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Boom and bust in the venture capital industry and the impact on innovation

  • Josh Lerner

After more than two decades of dramatic growth in the venture capital industry, the recent sharp decline in venture capital activity has raised concerns about the implications for technological innovation. This article argues that venture capital may have a powerful impact on innovation, but this effect is far from uniform. ; The author uses a supply and demand framework to consider the cyclical nature of the venture industry and explore why shifts in opportunities often do not rapidly translate into increased fund-raising. The discussion shows how the structure of venture funds and the information lags in the venture investment process may increase the tendency of the venture capital supply, when it finally adjusts to shifts in demand, to react excessively. ; In considering the implications of these shifts for innovation, the author considers both field-based and statistical evidence. This analysis shows that venture capital's impact on innovation is positive overall but is likely to differ at various times in the cycle. ; The study concludes that, although venture capital has made important contributions to technological innovation and economic prosperity, effective government policies should not seek merely to spur venture financing. Instead, the author urges policymakers to encourage private investment and address gaps in the private funding process, such as industrial segments that have not historically captured the attention of venture financiers.

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Article provided by Federal Reserve Bank of Atlanta in its journal Economic Review.

Volume (Year): (2002)
Issue (Month): Q4 ()
Pages: 25-39

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Handle: RePEc:fip:fedaer:y:2002:i:q4:p:25-39:n:v.87no.4
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  1. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  2. Hellmann, Thomas & Puri, Manju, 2000. "The Interaction between Product Market and Financing Strategy: The Role of Venture Capital," Review of Financial Studies, Society for Financial Studies, vol. 13(4), pages 959-84.
  3. James M. Poterba, 1989. "Venture Capital and Capital Gains Taxation," NBER Chapters, in: Tax Policy and the Economy, Volume 3, pages 47-68 National Bureau of Economic Research, Inc.
  4. Devenow, Andrea & Welch, Ivo, 1996. "Rational herding in financial economics," European Economic Review, Elsevier, vol. 40(3-5), pages 603-615, April.
  5. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  6. Samuel Kortum & Josh Lerner, 2000. "Assessing the Contribution of Venture Capital to Innovation," RAND Journal of Economics, The RAND Corporation, vol. 31(4), pages 674-692, Winter.
  7. Josh Lerner, 1997. "An Empirical Exploration of a Technology Race," RAND Journal of Economics, The RAND Corporation, vol. 28(2), pages 228-247, Summer.
  8. Freear, John & Wetzel, William Jr., 1990. "Who bankrolls high-tech entrepreneurs?," Journal of Business Venturing, Elsevier, vol. 5(2), pages 77-89, March.
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