from venture capital funds and targeted information on downstream opportunities (licensing). In this perspective, technological intermediation supports the development of technological knowledge markets in many activities: software, biotechnology, artificial intelligence, 3D, etc.
This intermediation mechanism creates specific constraints from the point of view of information [RIN 16]:
Today, the financing chain for innovative projects has been extended, and the number of stages of the intermediation has increased [EKE 16, p. 2]:
Step 1. Incubation
In the first stage of development, when the company does not yet exist and its business model is not established, financing is mainly based on love money (Family, Friends and Fools), public assistance (competitions, loans of honor), or assistance provided by incubators or accelerators.
Step 2. Seed
This is the first capital contribution made to the company. Funds can come from business angels, public authorities (grants), private savings mechanisms such as crowd-funding or specialized funds (priming funds).
Step 3. Start-up
Generally, it is at this stage that venture capital in the strict sense of the term becomes involved, mainly through the activity of specialized funds, but also through public aid at this point as well.
Step 4. Growth
During the growth phase, growth capital funds are also involved, which allow the company to expand its business volume and enter new markets.
Step 5. Exit
The last potential step is the exit: the resale of the company (usually to large companies wishing to take ownership of its assets, ideas, and/or the technologies it developed) or an initial public offering.
These five stages follow the path of a logistic curve from incubation to exit, with venture capital considered by these authors to include the start-up and growth phases.
Another slightly different definition has been proposed by the OECD [OEC 18a, p. 102] which is based on the definition proposed by EVCA:
“Venture capital is a subset of private equity (i.e. equity capital provided to enterprises not quoted on a stock market) and refers to equity investments made to support the pre-launch, launch, and early stage development phases of a business. Venture capital-backed companies [...] are new created or young enterprises that are (partially or totally) financed by venture capital”.
The seed phase is included as part of venture capital. The same is true in a more recent publication [OEC 18b] in which the OECD includes the following four steps in its definition of venture capital: seed/start-up/early stage/late stage venture.
In our opinion, these different definitions refer to constraints on the information available to work on long series. They are also explained by the confusion that often occurs between the company’s development stages and the investment stages:
Table I.1. Progression of development and investment of companies
(source: [NVC 18, p. 7])
Development of the company | Concept/Start-up | Development | Growth | Maturity |
Investment stages | Seed Angels | Early stage VC | Late stage VC | Exit |
The start-up and early stage phase includes the production of the concept, the business model, and the operational deployment. These three stages are situations in which the cash flow is negative. The so-called late stage phase corresponds to the company’s growth phase. During this phase, the viability of the product is made certain, the company begins to grow, and its marketing and sales operations play an increasingly important role. In most cases, and based on the data available to us, venture capital will be identified in our work during the start-up, early stage, and late stage phases1.
Thus, the company’s development is based on types of interventions made by the players by means of a technical, social, and cultural process that leads to the emergence of a technological variety, in other words, an innovation.
This structure can be identified by three elements:
“In this context, venture capitalists will tend to professionalize the firm’s management so as not to make it too dependent on the entrepreneur or a specific professional manager. The financing of innovation, driven by venture capital, tends to erase the role of the entrepreneur in some cases once the firm is incorporated, which facilitates the external financing of the firm during various ‘rounds of financing’” [GUI 08, pp. 71–72].
However, this allegiance structure remains flexible. There are situations regarding which the level of performance strengthens the power of venture capitalists, and there are situations of conflict in which decision-making power and control rights will be exercised by the entrepreneur;
In addition to representing an original mechanism for financing innovative projects, many studies have highlighted certain unique features of venture capital. Here are some of the most important aspects:
First, it appears that venture capital (public programs and the private financial sector) has enabled dynamic entrepreneurs to create companies whose emergence and growth have revolutionized high-tech industries such as IT, digital technology, biotechnology, medicine, etc., as well as services such as insurance, e-commerce, etc.
Second, venture capital represents only a small fraction of total R&D expenditures. Venture capital-backed firms accounted for about 3% of R&D spending in the United States between 1983 and 1992, while accounting for 8% of total patents filed during this period [KOR 00]. It was during the 1970s that venture capital became an important component of the new innovation system in the United States [KEN 11]2. In total, venture capital investment has accounted for about 10.2% of innovation flows in 15 European countries since the early 1990s.
Third, venture capital rarely funds fundamental research, with start-ups devoting a large part of their R&D expenditures to product development and marketing.
Fourth, venture capitalists are currently facing a new concept, one that they have looked on with uncertainty, regarding the entrepreneurial skills of the management team, markets, and technology. Betting on enlightened investors and decision-makers is not a sustainable proposition in this area. With regard to markets and technology, there is little or no data, making the future difficult to predict from existing benchmarks – though not impossible to imagine. From this point of view, venture capital works as a mechanism for selection and screening, that must involve experts, people with scientific, economic, and marketing knowledge, in order to define the scope of the new concept by carrying out testing and experimentation phases to establish highly uncertain ideas on solid foundations, particularly in high-tech sectors. In addition, venture capital funds accumulate knowledge and experience that support and assist entrepreneurs. In this way, the barriers to entry into entrepreneurship are not simply financial or informational, but social and psychological, and their extent also depends on the acceptability of innovation. Indeed, the start-ups invested in are not primarily producers of goods or services, they permeate the field of science and innovation and offer new methods for producing, consuming, knowing, and communicating. From this perspective, venture capital is an essential facility, by its nature, that is, it is an essential service infrastructure from which innovative ideas can be carried out and move forward to business start-ups3.
Finally, venture capital does not produce developments in isolation, rather, this type of financing is influenced by macroeconomic (GDP, interest rates, etc.), institutional, and organizational developments, without one single reading being applicable. For example, the relationship between venture capital investment and growth can be interpreted as directly one-to-one: venture capital is a growth factor and, in turn, growth has a positive and significant impact on the development of this industry in countries where it has reached a certain degree of maturity. Moreover, institutional changes are inextricably linked to the development of this industry4. Finally, the very significant role played by new players such as business angels has made it possible to have a more detailed division within the organization of the financing chain and to encourage the implementation of supervision and selection processes that have reduced the uncertainty surrounding the new concepts. Not to mention serial entrepreneurs and investors who are able to invest large sums in start-ups, either directly or through fund structures, and who have built a reputation for skills, qualifications, and integration into effective networks.
The fundamental issue addressed in this work is organized around the following four proposals:
“Instrumental knowledge represents the means of production used within a process of activity. They include scientific and technological knowledge, knowledge relating to management or organizational principles, etc. The second type refers to interpretative knowledge that helps to define situations, to develop representations of reality, and to give meaning to a productive activity. Interpretative knowledge is developed during a filtering phase that seeks to identify the contributions of new knowledge in relation to existing solutions and to evaluate technological projects in terms of their effectiveness and utility...” [GUI 08, p. 63].
Instrumental knowledge is held by entrepreneurs, and its purpose is to delimit all possible activities. The purpose of interpretative knowledge is to delimit all conceivable activities, they are held by venture capitalists (assisted by experts). Of course, there are overlaps: entrepreneurs also develop representations that are supposed to correspond to productive and market opportunities, venture capitalists hold instrumental knowledge they have obtained from areas such as their previous experience as entrepreneurs. The intersection between these two sets of knowledge represents the achievable activities;
The purpose of this book is to analyze the operating mechanisms and interpretation structures of this type of innovation financing, using a dual approach based on analytical considerations and applied economics. The scope of the investigation includes the United States, Europe and particularly France. We have paid less attention to the Asia/Pacific region due to the difficulty of obtaining significant samples of venture capital-backed companies. and series long enough to establish robust results and considerations. The levels of analysis that are the motivation for the three axes of our reflection are based on three types of logic.
Chapter 1 identifies the rationale of the main players who make use of this following financing mechanism: the project leader (the entrepreneur) and the person(s) responsible for the fund (venture capital). The logic of control and sanction is at the basis of the contractual model. The cooperative logic serves as a pillar for the scheme which postulates mutual dependence between the two players, with neither of them able to exert a unilateral and asymmetric influence on the behavior of innovative start-ups. In addition, facing how difficult it can be to select the right projects, venture capital works at the limits of uncertainty through syndication and staged financing, which partially reduces failures and disappointing investments (exits at zero value). The difficulty of selecting the right projects is therefore real. For his part, the entrepreneur must deal with a type of risk that cannot be diversified, and in all too many cases, when the ambiguity is removed it reveals only a negative outlook. In addition, some European countries, such as Italy, have distinguished themselves from the United States by promoting less permissive cultural behaviors in terms of innovation, resulting in a strong resilience of family capital and a strong attachment to traditional ownership values. This is what we have called the refusal attitude towards this type of funding.
Chapter 2 highlights the different forms of sectoral logic. Since the goal is to study a mechanism for financing innovative projects, it was natural to focus on the most promising sectors in terms of innovation, that is high-tech sectors. The sectoral orientation of venture capital makes it possible to highlight the specific features of Europe and the United States, as well as the consolidation mechanisms that distinguish the industrialization trajectory in the United States: R&D spending, manpower qualifications, testing and experimentation phases, etc. These innovative practices that seek to reduce ambiguity are not used with the same intensity in Europe. For example, R&D does not seem to be considered by private players as a crucial variable capable of transforming a small enterprise into a high-growth firm, which it feeds into both through filing patents and through its attractiveness to qualified productive resources. To complete this analysis, we have sought to highlight the determining factor of high-tech investment in Europe in order to assess the quality of the environment.
Chapter 3 focuses on macroeconomic and macro-social variables whose coherence is highlighted by the model presented. This leads us to favor the analysis of the institutions we have compared using structures typically employed for interpreting this activity: on the one hand, the market, and on the other hand, industry. Markets and industries are embedded in institutional mechanisms that we highlight in several ways: the construction of a European venture capital megafund, public authorities’ interventions through tax exemption mechanisms or, as a counterpoint, the insufficient mobilization of certain players in France faced with the need to create a real entrepreneurial ecosystem. The ambiguity on display here involves the attitude of public authorities, namely with regard to managing venture capital as a niche or to making it an instrument of industrial policy. A more specific analysis of the institutional variables is thus carried out to highlight the idea that orienting institutions so that they are complementary is stronger for market-based systems and that it favors the expansion of this industry.