that knowledge diffuses through the industry in the form of patents and, more importantly, a flow of people among companies.39

From another perspective, VC firms are even more fundamental to innovation in Internet and IT technologies than in other venues. Increasingly, much of the innovation in these areas is related to new business models and social innovation rather than technology. An example is the use of the Internet to bring together buyers and sellers at online auctions. The research related to these models seems to be carried out by starting new companies that succeed or fail in the real marketplace. Looked at in this way, the market itself is the laboratory and arbiter of success, and the whole system of VC firms can be thought of as a new way of conducting research.

Studies demonstrate that venture capitalists have a disproportionate impact on technological innovation relative to the size of their investments. Although they fund only a few hundred of the nearly 1 million businesses begun in the United States each year, venture capitalists backed roughly one-third of all the companies that went public in the past two decades—including several of the most successful IT firms, namely Amazon.com, Cisco Systems, Microsoft, Intel, and Yahoo (Gompers and Cohen, 1999; Lerner, 1999a,b). These companies have a significant impact on the economy. A study conducted by the venture firm Kleiner, Perkins, Caufield, and Byers found that the companies it had financed since its founding in 1971 had created 131,000 jobs, generated $44 billion in annual revenues, and had $84 billion in market capitalization (Peltz, 1996).

In the IT industry, VC firms are a growing source of funding, although insiders wonder how long the gold rush that took place during the period in which this report was written will last. Total VC investments in U.S. firms jumped from less than $4 billion in 1994 to $14.7 billion in 1998, with investments in IT-related companies rising from less than $2 billion to roughly $9 billion during that time.40 In the 4-year period between January 1995 and December 1998, VC firms invested a total of $46.6 billion in start-up companies in all industries; of that amount, $26 billion—or 56 percent—was invested in the IT sector. Roughly half of the IT-related investments went to firms in the computer software and services sector, with investments in communications, semiconductors, and computer hardware accounting for the rest (Table 2.9).41 Internet-related companies (e.g., Yahoo, Amazon.com, and eBay) also have garnered a growing share of VC investments. Venture capitalists reportedly invested $3.8 billion in Internet-related companies in the second quarter of 1999, up from $1.4 billion in the second quarter of 1998 and more than the $3.3 billion invested during all of 1997. 42

In contrast to the much smaller amounts of VC in Europe and Japan, almost half of VC investments in the United States represent early-stage



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