Much of the literature on venture capital (VC) policies is inspired by the success of a handful highly visible companies such as Microsoft, Compaq, Intel, Google, and Apple. These companies, nowadays, are huge and extremely powerful, but at some point in their development they had to resort to VC. These companies are, of course, the envy of many countries – who wouldn’t want to have such firms flourishing in his or her country?
Some argue (or hope) that if it is made sure that VC markets will, somehow, flourish in a certain country, that such companies will pop up and flourish there as well. More specifically, policy-makers have tried to derive lessons from Silicon Valley. Silicon Valley is the southern region of the San Francisco Bay Area in Northern California in the U.S., and houses the lion’s share of the world’s companies that receive and make VC investments.
Of course it makes sense if one is interested in establishing a VC industry and attracting VC to look at Silicon Valley for lessons. The problem is, however, that this is largely one, single success story – it is one data point. Nowhere else in the world has venture capitalism flourished to the extent it did in Silicon Valley. Therefore, looking at Silicon Valley different researchers might derive different lessons (which indeed happened), because everything that is unique to Silicon Valley could arguably be crucial to developing a venture capital industry and to attracting and nurturing innovative companies like Apple and Google.
Academics and European policy-makers have largely ‘learned’ that the availability of risk capital is a crucial ingredient to establishing a thriving VC industry and stimulating innovation. European governments have therefore actively stimulated venture capitalism by providing venture capital themselves or by leveraging private VC investments. Sound logical, doesn’t it?
It does sound logical, but I think it is nevertheless shortsighted. In my research I have found and described a few reasons why studying the specifics of Silicon Valley may be helpful, but not enough to help one establish an own, national VC industry. Let’s look at a few of those reasons.
The American industry is better able to support radical innovation
Hall and Soskice (2001) pioneered a field that because of the success of their work is now called varieties of capitalism. They distinguish between two main types of economies: liberal market economies (LMEs) and coordinated market economies (CMEs). LMEs are more likely to successfully sprout radical innovations, whereas incremental innovations are better stimulated in CMEs. LMEs emphasise short-term tenures, in which workers change jobs quicker and thus focus less on firm- or product-specific knowledge (which would induce incremental innovations). Hall and Soskice (2001, p. 40) argue that
the institutional framework of liberal market economies is highly supportive of radical innovation. Labor markets with few restriction on layoffs and high rates of labor mobility mean that companies interested in developing an entirely new product line can hire in personnel with the requisite expertise, knowing they can release them if the project proves unprofitable. Extensive equity markets with dispersed shareholders and few restrictions on mergers or acquisitions allow firms seeking access to new or radically different technologies to do so by acquiring other companies with relative ease, and the presence of venture capital allows scientists and engineers to bring their own ideas to market.
The institutional framework that supports the one, seems disruptive of the other – i.e. it is impossible to be both a LME and a CME. Venture capitalism has written radical innovation all over it. Anglo-Saxon countries, like the U.S. in which Silicon Valley is located, have economies that closely resemble a LME: its citizens are less risk-averse than those of CMEs, entrepreneurs can more easily hire and fire employees, quick and large profits can be obtained via liquid (second-tier) stock markets, etcetera, whereas their counterparts in Europe are more suited to support incremental innovations.
This explains why venture capitalism can be very succesful in the U.S. It also shows why European companies, where relationships between employers and employees are more long-term, are generally more willing and better able to invest in the training of their personnel, which gives them a competitive edge in other areas, for instance the car industry.
The crucial insight here is that a CME is not necessarily better or more competitive than a LME – or vice versa. They are both competitive because they both have competitive edges – the one with regard to incremental innovations, and the other with regard to radical innovations. Since VC is so strongly associated with radical innovation, it makes sense that VC markets are more active and succesful in the U.S. Moreover, if one truly wants to achieve this in Europe to a similar extent, one will have to adapt the institutional framework. But that will erode the competitiveness of most European countries as CMEs. Creating an environment that would maximally stimulate VC markets could very well erode the competitive advantage of other sectors and thereby decrease competitiveness of the country as a whole. On a country or even continental level it is absolutely unsure, at best, whether this would be a winning strategy. At a global level, however, it should be crystal clear that it is a losing strategy. Following the logic of specialisation it would be beneficial if (in a hypothetical example of two groups of countries) one group aims to be a CME if the other aims to be a LME.
In my research, I quantitatively confirmed the aforementioned reflections. For instance, I positively and significantly related indicators of VC activity (e.g. VC investments as a share of GDP) to labour market indicators measuring labour market rigidities (such as the strength of employment protection).
Stock markets: size, importance, and familiarity
A great deal of venture capitalism takes place in and via equity markets, which makes the familiarity with such markets and the comfortability with stock market transactions important. If entrepreneurs do not feel comfortable accepting capital from venture capitalists, perhaps because of a lack of trust (after all, venture capitalists take a stake in their project), then they will not easily engage in venture capitalism. This also holds for venture capitalists; if they perceive that financial markets will not allow them to close the contracts they desire (for instance to cope with incentive problems and information asymmetries) or to earn significant positive returns on their investments because the stock market is not active (or liquid) enough, then they will not easily provide VC to young firms.
Venture capitalism might therefore more easily develop in the U.S. than in Europe. To check this, I regressed indicators of the size of, the importance of, and the familiarity with stock markets (most notably by using the total market capitalisation as a share of GDP) with indicators of VC intensities. This confirmed the expected relationships.
Venture capitalism did not flourish in the United States
It flourished in Silicon Valley (and perhaps in the Boston area) – not everywhere in and evenly spread across the U.S. If an entrepreneur stumbles upon a technological breakthrough in, say, Montana or Kansas, and decides that he wants to bring it to the market, where do you think he will try to do so? Chances are that he will travel to Silicon Valley and try to convince one of the main VC funds there to invest in his project.
This shows that Silicon Valley feeds of the ideas that pop up in the entire country. This may even be stretched further if we consider the example of Jan Sloot, a Dutch inventor that is believed to have stumbled upon a major technological breakthrough regarding data compression. He (or rather, his advisors) did not decide to bring this invention to the market in the Netherlands or even Europe – they decided to travel all the way to Silicon Valley. The insight here: the ideas that may attract VC are not geographically bound.
Simplifying a bit, we may argue that the U.S. and Europe are similarly sized in terms of the population and the economy. As argued before, the particularities of the U.S. economy make that it optimally supports venture capitalism. Therefore, it seems reasonable to argue that the European economy may maximally support a VC industry in size roughly equivalent to Silicon Valley. The size and success of Silicon Valley remain spectacular, but I would say less to if one takes the right perspective (e.g. as a share of national GDP). This greatly limits the VC-potential of smaller economies, which will only be able to supply a limited deal activity.
Culture: stimulating in the one case, but obstructing in the other
I would like to finish with in my eyes the most interesting yet also most puzzling and troubling factor explaining why VC markets may develop with varying success across countries: cultural attitudes.
Briefly put, the American entrepreneurial mindset is optimal in facilitating venture capitalism. Americans attach less value to social security and accept greater job insecurity, which means that employment protection is weaker, which already reduces the risk entrepreneurs face. VC projects are by their very nature risky: the chances of failure are big, but so are the chances of huge successes (thus, the returns on VC projects are volatile).
Americans are also, in a general sense, less risk-averse than Europeans; they are more daring and more easily accept the riskiness of a project. But this is crucially supported by a smaller severity of the consequences of failure. If an American entrepreneur goes bankrupt, chances are that people will say or think, “Too bad, but at least he tried.” In Europe bankrupcty is more frequently and strongly accompanied by an adverse stigma. Moreover, the process of bankrupcty is way more difficult, lengthy, and far-reaching in Europe. If an entrepreneur goes bankrupt in Europe, the process of unwinding will generally take years – a lot longer than in the U.S. But even if an entrepreneur (and more specifically his motivation) survives this process, it is a lot more difficult to start over in Europe, which is partially explained by the adverse stigma.
The European Commission recognised already way back in 1999 that “[c]ulture is the main barrier to the development of risk capital markets” and that “[d]eveloping a less risk-averse culture […] is key to Europe’s economic growth and job creation.” This is an extremely interesting view on the matter. Let’s assume that, indeed, cultural attitudes significantly influence the success of venture capitalism – which does not seem much of an assumption. If one wants to stimulate VC markets, as the European Commission strives to, this would require adapting cultural values. So, somehow, voters who all have a particular cultural background, vote for national parties that best represent their interests (where culture plays a major role), which in turn have allowed the European Commission to become more powerful – but now this Commission wants to change cultural attitudes or values. That seems to me to be a very noxious and dangerous development. Apparently, somehow it is determined that the people themselves are culturally deficient – how can that possibly be politically legitimate?
For the European Commission preserving national cultures might not be an important goal – they are even seen as barriers – but most national politicians will certainly have deviating views on this. Or at least they should.
This leaves us with some interesting insights regarding VC policies, which on the surface seem to be rather technical in nature, but which are actually deeply rooted in and interact with institutional frameworks and cultural attitudes. My conclusion is that it is not at all clear that copying policy practices from Silicon Valley is (a) effective, (b) possible, and (c) desirable. I do not in any way wish to underestimate the importance of venture capitalism, but implementing effective and legitimate VC policies requires more than a casual look at the San Francisco Bay Area.