Market Selection of Competent Venture Capitalists

Venture capital is actually considered a very efficient mean for financing innovation. Kortum and Lerner (2000) estimate that a dollar invested in venture capital is three times more effective in stimulating patenting than a dollar invested in traditional R&D. Understanding venture capital is therefore a central matter for designing innovation policies. Venture capital has a very peculiar functioning. Venture capitalists finance young firms whose only activity is to develop radical innovations (start-ups). These new firms have no access to the banking system because they are too risky and have no collateral. But their future is also too uncertain to allow them to enter the financial market. Venture capitalists are assuming this uncertainty because they are looking for high-risk/high-reward investments. Venture capitalist are not wealthy individuals risking their own money (business angels), but fund managers. This means they provide institutional investors (pension funds, insurance companies, investment bank) with the possibility to invest in an asset, the venture capital fund, whose risk is manageable with traditional financial methods, like portfolio diversification. Venture capital is in fact turning the uncertainty of investing in radical innovations into a simple, though high, risk.