This paper examines an economic theory of when employees become entrepreneurs. It jointly addresses the two fundamental questions of when employees generate innovations, and whether these innovations ...are developed as internal ventures or outside the firm. The model shows that if generating innovations distracts employees from their assigned tasks, firms may discourage innovation. Firms may reject profitable opportunities that fall outside of their core activities. If employees own the intellectual property (IP), they may leave to do a start-up. The allocation of IP rights also affects the generation of innovation. The external entrepreneurial environment is a complement to firm-internal innovation. If the external environment is particularly good, firms may embrace employee innovation and take advantage of it through spin-offs.
This theory paper examines an ex post rationale for the patenting of scientific discoveries. Scientists do not know which firms can make use of their discoveries, and firms do not know which ...scientific discoveries might be useful to them. To bridge this gap, either or both sides need to engage in costly search activities. Patents increase (decrease) dissemination when the search intensity of firms is sufficiently inelastic (elastic), relative to that of scientists. Patents also facilitate the delegation of search activities to the universities’ technology transfer offices, which enables efficient specialization. Patenting may be thus become a complement to doing research.
This paper provides a new explanation for the use of convertible securities in venture capital. A key property of convertible preferred equity is that it allocates different cash flow rights, ...depending on whether exit occurs by acquisition or IPO. The paper builds a model with double moral hazard, where both the entrepreneur and the venture capitalist provide value-adding effort. The optimal contract gives the venture capitalist more cash flow rights in acquisitions than IPOs. This explains the use of convertible preferred equity, including automatic conversion at IPO. Contingent control rights are also important for achieving efficient exit decisions.
This article examines enterprises funded by government-sponsored venture capitalists (GVCs). We find that enterprises funded by both GVCs and private venture capitalists (PVCs) obtain more investment ...than enterprises funded purely by PVCs, and much more than those funded purely by GVCs. Also, markets with more GVC funding have more VC funding per enterprise and more VC-funded enterprises, suggesting that GVC finance largely augments rather than displaces PVC finance. There is also a positive association between mixed GVC/PVC funding and successful exits, as measured by initial public offerings (IPOs) and acquisitions, attributable largely to the additional investment.
This paper examines the impact venture capital can have on the development of new firms. Using a hand-collected data set on Silicon Valley start-ups, we find that venture capital is related to a ...variety of professionalization measures, such as human resource policies, the adoption of stock option plans, and the hiring of a marketing VP. Venture-capital-backed companies are also more likely and faster to replace the founder with an outside CEO, both in situations that appear adversarial and those mutually agreed to. The evidence suggests that venture capitalists play roles over and beyond those of traditional financial intermediaries.
In a dynamic model of moral hazard, competition can undermine prudent bank behavior. While capital-requirement regulation can induce prudent behavior, the policy yields Pareto-inefficient outcomes. ...Capital requirements reduce gambling incentives by putting bank equity at risk. However, they also have a perverse effect of harming banks' franchise values, thus encouraging gambling. Pareto-efficient outcomes can be achieved by adding deposit-rate controls as a regulatory instrument, since they facilitate prudent investment by increasing franchise values. Even if deposit-rate ceilings are not binding on the equilibrium path, they may be useful in deterring gambling off the equilibrium path.
This paper models the generation, circulation, and completion of new ideas, showing how markets and innovative firms complement each other in a symbiotic relationship. Novel ideas are initially ...incomplete and require further insight before yielding a valuable innovation. Finding the complementary piece requires ideas to circulate, which creates appropriation risks. Circulation of ideas in markets ensures efficient completion, but because ideas can be appropriated, market entrepreneurs underinvest in idea generation. Firms can establish boundaries that guarantee safe circulation of internal ideas, but because firms need to limit idea circulation, they may fail to achieve completion. Spin-offs allow firms to benefit from the market's strength at idea completion, whereas markets benefit from firms' strength at generating new ideas. The model predicts diverse organizational forms (internal ventures, spin-offs, and start-ups) coexisting and mutually reinforcing each other. The analysis provides new insights into the structure of innovation-driven clusters such as Silicon Valley.
This paper was accepted by Bruno Cassiman, business strategy.
Venture capitalists often hold extensive control rights over entrepreneurial companies, including the right to fire entrepreneurs. This article examines why, and under what circumstances, ...entrepreneurs would voluntarily relinquish control. Control rights protect the venture capitalists from hold-up by the entrepreneurs. This provides the correct incentives for the venture capitalists to search for a superior management team. Wealth-constrained entrepreneurs may give up control even if the change in management imposes a greater loss of private benefit to them than a monetary gain to the company. The model also explains why entrepreneurs accept vesting of their stock and low severance.
This paper develops a theory of how angel and venture capital markets interact. Entrepreneurs first receive angel then venture capital funding. The two investor types are ‘friends’ in that they rely ...upon each other׳s investments. However, they are also ‘foes,’ because at the later stage the venture capitalists no longer need the angels. Using a costly search model we derive the equilibrium deal flows across the two markets, endogenously deriving market sizes, competitive structures, valuation levels, and exit rates. We also examine the role of legal protection for angel investments.
(1) Background: Cross-border venture capital (VC) investments play an important role in the scaling up of high-growth companies. However, policymakers worry that foreign VC investments transfer the ...majority of economic activity to the investor country. On the one hand, start-ups welcome the foreign capital, expertise, and networks that accompany cross-border investments. On the other hand, policymakers are concerned that cross-border investments predominantly benefit foreign economies and fail to develop the local entrepreneurial ecosystem. This paper describes a framework for how policymakers can develop a set of policies toward cross-border VC investments. (2) Methods: The paper examines available data and trends about the role of cross-border investing, focusing on Europe, Israel, and Canada. Then, the paper explains the underlying economic challenges and develops a policy framework. (3) Results: The analysis shows that in addition to policies that aim to attract foreign investors, there are also important policies for the development of the domestic VC market. The analysis encompasses policies that are both financial and non-financial in nature. (4) Conclusions: A core insight for policymakers is to retain a balance of initiatives, attracting foreign investors while simultaneously making sure to strengthen the country's domestic VC industry and innovation ecosystem. The mix of policies will adjust as the domestic ecosystem matures.
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