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9
Venture Capital

MARTIN KENNEY

University of California, Davis

MARTIN HAEMMIG

UniBW Munich, Germany and Leiden University, Netherlands

W. RICHARD GOE

Kansas State University

INTRODUCTION

In 1946, the first venture capital (VC) firms were established in the United States with the objective of providing financial backing and business assistance to entrepreneurs in exchange for repayment in capital gains. These pioneering VC firms soon discovered that technology-based innovations most consistently yielded the greatest returns. Today, the ideal/typical VC firm is the U.S.-style limited partnership that is embedded in a local entrepreneurial ecosystem and invests in technology-related deals. The pioneering VC firms were also motivated to diffuse venture capitalism nationally and internationally. In retrospect, it would appear that they were successful. In the past two decades venture capitalism has spread globally. There are now domestically owned VC firms operating in at least 40 nations. Also, there is an increasing number of VC firms that have established offices or begun investing in multiple nations, or both (i.e., VC firms operating across national borders). The international diffusion of VC investing suggests that there are entrepreneurial ventures that merit funding in many nations.

In 2006, there can be little doubt that VC financing of entrepreneurial high-technology ventures plays a significant role in the U.S. national innovation system. Venture capitalists have backed nearly all of the significant U.S. information technology (IT) firms established during the past four decades. These include 3Com, AMD, Apple, Applied Materials, Cadence, Cisco, Google, Intel, Oracle, Netscape, Seagate, Silicon Graphics, Solectron, Sun Microsystems, Yahoo!, and many others. In biotechnology, the VC-financed firms include Amgen, Biogen, Cetus, Centocor, Chiron, Genentech, and many others. In the nontechnology fields, important VC-funded firms include Federal Express, jetBlue, eBay, Home



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9 Venture Capital MARTIN KENNEY University of California, Davis MARTIN HAEMMIG UniBW Munich, Germany and Leiden University, Netherlands W. RICHARD GOE Kansas State University INTRODUCTION In 1946, the first venture capital (VC) firms were established in the United States with the objective of providing financial backing and business assistance to entrepreneurs in exchange for repayment in capital gains. These pioneering VC firms soon discovered that technology-based innovations most consistently yielded the greatest returns. Today, the ideal/typical VC firm is the U.S.-style limited partnership that is embedded in a local entrepreneurial ecosystem and invests in technology-related deals. The pioneering VC firms were also motivated to diffuse venture capitalism nationally and internationally. In retrospect, it would appear that they were successful. In the past two decades venture capitalism has spread globally. There are now domestically owned VC firms operating in at least 40 nations. Also, there is an increasing number of VC firms that have established offices or begun investing in multiple nations, or both (i.e., VC firms operating across national borders). The international diffusion of VC investing suggests that there are entrepreneurial ventures that merit funding in many nations. In 2006, there can be little doubt that VC financing of entrepreneurial high- technology ventures plays a significant role in the U.S. national innovation sys- tem. Venture capitalists have backed nearly all of the significant U.S. information technology (IT) firms established during the past four decades. These include 3Com, AMD, Apple, Applied Materials, Cadence, Cisco, Google, Intel, Oracle, Netscape, Seagate, Silicon Graphics, Solectron, Sun Microsystems, Yahoo!, and many others. In biotechnology, the VC-financed firms include Amgen, Biogen, Cetus, Centocor, Chiron, Genentech, and many others. In the nontechnology fields, important VC-funded firms include Federal Express, jetBlue, eBay, Home 

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 INNOVATION IN GLOBAL INDUSTRIES Depot, and Office Depot. A number of these firms have changed the way hu- man beings work and interact or, to borrow a phrase from Steven Jobs, “they have changed the world.” Recently, new VC-financed firms, such as Facetime, MySpace, and YouTube, are driving yet further change. If one agrees that the VC-financed firms are critical to the U.S. position in the global technology economy, then the globalization of the VC industry is an important topic. The VC industry is not significant in terms of either direct employment or the total capital under management. Rather its significance lies in the role of venture capitalists in finding, funding, and assisting entrepreneurs whose firms will be instruments of Schumpeter’s (1939) “creative destruction” or successful in creating “new economic spaces.” Previous studies have attempted to measure the employment contribution of firms funded by VC and found it to be extensive (see, e.g., Global Insight, 2004). Our examination of the globalization of the VC industry proceeds as follows. The first section introduces VC as an organizational form. The second section examines the academic research on international VC investing. The following section describes the history of international VC investing, which began in the 1960s and has since grown enormously. The fourth section examines the reasons for the globalization of the VC industry and is followed by a quantitative section describing the international flows of VC. In the sixth section the growth of the VC investment in China is discussed. The concluding section discusses the implica- tions of the findings for our understanding of the globalization of VC. We find that there is little evidence at this time to indicate that the globalization of VC is having a negative effect on the U.S. innovation system. The existing evidence does suggest that U.S. VC firms are finding viable investments in other nations and foreign VC firms continue to find viable investments in the United States. vENTURE CAPITAL AS AN ORGANIZATIONAL FORM Professional VC firms are the subject of this chapter and, as far as is prac- ticable, buyout (BO) and angel investors are omitted from our analysis. Private equity (PE) firms are organizations that invest in firms with the aim of later sell- ing this equity at a higher price to capture the capital gains. VC is a subset of PE firms. We do not include BO firms because they acquire existing firms and thus are involved not in supporting emerging firms but rather in acquiring and reorga- nizing existing firms. Angel investing refers to equity investment in young firms by individuals or groups of individuals using their own funds and is a practice that is hundreds of years old. The difference between angels and venture capitalists is that the venture capitalists are professionals operating an organization that has raised institutional money. This chapter treats private VC as the ideal type and does not examine corpo- rate VC. The reasons for omitting corporate VC are threefold: First, as a whole, corporate VC is much less important than private VC. Second, many corporate

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 VENTURE CAPITAL VC operations have very different organizational structures, degrees of indepen- dence, compensation, and reporting relationships to the parent corporation than do the private VC firms. Finally, most corporate venture capitalists do not perform the lead-investor role, preferring instead to invest after, or in conjunction with, the private VC firms. The narrow definitions of VC are slippery in the real world. For example, “venture capital” investing in Japan and Korea traditionally has been in the form of loans (Clark, 1987; Kenney et al., 2004; Kuemmerle, 2001). The data collected on “venture” investment often commingles VC and BO—and even angel invest- ments if they are sufficiently large.1 In Europe, the acronym EVCA stands for the European Private Equity and Venture Capital Association, and BO continues to be the dominant investment pattern in Europe (Gompers and Lerner, 2001), al- though the relative shares may be changing. Despite the disparate definitions, the term “venture capital” in this chapter refers to equity investors in young firms. The VC firm is a small financial services professional organization (usually employing a total of less than 30 persons) that functions primarily to (1) assess business opportunities; (2) provide capital; and (3) actively engage, monitor, advise, and assist the firms in its portfolio (i.e., those firms in which VC has been invested). By investing, the venture capitalist accepts a substantial tranche of illiquid equity that converts its status to something like a “partner” to the en- trepreneur. The goal of the venture capitalist is not only to increase the value of that equity, but to eventually monetize the investment through a liquidity event such as an initial public stock offering or sale to another investor so it can reap the results of its investment. The final way of “reaping the reward” is firm failure and bankruptcy. In all of these scenarios, the venture capitalist “exits” the invest- ment (i.e., ends its ownership role in the firm). This is necessary to complete the process because the VC firm’s investors must be paid by liquidating the holdings. In environments in which exit is impossible, venture capitalists cannot invest. The economics of VC are characterized by high risk and high returns. Invest- ing in young firms is risky—many fail and become total losses. The compensation for the failures comes from investments that yield 10, 20, or even 100 times the initial capital invested by the venture capitalists. This asymmetric return profile means that venture capitalists only invest in firms offering the opportunity for ex- tremely large returns. To be clear, venture capitalists are industry-sector agnostic, but as a generalization, during the past five decades, the sectors that most often generate such opportunities are the information and communication technolo- gies. The biomedical fields are the only other ones with a long history of good returns. Of course, many other investment fields, such as energy in the 1970s, superconductivity, and now, possibly, nanotechnology, have come and gone with minimal returns. Operationally, venture capitalists invest only after rigorous reference check- 1All statistics used in this chapter are for VC only unless otherwise noted.

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 INNOVATION IN GLOBAL INDUSTRIES ing (due diligence) and, in return for capital, the venture capitalist receives equity and a seat on the board of directors from which to actively monitor and assist the firm’s growth. After investment, the ideal-typical VC firm provides assistance ranging from practical needs such as providing advice on issues that a fledgling firm might encounter, introducing contacts, and assisting in securing necessary executive talent, to more abstract needs such as providing “legitimacy” (Al- drich and Fiol, 1994) to help overcome “liabilities of newness” (Stinchecombe, 1965). PREvIOUS RESEARCH ON vENTURE CAPITAL GLOBALIZATION In many respects, the globalization of VC firms is puzzling. The academic literature suggests that VC investing is strongly localized (Sorenson and Stuart, 2001), although Florida and Kenney (1988) found that venture capitalists in finan- cial centers such as New York and Chicago exported capital to technology centers such as Silicon Valley, where the entrepreneurs and deals were clustered. More recently, Kogut et al. (2007) showed that even the early U.S. VC firms co-invested with distant firms. Also, by the mid-1980s, many East Coast VC firms established branch offices in other regions, particularly in Silicon Valley (Kenney and Florida, 2000). Perhaps this indicates that the emergence of the global VC firm should have been expected given the increasing globalization affecting nearly every industry, particularly those industries funded by venture capitalists. The international dimensions of VC are receiving increased attention from scholars (Gompers and Lerner, 2001).2 In the 1980s and 1990s, studies exam- ined the establishment of VC firms in other countries (Clark, 1987; Green, 1991; Kuemmerle, 2001; Manigart, 1994). There also have been a number of cross- country comparative studies, both at the institutional level (Kenney et al., 2004; Manigart et al., 1996) and in comparisons of practice (Pruthi et al., 2003). The literature offers three explanations for the uncanny success of VC as an institution in the United States and its relative slow diffusion to most other na- tions. The first explanation is inspired by the work by La Porta et al. (1998), which suggests that English common law-based nations have had the most successful VC industries. This success is ascribed to the proposition that non-common law legal regimes offer less protection to the owners of capital (Bottazzi et al., 2005; Hege et al., 2004; Lerner and Schoar, 2005). The legal/governance explanations may explain part of the cross-national variation, but these studies do not control for technological capability or entrepreneurial environment, which the extant lit- erature suggests is important for understanding the subnational regional success in VC investing. The second explanation is a variant on the governance explanation that fo- cuses on the nexus between ownership and control. Here, the existence of a local 2 See Zalan (2004) and Wright et al. (2005) for comprehensive reviews of the academic literature on VC globalization.

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 VENTURE CAPITAL stock market as the main source of capital for growing firms is singled out as a critical variable for vibrant VC industry growth. For example, Black and Gilson (1998) argue that economies with stock market-based financial systems have stronger VC industries than economies with bank-based systems, presumably because new firms can raise capital in these markets. In a cross-national compari- son, Jeng and Wells (2000) found that the numbers of inital public stock offerings (IPOs) in the domestic market were the strongest driver of VC investing. Since IPOs are highly visible markers of wealth creation, one would expect that they would have a demonstration effect. However, Stuart and Sorenson’s (2003) research suggests that in the United States this effect is very local. The stock market-based explanation has a powerful appeal because it resonates with the obvious need for there to be exits for the reproduction of VC. This conclu- sion is drawn from the success of VC firms in the United States and the United Kingdom (unfortunately, the European data used for empirical studies during this period came from the EVCA and do not distinguish between BO and VC). More recently, this perspective has been brought into question because IPOs on foreign markets have been the exit strategy of choice for Israeli and Chinese firms (Rock, 2001; Zero2IPO.com, 2005). These corporate governance/financial system arguments have been ques- tioned. For example, a study by Kaplan et al. (2003) of funding agreements from 23 nations (not including the United States) found that U.S.-style contracts could be written in a wide range of legal regimes and were used by more experienced venture capitalists. The implication is that legal systems might not be as signifi- cant an obstacle as some believe. In a study to be discussed further later in the section, Guler and Guillen (2005, p. 31) found that legal effects vanished after controlling for national strength in science and technology. Using national-level variables, Allen and Song (2005) confirmed the dubiousness of the “rule-of-law” position. They found that law and order were negatively related to VC investing. These studies suggest that governance and financial system explanations for the success of VC may be overemphasized. Given that venture capitalists have experi- enced some recent success investing in China, it may be that an English common law-based legal system may not be required. There is other evidence to confirm that the traditional arguments about legal environments may not be as important as previously thought. Through an analy- sis of contracts written by U.S. venture capitalists in foreign markets, Kaplan et al. (2003) conclude that in nearly any environment it should be possible for VC firms to write contracts or develop various mechanisms to ameliorate legal, regulatory, fiscal, and structural obstacles to investment and exit, although the contracts may initially appear cumbersome.3 We would extend this to suggest that if successful exits (through either acquisition or a public offering) occur 3 Lerner and Schoar (2005), studying private equity, come to different conclusions. However, this may be due to the difference in operation of PE and VC firms.

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 INNOVATION IN GLOBAL INDUSTRIES in these environments, then the contracts and other organizational features can coalesce into understood routines and be taken for granted. After routinization, the contracts would appear to the participants as unproblematic (e.g., offshore investment vehicles in China). The finance literature research on the global diffusion of venture capitalism is remarkable because it ignores the fact that the predominant deal flow for ven- ture capitalists has come from the information and communication technology (IT) field and the biomedical field. For example, in the United States from 2002 to 2005, investments in IT as a share of total VC investments ranged between 58 and 60 percent. Between 18 and 23 percent of total investments were in the life sciences, while the remainder were scattered across other industries. In Europe between 51 and 57 percent of the total investment was in IT, while the life sciences received a further 21 to 28 percent. In Israel, IT has been far more dominant, receiving 70-76 percent of total VC investments. In contrast, the life sciences received 16-19 percent (original data from VentureOne, Ernst & Young, and Martin Haemmig, 2006). These data indicate that, in each major Western VC market, more than 80 percent of all VC investments have been in the IT and biomedical fields. In the hotbeds of investment activity (e.g., Silicon Valley, Boston, Israel, Stockholm, Cambridge [England], Austin), the percentages of VC invested in these technology areas are likely to be even greater. This strongly sug- gests that VC investments in any nation cannot be explained without considering the nation’s technological base in general, and its IT and biomedical innovatory capabilities in particular. Few studies of VC globalization have controlled for the VC recipient nation’s technological base. Using a sample of Organisation for Economic Co-operation and Development (OECD) nations, Astrid Romain and Bruno van Pottlesber- ghe (2004) found that measures of technological strength such as patenting and research and development (R&D) investment were significant predictors of an increase in VC investment in that nation. In examining the overseas invest- ments by U.S. venture capitalists, Guler and Guillen (2005, p. 30) found that a one-standard-deviation increase in a nation’s U.S. patents led to a 77.5 percent increase in the number of ventures receiving investment from U.S. VC firms. Further, a one-standard-deviation increase in scientific publications led to a 113.4 percent increase in the number of ventures receiving investment from U.S. VC firms. No other measures, including stock market capitalization, political con- straints, or number of students studying in the United States, were as important. Although Guler and Guillen (2005) do not address the success of domestic VC firms, their study does provide evidence that suggests support for Romain and van Pottlesberghe’s (2004) conclusion that technological capabilities are necessary to attract VC investment. As Avnimelech et al. (2005) argue, the VC industry in the United States and other nations has co-evolved with the technol- ogy industries that venture capitalists fund. In short, scientific and technological advance are the fuel for creating firms capable of generating the returns necessary

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 VENTURE CAPITAL to support a VC industry. This would suggest that models purporting to explain national experience in attracting VC investment (from either national or exter- nal sources) that do not control for technological capability are fundamentally misspecified.4 With a few exceptions, previous studies have examined national VC indus- tries and thus measure the diffusion of VC as a social function. The phenomenon of interest in this chapter is the globalization of VC (i.e., VC firms operating across national boundaries). In a recent study of global VC investment patterns, Megginson (2004, p. 25) found that there was some evidence of “significant [international] convergence in funding levels, investment patterns, and real- ized return.” And yet, he concluded that, because national capital markets have remained relatively segregated and legal systems remain different, “it appears that no truly integrated global VC market will likely emerge in the foreseeable future.” There is evidence to qualify this conclusion. Today, an increasing number of venture capitalists are investing successfully across borders. One important method of investing internationally is syndication. Recently, there have been a number of academic studies on the international syndication of VC investments. For example, Mäkelä and Maula (2006) found that the presence of foreign venture capitalists and top managers with foreign experience increases the probability that a portfolio firm will list on foreign markets. Pagano et al. (2002) found that R&D-intensive firms were more likely to undertake a foreign IPO, and this was supported by Hursti and Maula (2007). The apparent growing tendency for international syndication is creating a global network of VC firms. This has occurred in conjunction with the increasing num- ber of foreign listings on stock exchanges such as the NASDAQ and the London AIM. With these changes, the grounds for Megginson’s (2004) conclusion may be weakening. THE HISTORy OF vC GLOBALIZATION During the past half-century, venture capitalism has diffused internationally in the sense that numerous nations have indigenous VC industries and increasing numbers of venture capitalists are investing across national borders. Although this chapter is most concerned with cross-national VC investing, the presence of local venture capitalists is often important because they are usually more tightly linked to local entrepreneurs and can function as intermediaries for larger foreign VC firms. Additionally, when foreign VC firms decide to enter a new market, 4 Perversely, the omission of technology variables in academic research is mirrored in “VC” invest- ing in certain nations. For example, in a survey of British venture capitalists, Murray and Lott (1995) found that “technology projects had to meet more rigorous selection criteria than non-technology projects” and “investors imposed higher investment return ‘hurdle rates’ at each stage of investment other than seed capital.” Though it is difficult to establish the direction of causality, this resonates with the perception that the U.K. VC industry is, in large measure, a PE industry.

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20 INNOVATION IN GLOBAL INDUSTRIES they will often form a partnership or even acquire a local VC firm. This suggests that the growth of local venture capitalists and the entry of foreign venture capi- talists into a market are intimately related. A rough way of tracking the diffusion of indigenous VC activity is through counting the number of national VC organizations. In 1973, the National Ven- ture Capital Association was established in the United States as the first national VC organization. Since then, at least, VC associations in 36 other nations have been formed. In addition to the United States, other early VC associations were established in Canada. These were followed by the establishment of a number of different national associations in Europe (largely contemporaneously) in the early 1980s. VC associations gradually spread to southern Europe and then later to eastern Europe. Because of the small size of the local VC industry in many of these nations, they had very few members. Over time, venture capitalists in Asia formed associations. The most recent major nation to form an association is China. Brazil has the only VC association in Latin America while South Africa has the only one in Africa. More recently, regional VC/PE organizations have been formed. For ex- ample, the EVCA was formed in 1983 and is the best organized of the regional VC associations. In 2001 the Asia Pacific Venture Capital Alliance was formed by the national organizations of Hong Kong, Korea, Malaysia, Singapore, and Taiwan. This was followed in 2002 by the formation of an organization called the Emerging Market Private Equity Association. This suggests that supranational structures are emerging, possibly leading to a global umbrella organization in the future. The fact that a nation has an association does not prove, in and of itself, that it contains a vibrant VC industry. The existence of an association does provide a certain visibility, and the association can lobby the government to improve the environment for both VC and entrepreneurship. In the United States, Israel, and Taiwan, the national associations have had policy impacts. The EVCA has played an important role in lobbying the European Union (EU). At a minimum, the existence of national and regional VC associations demonstrates the broad diffusion of VC investing. Cross-national VC investing has evolved gradually. The first important pe- riod was in the 1970s when a number of European financial institutions estab- lished U.S. subsidiaries or invested in U.S. VC firms. Corresponding roughly to the 1980s, a second period occurred when U.S. East Coast VC firms opened offices in Europe (especially in London) in search of European investments. In the mid-1980s, several U.S. West Coast VC firms were formed to invest in Taiwan and other parts of Sinophone Asia. Contemporaneously, a few Japanese VC firms began investing abroad. At the end of the decade, Taiwanese VC firms began investing in the United States. In addition, there was also an effort to es- tablish VC firms in various developing nations during the 1980s. A third period

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2 VENTURE CAPITAL of international VC development occurred in the 1990s and is discussed in the next section on current cross-national linkages. Pioneering venture capitalists were convinced of the importance of VC and the benefits it could provide to society. Early VC firms tended to invest locally (Hsu and Kenney, 2005). However, Kogut et al. (2006) showed that cross-regional co-investment occurred very early in the development of the U.S. VC industry. The initial efforts to globalize the VC model were missionary-like initiatives by the U.S. pioneers. The first effort was in 1960 when the Rockefeller VC operation opened an office in Brussels. Unfortunately, it had few successes and soon was abandoned (Wilson, 1985, p. 220). In 1962, American Research and Development (ARD) helped organize the Canadian Enterprise Development Corporation and European Enterprise Development Corporation. None of these initial efforts were sustainable and they were eventually discontinued. Several U.S. technology startups that were backed by U.S. VC firms began to provide large capital gains in the late 1960s. For example, ARD’s $70,000 investment in DEC in 1957 appreciated to more than $350 million in 1969. This provided incentives for both foreign and domestic investors to invest in VC funds. Because of the informal nature of the VC industry during this early period, little is known about its global interconnections. In the early 1970s, pioneering VC firms were established in the United Kingdom and then in the Netherlands and France (Manigart, 1994, p. 535). These marked the acceptance of the VC concept in Europe. Despite these new firms in Europe, there were only a few new entrants per year and very few investment opportunities. The first sustained global operations were by European financial institutions that either invested in U.S. partnerships or established VC investment operations in the United States. For example, in 1970, New Court Securities, which was an arm of the European Rothschild family, opened in New York City. Also, both the large French bank Indo-Suez and Guardian Ventures Limited of Canada es- tablished U.S. VC branches. Contemporaneously, Genstar Corporation of Canada became the sole investor in Sutter Hill Ventures in the San Francisco Bay Area. These pioneers invested in the United States, not in their home nation. Peter Brooke, the founder of TA Associates and one of the leading U.S. VCs, played a pivotal role in early international diffusion efforts. In 1971, he was ap- pointed as a founding director of Sofinnova, which was capitalized by various French banks with the mandate to invest in both France and the United States (Advent International Corporation, 1986). In 1974, Sofinnova opened an office in San Francisco and made a number of successful investments in the nascent field of biotechnology. In 1975, the Dutch investment company Orange Nassau started a U.S. fund managed by TA Associates. In the 1970s, some U.S. VCs believed Europe would provide significant investment opportunities. For example, in 1971, U.S. venture capitalist Philip Greer (1971) opined that Europe was attractive because the lack of competition meant that firm valuations were lower. He recognized that exits would be diffi-

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22 INNOVATION IN GLOBAL INDUSTRIES cult because the only stock market having the requisite liquidity was the London Stock Exchange. For this reason the prime exit strategy would be selling portfolio firms to U.S. corporations. Greer also identified a shortage of entrepreneurs in Europe. He stated, “The entrepreneur concept is typically American and such activi- ties have been discouraged in Europe.” These obstacles were compounded by a paucity of well-rounded managers, longer investment periods, a shortage of second- and third-stage financial sources, a European financial community that did not welcome outsiders, and higher costs of operation. Although Greer was optimistic about Europe, the reasons he identified were exactly those that stymied the development of the European VC industry up until the 1990s (PE investing was more successful). After a severe downturn in the mid-1970s, the U.S. industry reawakened and a few more U.S. VC firms entered Europe. In 1980, Peter Brooke established an international VC firm, Advent International, with a London office. From there, it soon expanded to Belgium in 1982 and Singapore and Malaysia (SEAVIC) in 1983. In addition to these offices, TA/Advent established linkages with Four Seasons Venture Capital in Sweden in 1982, TVM Techno Venture Management in 1983 in Munich, Germany, Advent Techno-Venture in 1984 in Tokyo, Alpha Associes in 1985 in Paris, and Horizonte Ventures in 1985 in Austria. The Advent network was the first VC firm with a global presence. Another pioneer was Apax, which was the result of a merger of a boutique international investment banking firm established in 1972 by Ronald Cohen in the United Kingdom, Maurice Tchénio in Paris, and Alan Patricof in the United States. In 1981, Cohen raised their first U.K. £10 million fund with the assistance of Patricof, who also invested in the fund. In 1983, Tchénio raised a fund in France in which Patricof also invested. From this union, Apax grew to be one of the leading international VC/PE firms, with offices in New York, Menlo Park, London, Paris, Milan, Munich, Madrid, Tel Aviv, Stockholm, and Zurich. As U.S. firms entered Europe, European firms continued to enter the U.S. market. For example, in 1981, the British firm 3i opened an office in the United States, although it withdrew in the early 1990s (Coopey and Clark, 1995, p. 179). Atlas Venture, a division of the Dutch ING Bank, opened an office in Boston in 1986. In 1982, Vincent Worms and Thomas McKinley at Partech International launched a Global Venture Fund for Banque Paribas in San Francisco and later in Paris. Yet another firm, Alta Berkeley, was formed in 1982 in London in coop- eration with the U.S. firm Burr, Egan, and Deleage. Thus a cadre of transatlantic VCs came into being. Despite the growth in VC operations, there was a continuing lack of high- quality deals in Europe (Murray and Lott, 1995). As the Chairman of Apax Partners, Ronald Cohen, put it: “Toward the middle of the decade (1980s) there was a general shift away from business risk. This was partly the result of burnt

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2 VENTURE CAPITAL TABLE 1 Net Returns in European and U.S. Venture Capital and Buyout Investments by Stages as of December 31, 2005a 1 yr 1 yr 3 yr 3 yr 5 yr 5 yr 10 yr 10 yr EU USA EU USA EU USA EU USA Balanced 32.7 24.3 2.8 11.7 –2.7 –3.5 7.6 18.9 All VC 25.4 15.6 0.6 7.5 –4.0 –6.8 5.3 23.7 Buyouts 20.9 31.3 7.9 16.3 5.0 5.2 12.6 9.2 aNet internal rates of returns to investors in EU funds formed during the period 1986-2005 and U.S. funds formed during the period 1986-2005. These rates were calculated from Thomson Financial, the National Venture Capital Association, and European Venture Capital Association data. fingers from start-up investments in the early 1980s, but also because of a move towards the quicker returns to be made from backing MBOs and exiting in a rising market” (quoted in Coopey and Clarke, 1995, p. 171). The theme of low returns for VC investing in Europe has been a constant refrain (see, e.g., Murray and Marriott, 1998) and is substantiated in Table 1, which compares returns from different investment stages in Europe and the United States. These data demon- strate that the long-run returns for early-stage investing in Europe have been far lower than in the United States. Even for the balanced funds category, U.S. funds outperformed European funds. It has only been since the stock market bubble’s collapse in 2000 that European VC funds have performed roughly as well as U.S. funds. The disappointing European VC returns contrast with the superior performance of European PE funds. A full explanation for the low returns to VC investing in Europe is outside the scope of this paper. However, it is possible to list some of the salient ele- ments of such an explanation. Important elements include the relative weakness of European universities, corporations, and nations in the information technolo- gies, with the possible exception of a few large corporate laboratories and a few universities. A similar but not quite as powerful advantage would be true in the biomedical sciences. Also, the enormous and very discerning U.S. IT market was a significant advantage. This meant Europe had fewer entrepreneurs, smaller con- centrations of entrepreneurs, and slower growth in its entrepreneurial firms. As a result, a path-dependent logic was set in motion, building upon significant first- mover advantage in the United States, particularly in Silicon Valley and Boston. These factors may partially explain why the United States developed both VC and BO investing, whereas European investors emphasized BO investing. Asia Japanese corporate venturers and large Japanese VC firms, nearly all of which were subsidiaries of large Japanese financial institutions, began globalizing slightly later in time than the initial European VC firms. In 1983 the largest Japa-

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0 INNOVATION IN GLOBAL INDUSTRIES TABLE 3 Interregional Flows of Venture Capital Investment (in millions of U.S. dollars) by Location of Firm and Location of Investment, 2005 2005 Location of Investments by VC Firms Location of VC Firm North America Europe Israel Asia Rest of World Total (origin of investor) ($M) ($M) ($M) ($M) ($M) ($M) North America 21,914 1,837 158 798 218 24,925 Europe 840 3,486 35 163 59 4,583 Israel 139 30 208 0 0 377 Asia 502 118 4 502 3 1,129 RoW 52 42 7 59 231 391 TOTAL ($M) 23,447 5,513 412 1,522 511 31,405 SOURCE: Compiled by Martin Haemmig, www.martinhaemmig.com, from data provided by Na- tional Venture Capital Association/Venture Economics, European Venture Capital Association, Asian Venture Capital Journal, and Israeli Venture Capital Association. THE CHINA SyNDROME In the past 5 years China has become a fertile environment for VC invest- ing, despite the fact that it does not have an adequate legal or financial system. What China does have is a booming economy with large numbers of increasingly wealthy consumers and trained engineers. Also, it is experiencing rapidly increas- ing R&D expenditures in both industry and government (Jefferson and Gian, 2007). This vortex of opportunity has attracted business persons of all types and venture capitalists are no exception. Foreign venture capitalists have flocked to invest in China in both technological and nontechnological fields. Because of the topic of this chapter, this section is confined to VC investing in China and does not examine the state of Chinese high technology, except in relationship to the firms that have funded by VC. With about $1.9 billion invested in 2006, China ranked second after the U.S. in total VC investment (Ernst & Young 2007). In 2007, venture capitalists raised $5.8 billion in funds dedicated to investment in China, which was nearly 50 percent more than in 2006 (Zero-2-IPO, 2008).9 This increase was, in large measure, motivated by the successful earlier exits by VC-backed Chinese firms on international stock markets. The data in Table 4 indicate that the most active VC firms are foreign, particularly those from the United States. Firms from other nations, such as Softbank from Japan, also are present. However, from 2005 to 2006 more domestic Chinese VC firms were entering the Top Twenty. Whether this is a trend or anomaly is not certain, but is an interesting phenomenon to watch. There are currently four avenues for venture capitalists to exit their invest- ments in Chinese firms. The first avenue is acquisition by foreign multinationals. 9 Some or possibly a large portion of these funds may be used in PE transactions.

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 VENTURE CAPITAL TABLE 4 Top Venture Capital Firms in China by US$ Invested, 2005 and 2006 Rank Firm Rank 2006 Nationality Firm Rank 2005 Nationality 1 IDG Technology Venture U.S. IDG Technology Ventures U.S. Investment 2 SAIF Partners (Softbank) Japan SAIF Partners (Softbank) Japan 3 Sequoia Capital China U.S. Venture TDF China 4 Legend Capital (corporate) China CDH Investments Singapore/U.S. 5 Granite Global Ventures U.S. DFJ ePlanet U.S. 6 Softbank China VC Japan Softbank China VC Japan 7 Walden International U.S. Granite Global Ventures U.S. 8 JAFCO Asia (corporate) Japan Intel Capital China U.S. (corporate) 9 Intel Capital (corporate) U.S. 3i U.K. 10 CDH Ventures Singapore/U.S. NewMargin Ventures China 11 iD TechVentures Ltd. China Warburg Pincus Asia LLC U.S. 12 WI Harper U.S. Doll Capital Management U.S. 13 Doll Capital Management U.S. Actis China Limited U.K. 14 Qiming Venture Partners China Sequoia Capital China U.S. 15 DT Capital Partners China Shandong High China Technology Investment (government) 16 Venture TDF China LP China Pacific Venture Partners Taiwan 17 Capital Today Group China Shenzhen Capital Group China (government) 18 Orchid Asia Group Hong Kong Legend Capital China (corporate) 19 CEYUAN Ventures China WI Harper Group U.S. 20 GSR Ventures China DragonTech Ventures Hong Kong SOURCE: Zero2IPO (various years). There have been a number of successes, including Yahoo’s $1 billion purchase of 40 percent of the Chinese e-commerce firm Alibaba, the purchase of Longshine in 2005 for $30 million by the U.S. firm Amdocs, and TDK’s purchase of ATL for $100 million in 2005. The second avenue is acquisition by Chinese firms. A number of these have provided high returns to their investors. The third exit window is listing on foreign markets, since Chinese firms backed by foreign VC cannot list on Chinese markets. Foreign VC firms play a

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2 INNOVATION IN GLOBAL INDUSTRIES vital role in advising and preparing Chinese firms for listing on the U.S. NAS- DAQ. Listing in the United States is important, because it has the largest and most liquid markets. Conversely, Chinese listings are becoming important for U.S. exchanges. In 2004 there were 21 VC-backed IPOs of Chinese firms, 10 of which were in the United States. These constituted more than 10 percent of the 93 VC-backed IPOs in the United States that year. In 2005, 20 VC-backed Chinese firms listed internationally. Of these, 8 exited in the United States. That year, there were only 57 VC-backed IPOs in the United States (Zero2IPO, 2005). Moreover, many Chinese listings performed well in the aftermarket. The final exit is in the increasingly active Chinese stock markets. U.S. VC firms have been intimately involved in the Chinese startups listing on U.S. markets. Using data from U.S. Securities and Exchange Commission fil- ings for IPOs, we extracted the names of the venture capitalists serving on these firms’ boards of directors. The preponderance of the firms had foreign venture capitalists on their board of directors (this includes non-Hong Kong venture capitalists located in Hong Kong). The representation of Silicon Valley venture capitalists is particularly striking. This suggests that these individuals may be transferring Silicon Valley-like practices and routines for managing high-technol- ogy startups to China. Do these Chinese startups have unique or global-class technology that might threaten U.S. dominance? Table 5 lists Chinese firms with IPO in the United States from 1999 to 2005. The activities of these firms suggest that the Chinese startups exiting in the United States are “me-too” emulators of overseas business models, semiconductor design firms operating at the lower-technology end of the marketplace (e.g., Vimicro and Actions), semiconductor fabrication firms that are direct competitors with Taiwanese firms (e.g., SMIC), or firms that are not based on technology but instead rely on business models that may not be adaptable outside of China. An example of such business models is Focus Media, which rents space in elevators on which it installs flat panel screens displaying adver- tisements. In summary, nearly all of these firms serve the rapidly growing and underserved Chinese consumer market or are part of a global division of labor that does not directly affect U.S. firms. This relatively negative assessment of the technology base of these VC- backed Chinese firms does not imply that China will not rapidly improve its technological capacity. Given the current trajectory, it is possible that some firms with unique global or near-global class technology may appear within 3 to 5 years. Certainly, the success of Huawei and ZTE,10 which were not VC financed, 10 Huawei and ZTE are the largest Chinese telecommunications equipment firms and have become significant competitors in not only the Chinese market but also global markets. Examples of their developed nation competitors include Cisco, Lucent, Nortel, and Alcatel. In 2006, Huawei’s global sales were $8.2 billion, of which 58 percent were outside of China (Huawei, 2007). In 2005, ZTE’s global sales were $2.9 billion (Byte and Switch, 2006), and it competed particularly fiercely in the wireless infrastructure space.

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 VENTURE CAPITAL TABLE 5 Chinese Entrepreneurial Ventures’ IPOs on the U.S. Markets, 1999-2005 Year of Analogous Firm Name IPO Activity Offshore Firms AsiaInfo Holdings 2000 Software and online services for China Many firms Netease.com Inc 2000 Online games Many firms Sohu.com Inc 2000 Web portal Yahoo! China Finance Online 2004 Chinese financial information Hoovers KongZhong Corp 2004 Wireless downloads (e.g., ring tones) Many firms Ninetowns Digital 2004 Software for import/export from China Many firms Elong Inc 2004 Travel site Expedia TOM Online Inc 2004 Wireless downloads (e.g., ring tones) Many firms Baidu.com Inc 2005 Web search Google Hurray! Holding 2005 Wireless downloads (e.g., ring tones) Many firms Vimicro International 2005 IC design Many firms Watchdata Technologies 2005 Smart card operating system for China Many firms China Medical Tech. 2005 Ultrasound cancer treatment equipment Many firms China Techfaith Wireless 2005 Handset design Many firms Ctrip.com International 2003 Travel site Expedia 51job Inc 2004 Job website Monster Linktone Ltd 2004 Wireless downloads (e.g., ring tones) Many firms Semiconductor Mfg. Int. 2004 Semiconductor foundry TSMC (Taiwan) Shanda Interactive 2004 Multiplayer games Many firms The9 Limited 2004 Multiplayer games Many firms Focus Media Holding 2005 Advertising in elevators Not technology China.com Corp 1999 Wireless downloads (e.g., ring tones) Many firms Asiacontent.com 2000 Internet solutions and online advertising Many firms Sina.com 2000 Web portal Yahoo! Wherever.net 2000 Discounted mobile telephony (defunct) Many firms Actions Semiconductor 2005 IC design Many firms Suntech Power 2005 Photovoltaics Many firms SOURCE: Compiled by authors. suggests such an outcome. The enormous investments by the Chinese govern- ment, the return of well-trained Chinese workers from overseas, and the growth of the Chinese economy make negative predictions about the level of Chinese technology and innovation unlikely to hold true in the long term. The evidence suggests that international VCs are more active than domestic VCs in China. For example, approximately 75 percent of the VC funds invested in China recently have come from foreign sources (Zero2IPO, 2005). Although it is difficult to be certain, there is evidence to suggest that clusters of entrepreneurial firms, VC firms, and other startup service providers may be emerging in Beijing and Shanghai (Kenney et al., 2004). All Chinese firms listed on the NASDAQ were focused on the Chinese internal market with the exception of the Semicon- ductor Manufacturing International Corporation, which was a semiconductor

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 INNOVATION IN GLOBAL INDUSTRIES fabrication firm competing directly with Taiwanese firms. The two Chinese semi- conductor design firms listed on the NASDAQ—Actions and Vimicro—appear to be focused on the domestic market. At this point, these firms are not competing directly with U.S. design firms, which focus on cutting-edge technologies. The firms that have listed thus far are not direct competition for U.S. high- technology firms. However, since U.S. VC firms are employing Chinese profes- sionals, there will be a transfer of skills from the United States to China in the craft of venture investing. Furthermore, the substantial numbers of startups that have grown and managed successful exits imply that a class of experienced en- trepreneurs is emerging in China. Already, a number of these entrepreneurs are being employed by U.S. VC firms or are establishing their own VC firms with significant investment from U.S. VC firms. The final missing ingredient is world- class technology. Despite the fact that China does not appear to have global-class technological opportunities, the rapidly growing domestic market is creating numerous opportunities for substantial capital gains attracting venture capitalists from around the world. DISCUSSION One question motivating this book is the availability of reputable quantitative information on R&D globalization. Only 5 years ago, it was nearly impossible to measure VC industry globalization because of the lack of comparable statistics and collection standards. The globalization of the VC industry has increased the demand for standardized information on industry trends throughout the global economy. At the behest of the EVCA and National Venture Capital Associa- tion, the comparability among North American, European, and Israeli data has improved. Thomson and Ernst & Young have initiated a global standardization initiative that is now being extended to Asia; this will further improve compara- bility. Within 5 years, a robust global reporting system should be in place. While the globalization of VC has diffused this institution to many other nations, Silicon Valley in the United States unambiguously continues to be the center of the VC industry. One issue of concern is whether investment in foreign companies by U.S. VC firms contributes to eroding the competitiveness of the United States in high-technology industries. U.S. VC firms have invested in Euro- pean companies for at least two decades. They soon learned to invest primarily in BO deals because there were too few startup deals. Recently, there have been bet- ter early-stage deals in Europe, which has attracted investment by U.S. VC firms. For example, the recent acquisition of Skype by eBay for $4 billion is an exit that will likely attract more U.S. VC investments in European firms. In addition, Israel continues to attract U.S. VC investment. An investigation of VC investments in Taiwanese companies found that Taiwanese startups do not appear to be in direct competition with U.S. startups, with the exception of the area of semiconductor

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 VENTURE CAPITAL design (U.S. Government Accountability Office, 2006). In sum, at this juncture it would appear that the investments of U.S. VC firms in Europe, Israel, and Taiwan have had a negligible effect on U.S. technological competitiveness. The cross-national investments by U.S. VC firms that have caused the great- est concern are those in China. This is due to the belief that these investments are assisting in the development of foreign competition for the U.S. lead in high technology. This may be a valid concern for the future. Chinese firms such as Huawei, ZTE, and Lenovo (none of which were VC-funded) are already serious competitors in certain markets. However, as we have discussed, Chinese firms funded by VC do not yet appear to pose competition at a global level. The other chapters in this book will answer the question of whether global-class technology is currently being developed, either in Chinese firms and universities, or in the R&D operations of multinational firms in China. This chapter did not examine VC investing in India, which up until the last 18 months has been quite limited, but in 2007 began to grow rapidly. There is little reason to believe that investment by foreign VC firms in the United States has had a negative effect on U.S. technological competitiveness; European VC firms have a long history of investing in the United States. It is more likely that the inflow of European VC has provided a net benefit to the U.S. economy—European governments believe this to be the case. One benefit for the United States is that, at a minimum, European VC firms, as well as Israeli VC firms, nearly always pressure their portfolio firms to open an office in the United States. Their objective has been to access U.S. knowledge and markets. In return, this validates and reinforces the United States as the center of global technology. It is difficult to interpret this as negative. There are recent developments in international stock markets that may have implications for U.S. technological competitiveness. A debate in the industry and exemplified by a 2005 article in the Venture Capital Journal suggests that the willingness of firms to list on U.S. markets may be decreasing due to the high cost of complying with Sarbanes-Oxley (SOX) legislation (Sheahan, 2005). The argument is that U.S. markets may be losing their centrality in VC invest- ing, particularly for smaller IPOs. For example, of a total of 78 IPOs in 2005 by 30 top-quartile U.S. VC firms, only 45 were listed in the United States. The remaining 33 were listed in non-U.S. markets including London (LSE and AIM), Taiwan, Hong Kong (main board and GEM), Japan (JASDAQ), Korea (Kosdaq), Singapore, and Malaysia. Whether this recent trend will endure is uncertain as it is also possible that these offshore IPOs involve lower-quality firms. SOX may be shifting inferior listings to markets with looser disclosure and listing standards. Alternatively, shifting listings away from U.S. markets could impact the health of U.S. equity markets by encouraging listing abroad. Despite this shift in list- ing, the larger exits for VC-financed high-technology firms continue to be on the

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 INNOVATION IN GLOBAL INDUSTRIES NASDAQ. So, the suspicion that SOX legislation is convincing firms to list in other markets has not been definitively proven.11 CONCLUSION The VC industry has experimented with globalization for the past 40 years. In the last 10 years, and particularly since the 2000 U.S. stock market meltdown, globalization has advanced rapidly as the largest VC firms have established cross- national partnerships and overseas offices and have co-invested abroad. We ex- pect this trend to continue to grow as other nations develop significant clusters of expertise and firms worthy of VC investment, global corporations accelerate their practice of acquiring foreign startups, and exit markets are increasingly global. The reasons for globalization vary not only by VC firm, but also by nation. Until recently, U.S. VC firms, particularly in Silicon Valley, experienced little pressure to globalize. For European and Asian firms, better returns and more investment opportunities were prime motivators for investing and operating in the United States. For the European firms, the ability to assist their portfolio firms abroad (in the U.S. market) was also an important globalization motivator. In contrast, Asian VC firms did not attach as much importance to these reasons, suggesting that the Asian firms in which they were investing had minimal global operational ambitions (e.g., nearly all of the Chinese firms that went public on NASDAQ did not target external markets). Although U.S. VC firms have been privileged by being located in the world’s largest and most lucrative investment environment, many major U.S. VC firms are globalizing. In 2007 the VC industry was well into the process of globalization. The IT industries have always been the core business field for VC investing and U.S. firms have dominated this field. At this time, there is no indication that any other business field, such as biotechnology, nanotechnology, superconductivity, or green energy technologies, will displace the IT sector in the near future in terms of the size and speed of capital gains generation. Should the U.S. ability to gen- erate IT and biomedical innovations capable of being commercialized for large capital gains decline, VC firms will shift their investment to more promising locations and technologies (if any emerge). The continuing globalization of R&D described in the other chapters of this volume suggests that VC firms will also continue to globalize as investment op- portunities proliferate. At this point, VC industry globalization does not threaten U.S. leadership in technological innovation. Extrapolating from the historical record, what would be most likely to threaten innovation leadership would be U.S. decisions that weaken the flow of innovative opportunities and the supply of technically proficient, well-trained entrepreneurs (e.g., changes in immigra- 11 Doidge et al. (2007) dispute the hypothesis that SOX has caused listings to be moved to London markets.

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 VENTURE CAPITAL tion policy, research funding policy, tax policies, or secrecy that stifles the free flow of engineers, scientists, and information). There is little evidence to suggest that innovation is a zero-sum game (i.e., if Country A innovates, then Country B cannot). Having said this, it is undeniable that technological expertise is not as concentrated in the United States as it was even one decade ago. Moreover, technological creativity is based on the talent of human beings, and they are more mobile than ever. Venture capitalists are opportunistic and their firms’ investments will flow to opportunities wherever they are located. There can be little doubt that the addition of VC to a region that already has the technical capabilities and a fledgling en- trepreneurial environment can accelerate and feed the development of a virtuous circle of further entrepreneurship and a concomitant increase in VC investment. A supply of VC without a large number of high-technology entrepreneurs will not ignite new firm formation. The globalization of VC will not result in a lack of available capital in the United States. Policies that reduce the number of global- class technologists and entrepreneurs in the United States will directly affect decisions by venture capitalists to invest in the United States. ACkNOWLEDGMENTS Martin Haemmig thanks Jesse Reyes (formerly Vice President at Venture Economics) and John Gabbert (until recently at VentureOne) for providing data. Martin Kenney thanks the Alfred P. Sloan Foundation for supporting his research on the globalization of the venture capital industry. The authors thank Rafiq Dos- sani and John Taylor of the National Venture Capital Association for comments. We owe a debt of gratitude to Jeffrey Macher, David Mowery, and two anony- mous reviewers for their invaluable critiques and comments that sharpened our thinking and improved the chapter. REFERENCES Advent International Corporation. (1986). Advent International Corporation. Boston, MA. Aldrich, H. E., and M. C. Fiol. (1994). Fools rush in? The institutional context of industry creation. Academy of Management Review 19(4):645-670. Allen, F., and W. Song. (2005). Venture Capital and Corporate Governance. Wharton Financial Center Working Paper 03-05. Asian Venture Capital Journal. (2001). The 2000 Guide to Venture Capital in Asia, Volume . Hong Kong: Asian Venture Capital Journal. Avnimelech, G., M. Kenney, and M. Teubal. (2004). Building Venture Capital Industries: Under- standing the U.S. and Israeli Experience. Berkeley Roundtable on the International Economy, Working Paper 160. Aylward, A. (1998). Trends in Venture Capital Finance in Developing Countries. International Fi- nance Corporation Discussion Paper Number 36. Washington, D.C.: The World Bank.

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