Influences of Information Technology on Supply Chain Performance
Financial economists argue that specialized financial intermediaries can address these problems. By intensively scrutinizing firms before providing capital and then monitoring them afterward, they can alleviate some of the information gaps and reduce capital constraints. The financial intermediary that specializes in funding young high-technology firms is the venture capital organization. Doriot, and local business leaders.
A small group of venture capitalists made high-risk investments in emerging companies that were formed to commercialize technology developed for World War II. Because institutional investors were reluctant to invest, ARD was structured as a publicly traded closed-end fund and marketed mostly to individuals Liles, The first venture capital limited partnership, Draper, Gaither, and Anderson, was formed in Imitators soon followed, but limited partnerships accounted for a minority of the venture pool during the s and s.
Most venture organizations raised money either through closed-end funds or SBICs, federally guaranteed risk capital pools that proliferated during the s.
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Although investor demand for SBICs in the late s and early s was strong, incentive problems ultimately led to the collapse of the sector. The annual flow of money into venture capital during its first three decades never exceeded a few hundred million dollars and usually was substantially less. The activity in the venture industry increased dramatically in the late s and early s. Industry observers attributed much of the shift to the U. Prior to that year, ERISA regulations limited pension funds from investing substantial amounts of money in venture capital or other high-risk asset classes.
Pension funds supplied just 15 percent. These annual commitments represent pledges of capital to venture funds raised in a given year. This money typically is invested over three to five years, starting in the year the fund is formed. The subsequent years saw both very good and trying times for venture capitalists.
On the one hand, venture capitalists had backed during the s and s many of the most successful high-technology companies, including Apple Computer, Cisco Systems, Genentech, Netscape, and Sun Microsystems. At the same time, commitments to the venture capital industry were very uneven. The annual flow of money into venture funds increased by a factor of 10 during the early s, peaking at just under 6 billion dollars. From through , however, fund-raising steadily declined.
This process of rapid growth and decline has created a great deal of instability in the industry.
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To address the information problems that preclude other investors in small high-technology firms, the partners at venture capital organizations employ a variety of mechanisms. First, business plans are intensively scrutinized: Of those firms that submit business plans to venture capital organizations, historically fewer than 1 percent have been funded Fenn et al. The decision to invest frequently is made conditional on the identification of a syndication partner who agrees that this is an attractive investment Lerner, In exchange for their capital, the venture capital investors demand preferred stock with numerous restrictive covenants and representation on the board of directors.
Once the decision to invest is made, the venture capitalists frequently disburse funds in stages. Managers of these venture-backed firms are forced to return repeatedly to their financiers for additional capital in order to ensure that the money is not squandered on unprofitable projects. In addition, venture capitalists intensively monitor managers, often contacting firms on a daily basis and holding monthly board meetings during which extensive reviews of every aspect of the firm are conducted.
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Various aspects of the oversight role played by ven-. Note that, even with these many mechanisms, the most likely primary outcome of a venture-backed investment is failure or, at best, modest success. Gompers documents that, out of a sample of venture capital investments made over three decades, only The next best alternative, a similar investment in an acquired firm, yields a cash return of only 40 cents over a 3.
About one in six investments was a complete loss, while 45 percent were either losses or simply broke even. The elimination of the top-performing 9 percent of the investments was sufficient to turn a 19 percent gross rate of return into a negative return. In short, the environment in which venture organizations operate is extremely difficult.
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These circumstances have led to venture capital organizations emerging as the dominant form of equity financing for privately held technology-intensive businesses. At the same time, there are reasons to believe that despite the presence of venture capital funds, there still might be a role for public venture capital programs. In this section, we assess these claims. We highlight two arguments: that public venture capital programs may play an important role by certifying firms to outside investors, and that these programs may encourage technological spillovers.
We then highlight two classes of problems that can affect these programs. A growing body of empirical research suggests that new firms, especially technology-intensive ones, may receive insufficient capital because of the infor-. As discussed earlier, venture capitalists specialize in financing these types of firms.
They address these information problems through a variety of mechanisms. Many of the studies that document capital-raising problems examine firms during the s and early s, when the venture capital pool was relatively modest in size. Since the pool of venture capital funds has grown dramatically in recent years Gompers and Lerner, , a , even if small high-technology firms had numerous value-creating projects that they could not finance in the past, one might argue that it is not clear that this problem remains today.
A response to this argument emphasizes the limitations of the venture capital industry. Venture capitalists back only a tiny fraction of the technology-oriented businesses begun each year. In , a record year for venture disbursements, companies received venture financing for the first time VentureOne, ; to put this in perspective, the Small Business Administration estimates that in recent years close to one million businesses have been started annually. Furthermore, these funds have been very concentrated: 49 percent of venture funding in went to companies based in either California or Massachusetts, and 82 percent went to firms specializing in information technology and the life sciences VentureOne, It is not clear, however, what lessons to draw from these funding patterns.
Concentrating investments in such a manner may well be an appropriate response to the nature of opportunities. Consider, for instance, the geographic concentration of awards. Recent models of economic growth—building on earlier works by economic geographers —have emphasized powerful reasons why successful high-technology firms may be very concentrated.
The literature highlights several factors that lead similar firms to cluster in particular regions, including knowledge spillovers, specialized labor markets, and the presence of critical intermediate goods producers.
A related argument for public investments is that the structure of venture investments may make them inappropriate for many young firms. Venture funds tend to make quite substantial investments, even in young firms; the mean venture investment in a start-up or early-stage business between and ex-. The literature on capital constraints reviewed by Hubbard  documents that an inability to obtain external financing limits many forms of business investment. Particularly relevant are works by Hall , Hao and Jaffe , and Himmelberg and Petersen The substantial size of these investments may be partially a consequence of the demands of institutional investors.
The typical venture organization raises a fund structured as a limited partnership every few years.
Furthermore, governance and regulatory considerations lead institutions to limit the share of any fund that any one limited partner holds. Consequently, venture organizations are unwilling to invest in very young firms that require only small capital infusions.
This problem may be increasing in severity with the growth of the venture industry, as discussed earlier. As the number of dollars per venture fund and dollars per venture partner has grown, so too has the size of venture investments.
Again, it is not clear what lessons to draw from these financing patterns. Venture capitalists may have eschewed small investments because they were simply not profitable, because of either the high costs associated with these transactions or the poor prospects of the thinly capitalized firms. Support for these claims is found in recent work on the long-run performance of initial public offerings IPOs. Brav and Gompers show that IPOs that had previously received equity financing from venture capitalists outperform other offerings. These findings underscore concerns about policies that seek to encourage public investments in companies that are rejected by professional investors.
Furthermore, it appears that there were in a number of financial innovations to address the needs of early-stage entrepreneurs. The structure of venture partnerships is discussed at length by Gompers and Lerner , a. There are two primary reasons that venture funds do not simply hire more partners if they raise additional capital. First, the supply of venture capitalists is quite inelastic. The effective oversight of young companies requires highly specialized skills that can only be developed with years of experience.