Who Becomes the Winner? Effects of Venture Capital on Firmsâ€™ Innovative Incentives - A Theoretical Investigation
It is well established in the empirical literature that venture capital (VC) plays an important role in the promotion of innovation at industry level and the professionalisation of firms at micro-level. Whilst the VC-to-success link has been well explored, the mechanism behind how and why certain venture-backed firms are apparently more successful is an important question that has been largely ignored within the majority of the literature. In this paper, we fill this gap by specifically analysing firms' pre- and post-VC investment decisions. By considering a two period, multi-stage game, we analyse whether VC spurs innovation (i) directly after being granted; (ii) indirectly by incentivising firms to increase initial research efforts to increase their chances of receiving VC funding and its associated benefits; or (iii) a combination of both. Our results show that VC has both direct and indirect effects on firms' innovation decisions regardless of whether the firm is successful in securing VC funding or not. Furthermore, we find that the commonly held assertion that venture capital spurs success is too simplistic: whilst venture capital spurs innovation amongst the lucky, chosen few, it unambiguously suppresses innovation of non-VC-backed firms, a result that has been overlooked in the empirical literature. The issue of `who becomes the winner' in the final product market however is ultimately dependent upon the extent of heterogeneity amongst firms. Further, we show that VC funding, equity stake and value-adding services all have impacts upon firms' incentives to invest in the first stage.
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