Buzz

Toward A Global Model Of Venture Capital?

William L. Megginson, University of Oklahoma


By any measure, the scale of venture capital fund-raising and investment has grown exponentially over the past two decades, and venture capital investing has enjoyed an extremely good press. Although it is a historically recent and predominantly American financial innovation, venture capital has been embraced by policymakers, academics, and business commentators around the world as a key tool for economic and technological development, and the U.S. venture capital industry is often held up as a model for other nations. Yet very little research or commentary has been directed toward evaluating whether it is possible (or even desirable) to replicate the American model of venture capital elsewhere- or toward assessing how much convergence may already be occurring among the major national markets for venture capital. This article is a first crack at addressing these issues.

Anyone wishing to compare worldwide venture capital practices soon encounters some confusion with terminology, since venture capital means different things in different national markets. Defined broadly, "venture capital" has been a fixture of Western civilization for many centuries. The decision by Spain's Ferdinand and Isabella to finance Christopher Columbus's voyage of exploration can be considered one of history's most profitable venture capital investments (at least for the Spanish). In the United States, venture capital is more typically defined as a professionally managed pool of money raised for the sole purpose of making intermediateterm, actively managed, direct equity investments in rapidly growing private companies, with a welldefined exit strategy-preferably through an initial public offering. In Western Europe, on the other hand, venture capital is usually defined as investment in early- and expansion-stage companies, and the main focus is on the broader category of private equity, which includes both venture capital and buyout financing of private companies. The discussion below will clearly distinguish between venture capital, narrowly defined in the American usage as non-public financing of entrepreneurial growth companies with a well-defined exit strategy, and the broader private equity which includes both venture capital and buyout funds.

The total volume of private equity raised in almost all developed countries has grown very sharply over the past 15 years. While this growth was particularly rapid between 1990 and 2000, even today's relatively depressed levels of private equity financing are an order of magnitude higher than those of 15 years ago. PricewaterhouseCoopers, the principal source of U.S. and global data for this study, reports that private equity fund-raising grew from roughly $10 billion worldwide in 1989 to a peak of $250 billion in 2000, before declining to $88 billion in 2002. Private equity investment showed similar if less pronounced growth and retrenchment. (There is almost always a difference between funds raised and invested, with fund-raising typically exceeding investment.) While the United States still accounts for about two-thirds of the world's total private equity fund-raising and investment, and an even higher fraction of true venture capital funding, other countries have been adopting many American investment and fund-raising practices, and at least a superficial case for convergence in private equity financing techniques can be made. On the other hand, striking differences remain between North American, Western European, and Asia-Pacific private equity fundraising and investment practices. This article poses the question: Is a truly global, integrated market for venture capital and private equity investment now emerging, or will the "global" private equity industry continue to consist of segmented national markets with distinctive fund-raising and investment practices? Much will ride on the answer.

The Economic Impact of Venture Capital Investing

It is not hard to understand why policymakers are such strong proponents of private equity (PE) in general and venture capital (VC) in particular. Both academic and practitioner-oriented research has clearly demonstrated that such investing creates significant economic value. A recent study published by the National Venture Capital Association documented the scale and economic impact of 30 years of VC investment in the United States.[1] Over the period 1970-2000, American venture capitalists invested $273.3 billion in 16,278 companies in all 50 states, with no less than $192 billion of that investment coming during the six-year period 1995-2000. Venture capital-backed firms employed 7.6 million people and generated $1.3 trillion in sales during 2000, representing 5.9% of the nation's jobs and 13.1% of America's GDP that year. The study also found that, over the study period, "venture capital-financed companies had approximately twice the sales, paid almost three times the federal taxes, generated almost twice the exports, and invested almost three times as much in R&D per $1,000 in assets as did the average nonventure capital-backed companies."[2] Finally, the study documented that, on average, every $36,000 in VC investment created one new job. Key details of this study are reproduced in Table 1.

In Europe, a study by the European Private Equity and Venture Capital Association (EVCA) found that VC-backed European companies generated significantly higher growth rates in sales, research spending, exports, and job creation during the 1990-1995 period than did otherwise comparable non-VC-backed companies.[3] Recent updates of this study have shown that European private equity funds invested ?9.8 billion in 8,684 VC-stage companies during 2002, and roughly one-third the total investment was in early-stage companies.[4] Finally, a recent survey found that an astonishing 95% of European venture-backed companies said they either would not exist or would not have developed as quickly without VC investment.[5]

Entrepreneurial growth companies often have great difficulty obtaining external financing because they typically invest in riskier assets and because there are pervasive information disparities between the entrepreneur and financier. Several academic studies have examined how venture capital helps overcome the significant problems involved in funding these companies and also influences firm growth and development.[6] One study found that venture capitalists help correct the misalignment between owner and manager interests through sophisticated contracting, pre-investment screening, and postinvestment monitoring and advising.[7] Another study showed that "innovator firms" are much more likely to obtain VC funding than are "imitator firms" and that these innovative companies are able to bring products to market significantly faster than other companies.[8] In short, venture capitalists create value through their role as active investors who bring much more than money to their portfolio companies.

It is not hard to understand why policymakers are such strong proponents of private equity in general and venture capital in particular. Both academic and practitioner-oriented research has clearly demonstrated that such investing creates significant economic value.
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An Overview of the Global Market for Venture Capital

As noted earlier, the global venture capital and private equity market has grown dramatically since 1989, and growth was nothing short of explosive from 1995 to 2000. Figure 1 describes the evolution of venture capital and private equity fundraising between 1995 and 2003, both on a global basis and by region. The annual amount of funding increased from $44 billion in 1995 to $250 billion in 2000, and then fell to $88 billion in 2002. By far the largest fraction of this increase and subsequent decline in fund-raising occurred in North America, where total financing rose from $31 billion in 1995 to $181 billion in 2000, then fell to $57 billion in 2002. The increase in total funds raised in Western Europe between 1995 and 2000, from $6 billion to $44 billion, was much more modest in an absolute sense (though a seven-fold increase), but so was the subsequent decline to $26 billion in 2002. Since these data are presented in dollars, however, at least part of this apparent moderation is explained by the steady decline of the euro versus the dollar during the boom

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years (from $1.17/? in January 1999 to $0.82/? in April 2002), and its dramatic appreciation since then (to $1.24/? in January 2004). Though it is the world's third largest private equity market, the Asia-Pacific region has seen a far less dramatic change in the total volume of PE fund-raising over the period 1995- 2002. The regional total climbed moderately from $7 billion in 1995 to $18 billion in 2000, and then fell back to $3 billion in 2002. Finally, the total annual amount of private equity funds raised outside of North America, Western Europe, and the Asia Pacific region has never accounted for more than a few billion dollars in total, even during peak years.[9]

Total private equity investment, globally and by region, shows the same pattern of very rapid increase followed by sharp contraction that is observed for total fund-raising, though both the rise and subsequent decline are less extreme. Worldwide investment grew from $41 billion in 1995 to $206 billion in 2000, and then fell back to $102 billion in 2002. While the amount of funds raised typically exceeds investment, the differences in 1998 ($42 billion) and 2000 ($44 billion) were especially large.[10] North American PE investment increased more than sevenfold, from $21 billion to $152 billion, between 1995 and 2000, and then dropped by three-fifths (to $64 billion) over the next two years. Western European PE investment increased at a much more sedate pace than in North America, rising from $6 billion in 1995 to $32 billion in 2000, but this increase has also proven more robust-total European investment fell only moderately to $22 billion in 2001, and then increased to $26 billion in 2002. Even if one accounts for the impact of a changing dollar-euro exchange rate, it seems clear that PE investment is less volatile in Europe than in North America. Total PE investment in the Asia-Pacific region has been both small in absolute terms and relatively stable, increasing from $6 billion region-wide in 1995 to $12 billion in 2000, and then falling back to $9 billion in 2002. Interestingly, high-tech investment nearly quadrupled between 1998 and 2000, rising from $32 billion worldwide to $119 billion, but then fell even more (to only $26 billion) over the next two years.

Figure 2 presents greater detail about the distribution of private equity investment between true venture capital and buyout financing, and among different stages of VC investment. In 1998, buyout financing accounted for almost two-thirds (64%) of total private equity investment worldwide, whereas early- and expansion-stage venture capital investment accounted for only 11% and 16% of worldwide PE investment, respectively. By 2000, these percentages had quite literally been reversed-buyout financing accounted for only 28% of total PE investment, while early-stage (21%) and expansion (41%) financings accounted for a combined 62%; late-stage venture capital investment accounted for an

Given the amount of media and political attention lavished on venture capital in the United States, most people are surprised to learn just how small the industry actually was before 1998. Total investment spending by institutional venture capitalists never reached $6 billion per year until 1996.


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additional 10% of total PE financing. As the global economy slowed after March 2000, weighed down by severe problems in the key IT and telecommunications industries, the pattern of private equity investment swung once more to favor buyout financing over true venture capital investing. In 2002, buyouts accounted for 63% of global PE investment.

Given the amount of media and political attention lavished on venture capital in the United States, most people are surprised to learn just how small the industry actually was before 1998.[11] The total amount of capital invested each year from 1989 through the third quarter of 2003 is detailed in Figure 3. Total investment spending by institutional venture capitalists never reached $6 billion per year until 1996, but then it surged to an astonishing $102.3 billion spread over 5,606 companies in 2000, before declining to $21.2 billion invested in 3,028 deals during 2002. Total VC spending peaked at $28.5 billion in the third quarter of 2000, and declined continuously after that until the third quarter of 2003.

As in the United States, private equity investment in Europe grew rapidly from 1995 to 2000 and, unlike in America, has held up rather well since then, as also shown in Figure 3. According to a survey of pan-European private equity and venture capital activity conducted for the EVCA by PricewaterhouseCoopers, total private equity investment grew from a stable level of about ?5 billion per year during the 1989-1996 period to ?24 billion in 1999 and ?34.7 billion (invested in some 10,440 companies) in 2000. Disbursements dropped to ?24.3 billion in 2001, but then rebounded slightly to ?27.6 billion during 2002.

Why did the total volume of private equity fundraising and investment decline so precipitously after 2000, and why has so much of the remaining investment shifted back from high-technology (mostly true venture capital) investment to buyout financing? Venture capital fund-raising and investment collapsed because the window of opportunity for "harvesting" a private equity investment through an initial public offering closed after the American and European stock markets began their dramatic declines in March 2000. These exchanges-particularly NASDAQ and Europe's technology-oriented Neuer Markt and Nouveau March‚-had provided enthusiastic markets for VC-backed initial public offerings throughout the late 1990s, which helped convince venture capitalists in North America and Western Europe that they would be able to exit their private equity investments on attractive terms. But the closing of the IPO exit option quickly discouraged private equity financing of all but the most promising technology companies.

I will discuss the importance of a viable exit opportunity to promoting venture capital investment more fully later, when I compare exit techniques of the United States and Western Europe. The next task, however, is to examine the relative importance of private equity investment in different countries and, in particular, to evaluate the role of a nation's legal system in determining how much venture capital and private equity is invested each year.

INTERNATIONAL COMPARISONS OF PRIVATE EQUITY INVESTMENTS AND THE ROLE OF LEGAL TRADITION

Almost without exception, government and business leaders around the world have come to realize that venture capital and private equity investment can play a very positive role in promoting economic development and technological progress. This realization has prompted leaders of developed countries in particular to attempt to promote vibrant national venture capital markets. How successful have these efforts been? Table 2 details the total amount of private equity investment in the 20 countries receiving the most private equity investment during 2002, as well as directly relevant macroeconomic and financial information for these countries. The two largest VC markets in 2002 were, as expected, the U.S. and Great Britain, followed by France, Italy, Japan, and Germany. Italy and Japan both surpassed Germany for the first time in 2002, following Germany's drop from third place in 1999 and its relative decline as a private equity market. While it is not surprising that these G-7 countries would be the six largest private equity markets in absolute terms, the next six countries on the list are- with the exception of Canada-much smaller national economies. Nonetheless, Korea, the Netherlands, Canada, Sweden, Australia, and India all attracted at least $1 billion in private equity investment in 2002.

Table 2 also presents venture capital and private equity investment, market capitalization, and R&D spending as a percentage of 2002 GDP. This reveals dramatic variations in the relative importance of private and public capital market finance and R&D spending among the 20 countries. Private equity investment as a percent of GDP ranges from a trivial 0.028% in China and 0.06% in Japan to 0.58% in Sweden, 0.60% in the United States, 0.62% in Britain, and 0.95% in Israel.[12] Stock market capitalization as a percent of GDP varies between lows of 17.4% in Indonesia, 34.5% in Germany, and 37.4% in China to 105.8% in the United States and 112.1%, 115.8%, 165.9%, and 284.1% in South Africa, Britain, the Netherlands, and Hong Kong, respectively. Finally, research spending varies from lows of 0.21%, 0.50%, and 0.65% of the GDPs of Hong Kong, India, and South Africa, respectively, to highs of 3.40% and 4.27% for Finland and Sweden, and an astounding 4.85% for China. America's R&D spending to GDP ratio is 2.82%, the sixth highest overall. One remarkable trend is the rise of South Africa, India, and Korea as recipients of private equity investment. Where most countries saw a decline in private equity investment both in absolute and relative terms between 2000 and 2002, these countries saw significant increases in both measures.

As a further step in analyzing the international differences in private equity financing, Table 3 ranks the top 20 recipient countries by PE funding as a percent of GDP, and shows separate rankings for market capitalization and R&D spending relative to national output. Table 3 also shows the importance of legal tradition as an influence on the relative importance of stock markets and, especially, private equity financing. This information comes from the "law and finance" literature, which documents that countries with English common law codes offer

One remarkable trend is the rise of South Africa, India, and Korea as recipients of private equity investment. Where most countries saw a decline in private equity investment in both absolute and relative terms between 2000 and 2002, these countries saw significant increases.


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greater protection to investors and thus have much larger capital markets than do countries with commercial codes based on the German, Scandinavian, and French families of civil law (all of which are ultimately drawn from Roman law).[13] The average ratio of venture capital spending to GDP for the eight English common law countries is 0.47%, almost twice the 0.26% ratio of the 12 civil law countries. Likewise, the average ratio of stock market capitalization to GDP for the common law countries, 110.6%, is over two-thirds larger than the 68.7% capitalization-to-GDP ratio for civil law nations. At the peak of the boom in 2000, these differences were even more pronounced, with the average private equity to GDP ratio for the common law countries at 1.14% versus 0.31% for the civil law countries, and the market capitalization ratios at 166.4% and 105.0%, respectively. The slowdown in global private equity financing between 2000 and 2002 was thus a result of the leading countries pulling back, rather than an across-the-board contraction in fund-raising and investment.

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On the other hand, R&D spending relative to GDP is substantially higher in civil law (2.49%) than in common law (1.54%) countries, and these values are virtually identical to those computed in 2000.[14] It appears that civil and common law countries invest to create growth opportunities in very different ways. Civil law countries invest higher proportions of national income in R&D than do common law countries, but the latter rely much more heavily on financial markets in general, and venture capital markets in particular, to finance growth-oriented investment.[15]

PRIVATE EQUITY FINANCING IN THE UNITED STATES AND WESTERN EUROPE

Having surveyed the global market for venture capital and private equity investment, I now attempt to answer the primary question posed by this study's title: Is the world moving toward a truly global,

The sharpest differences between the venture capital and private equity markets of the United States and Europe relate to how the investment vehicles in the two regions are organized and funded.


integrated market for venture capital and private equity, or will the current pattern of segmented national markets-each with distinctive fund-raising and investment patterns-likely persist indefinitely? I concentrate on the United States and Western Europe, because these regions account for the vast bulk of total private equity raised and invested each year. I contrast the organization of fund-raising, investment, and exit in these two regions, and then discuss the return experiences achieved by American and European private equity investors over the recent past. The last section briefly surveys fundraising and investment patterns observed in Japan, Canada, Israel, and key developing countries- especially China and India.

The Organization and Funding of Venture Capital and Private Equity Funds in the United States and Europe

The sharpest differences between the venture capital and private equity markets of the United States and Europe relate to how the investment vehicles in the two regions are organized and funded. The United States has both institutional venture capital funds and angel capitalists. Venture capitalists are formal business entities with full-time professionals dedicated to seeking out and funding promising ventures, while angel capitalists (or business angels, as they are sometimes called) are wealthy local businesspeople who make private equity investments on a more ad hoc basis and who do not generally operate as formal business entities. There is a vibrant market for this angel capital-one that routinely provides over $50 billion per year in total equity investment to private businesses in the United States.[16] Until very recently, in fact, angel capitalists provided far more total investment to entrepreneurial companies each year than did institutional venture capital firms. Nonetheless, we focus on the latter group throughout this paper since these firms operate nationally and provide the performance benchmark against which all private equity investment is compared.

There are four basic categories of institutional venture capital funds. First, Small Business Investment Companies (SBICs) are federally chartered corporations that were established as a result of the Small Business Administration Act of 1958. Since then, SBICs have invested over $14 billion in approximately 80,000 small firms.[17] Historically, SBICs have relied on their unique ability to borrow money from the U.S. Treasury at very attractive rates. They were thus the only types of venture capitalist that structured their investments as debt rather than equity, although this feature seriously hampered their flexibility. A revision of the law in 1992 made it possible for SBICs to obtain equity capital from the Treasury in the form of preferred equity interests, and also to organize themselves as limited partnerships, but these changes did little to arrest the longterm decline in the SBICs' share of the American venture capital market.

Second, financial venture capital funds are subsidiaries of financial institutions, particularly commercial banks. They are generally set up both to nurture portfolio companies that will ultimately become profitable customers of the corporate parent and to earn high investment returns by leveraging the financial expertise and contacts of existing corporate staff. Third, corporate venture capital funds are subsidiaries or stand-alone firms set up by nonfinancial corporations. They are generally established by industrial firms eager to gain access to emerging technologies by making early-stage investments in high-tech firms.

Finally, venture capital limited partnerships are funds established by professional venture capital firms that act as the general partners in organizing, investing, managing, and ultimately liquidating the capital raised from the limited partners. Although most venture capital limited partnerships have a single-industry focus, the firms themselves are not associated with any single corporation or group. Venture capital limited partnerships now control over 75% of total industry resources in the United States, and their sway over the industry seems to be increasing. These limited partnerships have risen to dominance largely because they can focus totally on the financing and development of portfolio companies as stand-alone ventures (unlike corporate and financial venture capital funds that must balance the competing interests of the portfolio company and the corporate parent) and because the limited partnership has the advantages of limited life and limited liability for investors, as well as tax advantages.[18] The fact that a relative handful of funds dominate venture capital fund-raising every year reflects both the comparative advantage of limited partnerships in general, and the value of experience and reputation in particular. Most of the top U.S. venture capital firms are organized as general partnerships, and many are concentrated in California's Silicon Valley outside of San Francisco.

Most venture funds are organized and capitalized by private negotiation between the fund's sponsor and a well-established group of institutional investors. In addition to organizing the limited partnership, the sponsoring firm acts as the general partner (and has unlimited liability) over the fund's entire life, which is generally seven to ten years- though some last 15 years or more. To say that a fund is "capitalized" at its inception is something of a misnomer; in actual practice, the limited partners make capital commitments, which the general partner then draws on over time as the fund becomes fully invested. As general partner, the VC firm is responsible for (1) seeking out investment opportunities and negotiating the terms upon which these investments will be made; (2) monitoring the performance of the portfolio companies and providing additional funding and expertise as these private firms develop; (3) finding an attractive exit opportunity, preferably through an IPO or a merger, that will allow the fund to liquidate its investment in the portfolio companies; and (4) distributing the realized cash returns from exit to the limited partners and then terminating the fund's existence. For its services, the general partner usually receives a percentage claim called carried interest on the realized return (almost always 20%) as well as an annual management fee of about 2% of the fund's total committed capital.

Institutional investors such as pension funds have become by far the dominant sources of funding today. While very few pension funds allocate more than 5% of their total assets to private equity funding, their sheer size makes them extremely important investors, and their long-term investment horizons make them ideal partners for venture capital funds. They typically account for 30-45% of all new monies raised by institutional venture capital firms.[19] Financial and nonfinancial corporations usually represent the second largest contributors of capital to venture funds, accounting for 10-30% of the total. Foundations and endowments are the third important source of venture capital funding, usually accounting for 10-25% of the total. Foreign investors have become increasingly important recently, and (in combination with "other" investors) accounted for 22% of 1999's total funding. Individuals and family trusts are the final major sources of venture capital. While these two groups together now account for only 10-25% of total venture capital funding, it should be noted that the absolute size of the pool of capital under management is much larger than it was in the early years when family money dominated the industry.

In Europe, on the other hand, private equity funds have traditionally been organized as investment companies under various national laws, and their approach to dealing with portfolio companies has been much more akin to the reactive style of U.S. mutual fund managers than to the proactive style of America's venture capitalists. However, a comprehensive recent study shows that European practices are evolving more towards an American model, and that private independent venture capital partnerships now dominate the industry-accounting for 70% of the firms in their sample.[20] To date, the European Union has had little success in establishing community-wide commercial laws, taxation regimes, or corporate governance policies, so each country's private equity funds are organized and funded in segmented national markets. While this theoretically need not prevent capital raised by funds in one

Although governments accounted for only 11.1% of total European private equity fund-raising in 2002, their influence is far greater and generally more pernicious...Government efforts to promote a robust entrepreneurial sector would probably be better focused on eliminating regulatory roadblocks, lowering taxes, and providing a more favorable overall business climate.


European country from being invested elsewhere in the European Union, the reality is that investment also tends to be largely localized-though the above study shows that this is slowly changing as well and that cross-border investments have become much more common recently. The relative lack of a vibrant entrepreneurial high-technology sector in Europe also hampers continental venture capitalists' efforts to attract technologically savvy fund managers or entrepreneur/founders who wish to achieve rapid corporate growth.

Since the early 1980s, a cumulative total of some ?200 billion has been raised for investment in European private equity. The principal sources of European venture capital and private equity funding differ dramatically from that of their American counterparts, however. European private equity funds rely far more on funds from financial institutions (which tend to be very powerful in Europe) and much less on pension funds, foundations, and wealthy individuals. Pension funds, in particular, play a much smaller role in the old world than in the new, due primarily to continental Europe's reliance on government-run, pay-as-you-go pension systems. Outside of Britain, Switzerland, and the Netherlands, private pension funds are small and play little role in capital market financing anywhere in Western Europe. The European Private Equity and Venture Capital Association (EVCA) reports that banks, insurance companies, and government agencies accounted for over half (52.2%) of the ?27.5 billion raised by European private equity funds in 2002, while pension fund money represented only 16.3% of total fund-raising. Individuals accounted for only 6.0%.

Although governments accounted for only 11.1% of total European private equity fund-raising in 2002 (versus 5.6% in 2000), their influence is far greater and generally more pernicious than this absolute level might indicate. European governments have long taken an activist approach to the promotion and support of VC investment. Unfortunately, both academic research and anecdotal evidence indicates that government efforts to promote a robust entrepreneurial sector would probably be better focused on eliminating regulatory roadblocks, lowering taxes, and providing a more favorable overall business climate than on attempting to directly identify and fund "sunrise" industries. The EVCA explicitly addressed the need for governments to provide a better regulatory environment for entrepreneurship in two recent White Papers.[21] Tellingly, the EVCA called for governments to provide direct financial support only when matched by private financing.

Aggregate Investment Levels of U.S. and European Venture Capital and Private Equity Firms

I now compare patterns observed in venture capital investing in the United States with those observed in European private equity investing, and show that there are many more similarities than were observed for organization and fund-raising. Although substantially more venture capital is invested in the United States than in Europe, the two regions' investors finance similar industries and generally target similar fractions of their venture capital investments to early-, expansion-, and late-stage deals.

While Figure 3 may suggest that true venture capital financing has fallen less sharply in Europe than in the United States since 2000, this is not the case, since the data for European private equity funding include both true venture capital and buyout financing. After a brief surge in the fraction of private equity funding allocated to early- and expansionstage investment in entrepreneurial growth firms in 2000, this venture capital financing fell in 2002 to about one-third of total private equity investment. During 2002, ?9.8 billion was invested in 8,684 earlyand development-stage deals in Europe, while ?16.9 billion was invested in 1,171 buyout-stage deals.

Of course, the fraction of American venture capital allocated to startup, early-stage, expansion-, and late-stage financing fluctuates substantially from one year to the next. The popular image of venture capitalists holds that they specialize in making investments in startup or very early-stage companies. This is only partly true. In fact, the 217 earlystage financings recorded during the third quarter of 2003 accounted for only 26% of the total number of deals (667) and 22.7% of the $4.2 billion invested that quarter. The number (42) and value ($135 million) of truly early-stage startup and seed capital financings represented only 6.3% and 3.2% of the respective 3Q2003 totals. Similarly small fractions of total

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funding were allocated to early-stage deals in prior years. Expansion-stage financings were the most numerous (334) and accounted for the largest single fraction (54.9%) of total venture capital disbursements during 3Q2003, as in most previous years. Being rational investors, venture capitalists are as leery as anyone else of backing extremely risky new companies, and will do so only if the entrepreneur/ founder is well known to the venture capitalists, the venture is extraordinarily promising, or both. Laterstage investments (116 deals and $946.4 million invested in 3Q2003) cover funding for marketing programs, major production plant expansions, and financing in preparation for accessing the public capital markets. This has accounted for 12-23% of total investment over the past six years.

Industrial and Geographic Distribution of Venture Capital and Private Equity Investments in the United States and Western

One reason why institutional venture capital investments have been so successful historically, particularly in the United States, is that these firms' managers tend to invest only in industries where they have some competitive advantage, and where their brand of active involvement in portfolio company management can create real economic value. Table 4 presents a listing of the industries that received the most U.S. venture capital funding in 1998, 2000, and the third quarter of 2003. In a striking change from the pattern observed during the Internet frenzy of 1999-2000, roughly half (51.1%) of 3Q2003's total investment went into the area of information technology (telecommunications, networking equipment, computers and peripherals, software, and IT services), compared to 83.4% in 2000. The 3Q2003 figure is actually closer to the fraction of venture capital invested in IT during 1998 (56.8%) and earlier years, perhaps suggesting a return to more traditional industry investment patterns. The biggest single target for VC investment during 3Q2003 was biotechnology (20.7%), which is another dramatic change from the boom years. Health care-related products and services (medical devices plus health care services) accounted for a combined total of 10.1% of VC investment during 3Q2003, while consumer products and services, media and entertainment, industrial, and other products and services received the remaining 18.2% of total investment for the quarter.

Historically, European VC has been funneled to different industries and different types of companies than in the United States, though this has been changing of late. As recently as 1996, less than one-fourth of European venture capital went into high-technology investments, but this

One reason why institutional venture capital investments have been so successful historically, particularly in the United States, is that these institutions tend to invest only in industries where they have some competitive advantage, and where their brand of active involvement can create real economic value.


fraction grew to more than 50% during the peak year of 2000. By 2002, the expected allocation of funding to high-tech industries had fallen back to 20.2% of total PE funding, with the rest allocated to non-high-tech expansion and development (13.4%) and buyout financing (66.3%).[22] As in the United States, roughly half of European high-tech VC investment is funneled into computers and communications businesses today, versus over 80% during 2000.

Yet another striking regularity in venture capital investment patterns concerns geographical distribution-private equity fund-raising and investing patterns in both Europe and America are highly concentrated geographically. In the U.S., California was the single largest recipient of venture capital investment in the third quarter of 2003, accounting for some 40% of all deals and 43% of total nationwide investment. Silicon Valley alone accounted for 193 deals (of 667 total nationwide) worth $1,385 million, or 32.9% of the $4,216 million total investment, while the San Diego, Los Angeles, and Sacramento areas accounted for an additional 73 deals worth $442 million. The next three largest recipients of VC financing during 3Q2003 were New England (106 deals, $692 million investment), the greater New York area (47 deals, $346 million investment), and the Southeast (50 deals, $295 million investment). Although individual state totals bounce around somewhat, the basic geographic pattern of VC investment rarely varies much from year to year.

In Europe, the United Kingdom accounted for 52% of total European PE fund-raising (?27.5 billion) and 37.6% of total European PE investment (?27.6 billion). France ranked second in terms of both fundraising (17.4%) and investment (21.2%) due to a surge in buyout activity during 2002, while Italy took over third place for the first time with 7.4% of European fund-raising and 9.7% of investment. Germany dropped to fourth place in Europe and sixth place overall during 2002, accounting for 6.2% of funds raised and 9.2% of investment, while the Netherlands raised 4.3% of European PE funding and attracted 6.2% of investment, despite having an economy only one-fifth the size of Germany's. Finally, smaller countries such as Finland, Sweden, and Switzerland are always disproportionately well represented in the European PE fund-raising and investment rankings.

How Venture Capitalists Structure Their Investments

The world of finance offers few more interesting examples of sophisticated financial contracting than venture capital investment agreements.[23] While relatively little detailed information is available regarding European venture agreements, they presumably contain many of the same features as their American counterparts and depend on similar elements: (1) the experience and reputation of the entrepreneur; (2) the attractiveness of the portfolio company as an investment opportunity; (3) the stage of the company's development; (4) the negotiating skills of the contracting parties; and (5) the overall state of the venture capital market. If a respected and experienced entrepreneur approaches a venture capitalist with an opportunity to invest in an established company with a promising technology at a time (such as the late 1990s) when competition between venture capital funds is fierce, the entrepreneur will be able to secure financing on very attractive terms.[24] If, on the other hand, an inexperienced entrepreneur asks for startup funding at a time when little venture capital is being raised (such as the early 1990s), the entrepreneur will have to accept fairly onerous contract terms to attract any funding.

The first step in any private equity financing is invariably for the parties to agree on a current valuation for the portfolio company based on the company's past R&D efforts, its current level of sales revenue and tangible assets, and the present value of expected future profits if the company obtains new capital for growth. This valuation is also critical to determining how much of the company the venture capital fund will receive in exchange for its investment. Next, the parties must agree on the amount of new funding the venture capitalist will provide and the required return on that investment based on the perceived risk.[25]

While the actual distribution between earlyand later-stage funding varies from year to year, one principle of venture capital and private equity funding never changes: the earlier the development stage of the portfolio company, the higher must be the expected return on the financier's investment. Professional venture capitalists in the United States typically demand compound annual investment returns in excess of 50% on startup investments, but are often willing to accept returns of 20-30% per year on later-stage deals, since the risk of the investment is far lower in more established portfolio companies. Though less is known about the compound annual returns demanded by European private equity investors for different stage deals, anecdotal evidence suggests that they demand similar risk premiums for earlystage investments. On the other hand, it is usually not a stark choice between early- and late-stage investments. Both American venture capital and European private equity funds that invest in a company during its early years tend to remain committed to the firm as it develops, and will often participate in second-, third-, and higher-round financing as the portfolio company matures. Each successive round generally embodies a lower required return, unless funding must be obtained under conditions of duress.

One key method of minimizing investment risk is to use staged financing. Rather than investing the entire amount at once, the venture capitalist will invest only enough to fund the company to its next development stage (e.g., to develop a working prototype), and to demand a very high return on that initial investment. Once the company successfully achieves the intended outcome, the venture capitalist will provide funding for the next development stage, and since the risk is lower the funding will be provided at a higher per-share price (a lower required return). Staged financing shifts risk to the entrepreneur in return for increasingly more attractive pricing while providing tremendous incentive to create value; it also gives the venture fund an extremely valuable option to deny or delay additional funding.[26]

Another distinguishing characteristic of venture capital investment contracts is their extensive and very sophisticated use of covenants. Some of these covenants are found in many standard bond and loan financing agreements and specify maximum acceptable leverage and dividend payout ratios, levels and types of business insurance, and restrictions on disposition of assets. Other covenants lay out the terms under which additional funding will be provided by the venture capital funds as well as termination and golden parachute rights for the entrepreneur if he or she is forced out.

Perhaps the most fascinating and distinguishing feature of venture capital investment contracts in the United States is their extensive reliance on convertible securities (particularly convertible preferred stock) as the investment vehicle of choice. Venture capitalists can exercise effective voting control with common stock only if they purchase a majority of a firm's common shares, and at the same price as other investors. This would be extremely expensive and would place far more of the firm's business risk on the venture group than on the entrepreneur. Since convertible debt or preferred stock is a separate class of

One key method of minimizing investment risk is to use staged financing. Staged financing shifts risk to the entrepreneur in return for increasingly more attractive pricing while providing tremendous incentive to create value; it also gives the venture fund an extremely valuable option to deny or delay additional funding.


security from common stock, contract terms and covenants specific to that issue can be negotiated, and multiple classes of convertible debt or preferred stock can be created to accommodate different investor groups.[27] What's more, the senior status of convertible preferred stock provides maximum protection for the venture group's investment (relative to the entrepreneur and existing owners) while preserving the company's borrowing capacity (for trade credit and shortterm bank loans).

The coupon rate on these convertible securities is typically set at zero (or a very low percentage rate), clearly implying that venture capitalists structure their investments in this way for contract flexibility reasons, rather than to earn a positive cash flow on their private company investments. Convertible securities give the venture capital group a claim on the portfolio company's earnings and market value in the event the firm is highly successful. Most convertible securities are converted into common stock prior to an initial public offering, partly to present an uncluttered balance sheet to prospective investors and partly to lock in common equity stakes (and capital gains) before inviting in new stockholders.[28] Finally, convertible preferred stock has an advantage over debt financing in that it forestalls the likelihood that the venture capitalist as creditor is shown to be legally exercising control over the company (through contract terms or demands upon management), which would jeopardize the tax-deductibility of interest payments.

A study cited earlier makes clear that European venture capital investment contracts do indeed differ significantly from those in America with respect to the type of security used. Over 70% of all European VC investment contracts involve purchases only of common stock, with slightly over 20% using convertible equity and less than 5% using either straight or convertible debt. On the other hand, they also show that European and American VC investments are equally likely to be syndicated among multiple firms.[29]

The Profitability of Venture Capital and Private Equity Investments

By their very nature as illiquid investments in rapidly growing private companies, venture capital or private equity returns are difficult to value prior to realization (through IPO, merger, or liquidation). There tend to be boom and bust investment cycles, in which very high realized returns prompt excessive new capital inflows into VC funds, which in turn cause returns to drop sharply over the next harvest cycle.[30] Investments made by American venture capital funds during the middle 1990s, and which matured during the 1999-2000 period, earned average compound annual returns of up to 30%. Although the 30% annual return was typical for venture capital funds during the 1970s and early 1980s, Figure 4 makes clear that such a level of profitability was never achieved from 1984 to 1994. Returns were again at target levels in 1995 and 1996, and then surged to over 70% during 1999. However, more recent returns following the collapse of the NASDAQ market in March 2000 have been uniformly negative. A key question is whether the massive influx of new venture capital during the 1998-2000 period will have the same negative impact on returns over the next five years.

European private equity returns, also presented in Figure 4, show far less volatility, with the exception of two extremely negative returns in 1985 and 1986 followed by an extremely positive return during 1987. European private equity returns have also generally been significantly lower than American VC returns. In fact, a breakdown of European PE returns by fund type would show that buyout funds earned significantly higher returns than did true venture capital funds during the late 1980s and most of the 1990s, with European VC funds only achieving dramatically positive returns during the boom years from 1997 to 1999. On the other hand, European private equity fund returns have been far better than the massively negative returns earned by American

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VCs since March 2000. Looking forward, the returns that private equity investors can expect to earn will depend largely on whether and how much the public equity markets recover, and in particular whether the IPO window re-opens in Europe and the United States.

Exit Strategies Employed by Venture Capitalists and Private Equity Investors

Neither American venture capitalists nor European PE fund managers are long-term equity investors. Both groups desire to add value to a private company and then to harvest their investment once the company matures sufficiently. There are three principal methods of exiting an investment: (1) through an initial public offering (IPO) of shares to outside investors; (2) by selling the portfolio company directly to another company (the merger or M&A option); and (3) by selling the company back to the entrepreneur/founders (the redemption option[31]). IPOs are by far the most profitable and prestigious option for the venture capitalists. They are also a very realistic option, particularly in the United States; during the 1990-2000 period, 5,803 companies executed IPOs on American capital markets, and these issues raised $419.5 billion. The importance of venture capital-backed IPOs grew steadily over the decade, to the point where well over half of all IPOs in 1999 were VC-backed, and these represented almost half of the then-record $71.0 billion raised in that year.[32] VCs also create value at IPO by attracting prestigious underwriters and by certifying disclosure. Several researchers have found that VC backing reduced the level of IPO underpricing during the 1980s, though 1990s data show the opposite, especially during the "Internet Bubble" of 1999-2000.[33]

American venture capitalists do not exit at the time of an IPO, partly because the underwriters won't allow them to. Instead, they retain shares for several months or even years and then typically distribute stock back to the limited partners, rather than selling the shares on the open market.

One of the great disappointments of European policymakers wishing to duplicate America's success in high-technology development has been the failure, until very recently, to establish a large, liquid market for the stock of entrepreneurial growth firms. This has had a direct impact on the exit strategies of European venture capitalists.


These distributions usually occur after a period of sharply rising stock prices, and the average stock price response to distribution announcements, which are not generally anticipated, is significantly negative.[34]

European PE investors have traditionally faced a much more restricted set of exit opportunities. Trade sales and write-offs each accounted for roughly 30% of total divestments during 2002, with IPOs accounting for only about 5% of the ?10.7 billion total. In fact, one of the great disappointments of European policymakers wishing to duplicate America's success in high-technology development has been the failure, until very recently, to establish a large, liquid market for the stock of entrepreneurial growth firms. Although several stock markets exist, and these collectively rival U.S. exchanges in total capitalization of listed companies, no European market emerged as a serious alternative to America's NASDAQ or NYSE as a market for initial public offerings until the German Neuer Markt and other markets such the French Nouveau March‚ reached critical mass in the late 1990s. This has had a direct impact on the exit strategies that European venture capitalists followed in harvesting their investments in portfolio companies. The number of European IPOs surged after these markets matured, especially the Neuer Markt, which had attracted over 300 listings by early 2000.[35] Unfortunately, the Neuer Markt collapsed almost as fast as it took off, and the number of European IPOs fell from 249 in 2000 to a mere 47 in 2001. By the end of 2001, the Neuer Markt's total capitalization had fallen by over 90% from its March 2000 peak, amid a series of accounting scandals and great acrimony among investors, entrepreneurs, and exchange officials, and was officially shut down in June 2003. Today, the European IPO market remains effectively closed to all but the most wellestablished and profitable companies, though a few European (and a great many Israeli) technology companies have been able to execute IPOs on U.S. markets.

VENTURE CAPITAL MARKETS OUTSIDE THE UNITED STATES AND WESTERN EUROPE

The key markets outside of the United States and Western Europe are Canada, Israel, Japan, China, and India. The venture capital industries of Israel and Canada differ dramatically from those in other advanced countries. Canadian government policies led to its venture capital system being based on funds sponsored by labor unions.[36] Rapid growth in Canada's VC market during the late 1990s, however, weakened the union funds' grip on VC funding, and total investment grew at a compound annual rate of 60% between 1994 and 2000. In 2000, Canada was the world's fifth largest recipient of VC financing, and attracted almost as much investment ($4.3 billion versus $4.4 billion) as Germany, a nation five times as large. This preeminence was not to last, however; by 2002, Canada had fallen to ninth place overall, having attracted only $1.57 billion in total PE investment, though it still ranked fourth in high-tech investment.

In a relative sense, Israel has achieved the greatest success in venture capital and private equity, since it was the sixth largest recipient of PE funding in 2000 (receiving $3.2 billion) and the world's largest recipient when VC financing is expressed as a percent of GDP (3.17%). Even during 2002, Israel attracted almost $1 billion and remained the leader when PE investment is expressed as a percentage of GDP (0.95%). Part of Israel's success can be traced to deliberate policy decisions in the early 1990s by the Likud government, which took concrete steps to commercialize defense-related technology developed with public funding. The influx of trained engineers and scientists from the former Soviet Union also helped, as did the pioneering steps taken by Israeli entrepreneurs to go public in the United States, since this opened a path to public markets others could and did follow.

Venture capital fund-raising and investment in Asia grew significantly between 1995 and 2000, though much less rapidly than in Europe or the United States because of a moribund VC industry in Japan. Elsewhere in Asia, growth was more robust, albeit from a low base. Japan has a financial specialty referred to as "venture capital," but most of the firms involved are commercial or investment bank subsidiaries that make very few truly entrepreneurial investments.[37] Venture capital shows no real sign of taking root in Japan, and the world's second-largest economy attracted only $2.38 billion (0.06% of GDP) in venture funding in 2002. Although China is the fastest-growing major economy in the world, venture capital and private equity play very little role in its development, largely because the country lacks the basic legal infrastructure needed to support a vibrant VC market and because the Chinese stock markets are inefficient and highly politicized.[38]

In many ways, India is the most interesting and promising private equity market in the world today. It ranked 12th overall in total investment during 2002, up from 19th in 2000, and the total amount invested ($1.05 billion) was more than twice that of 2000. India's history as a former British colony has given it a common law legal system, multiple stock exchanges, and a heritage of English as the native tongue of its educated classes. India's rapid economic development since 1991 has been propelled both by the macroeconomic and market opening reforms adopted that year and by relatively large inflows of foreign investment, which were in turn attracted by India's vast potential and by the quality of the graduates of its elite universities and technical institutes. Crucially, much of India's growth has been in the IT sector, which is the traditional target of true venture capital investment. For all these reasons, India should become one of the five leading venture capital markets by the end of this decade.

What about venture capital investment in emerging markets besides China and India? An empirical analysis of the structures employed in 210 transactions by private equity investors in developing countries showed that convertible securities are rarely employed in developing countries, and that investors are much more likely to invest in traditional, low-tech industries in emerging markets than are American venture capitalists.[39] This analysis also found that a nation's legal system significantly impacts the transaction structure chosen for investments, with investors in countries with French or socialist legal systems showing much greater determination to achieve majority voting control than in English common law countries.

CONCLUSION: IS A GLOBAL MARKET FOR VENTURE CAPITAL AND PRIVATE EQUITY EMERGING?

So, is a truly global market for venture capital and private equity emerging? At least a superficial case can be made that this is occurring among the Atlantic economies of Western Europe and North America, since recent years have witnessed significant convergence in funding levels, investment patterns, and realized returns. Nonetheless, it appears that no truly integrated global venture capital market will likely emerge in the foreseeable future. Instead, we will probably continue to see what we've seen over the past decade-continued growth in the total value of venture funding and investment, but in largely segmented national markets. The biggest impediment to convergence is the difference in legal systems among countries. U.S. venture capital and European private equity are heavily dependent on legal regimes that are nation-specific and not easily transferable. What's more, the failure to date of every major IPO-oriented stock market in Europe and Asia suggests how fiendishly difficult it will be for even advanced countries to develop truly robust markets that entrepreneurial growth companies and their financiers can use to access the investing public.

On the other hand, there is reason to hope that venture capital and private equity finance will become a truly global industry over the long term, especially since a very strong rebound in

In many ways, India is the most interesting and promising private equity market in the world today. Crucially, much of India's growth has been in the IT sector, which is the traditional target of true venture capital investment.


fundraising and investment appears imminent. At this writing (late January 2004), the American economy is in the early stages of what promises to be a period of very rapid growth, while Europe and Japan also seem poised for at least reasonable growth and the key economies of Asia are growing at rates of 7% or more. Stock markets in all key regions have bounced back strongly from their lows of 2002, and there is even some evidence of a rebirth in IPOs. A rising stock market invariably promotes innovation and optimism, so we can expect new IPO markets to develop and old ones to revive. Perhaps most important, it now seems clear that private equity fund-raising and investment have hit their cyclical lows-at levels that are nonetheless ten times those seen in the 1991-1992 recession-and are poised for strong takeoffs. The ability of profit-seeking entrepreneurs and investors to commercialize scientific advances has been repeatedly demonstrated, and I believe that growth in venture capital and private equity will once again surprise on the upside. Specifically, the annual value of fund-raising and investment will surpass $250 billion globally within three or four years, and could reach one-half trillion dollars per year before the end of what promises to be a remarkable decade.

WILLIAM MEGGINSON is Professor & Rainbolt Chair in Finance at the University of Oklahoma's Price College of Business.


[*] This paper is based on Chapter 15 of Corporate Finance (Cincinnati: South- Western Publishing Company, 2004) which I co-authored with Scott B. Smart and Larry J. Gitman; the chapter is entitled "Entrepreneurial Finance and Venture Capital." I am grateful for comments received during presentations at Peking University and Tsinghua University (Beijing, PRC) in May 2002, and on earlier versions of the material in this paper presented at the Shanghai Seminar on Venture Capital Development, Fudan University (Shanghai, PRC) in December 1999, at the Chinese University of Hong Kong in October 2000, and in various graduate and undergraduate classes in the engineering and business schools of the University of Oklahoma. I am also very grateful to Richard Testa and Suzanne Trimbath for providing detailed comments on an earlier draft, to Keith Arundale of PricewaterhouseCoopers for making several tables and figures collected by his firm available to me in machine-readable format, and to Janice Willett for very professional assistance in editing and shortening the manuscript. I also appreciate comments received from Marco Da Rin, Grant Fleming, Jim Verbrugge, Thomas Hellmann, Josh Lerner, Florencio L¢pez-de-Silanes, Sunil Wahal, and Peter Wolken. Finally, the financial support of the Milken Institute (in the form of an Outstanding Research Award) in revising this manuscript is gratefully acknowledged.

[1] The study is by DRI-WEFA and is available at www.nvca.com.

[2] See John Taylor, Channa Brooks, and Andrew Hodge, "DRI-WEFA Study Identifies Venture Capital as a Key Factor Powering U.S. Economic Growth," www.nvca.com, June 26, 2002.

[3] The study is entitled "The Economic Impact of Venture Capital in Europe" and is available at www.evca.com.

[4] These data are from the EVCA Final Survey of Pan-European Private Equity and Venture Capital Activity 2002, published by EVCA (www.evca.com), June 4, 2003.

[5] See the Survey of the Economic and Social Impact of Venture Capital in Europe, published by EVCA (www.evca.com), June 20, 2002.

[6] Several studies document significant value creation by VCs. See Tyzoon T. Tyebjee and Albert V. Bruno, "A Model of Venture Capitalist Investment Activity," Management Science, Vol. 30 (September 1984), pp. 1051-1066; William A. Sahlman, "Aspects of Financial Contracting in Venture Capital," Journal of Applied Corporate Finance, Vol. 1 (Summer 1988), pp. 23-36 and "The Structure and Governance of Venture Capital Organizations," Journal of Financial Economics, Vol. 27 (September 1990), pp.473-524; Michael Gorman and William A. Sahlman, "What do Venture Capitalists Do?," Journal of Business Venturing, Vol. 4 (1989), pp. 231-248; Josh Lerner, "Venture Capitalists and the Oversight of Private Firms," Journal of Finance, Vol. 50 (March 1995), pp. 301-318; and Thomas Hellmann and Manju Puri, "Venture Capital and the Professionalization of Start-Up Firms: Empirical Evidence," Journal of Finance, Vol. 57 (February 2002), pp. 169-197.

[7] See Steven Kaplan and Per Str”mberg, "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," Review of Economic Studies, Vol. 70 (April 2003), pp. 281-315.

[8] See Thomas Hellmann and Manju Puri, "The Interaction Between Product Market and Financing Strategy: The Role of Venture Capital," Review of Financial Studies, Vol. 13 (Winter 2000), pp. 959-984.

[9] The promises and challenges confronting private equity investors in developing countries are discussed at length in Roger Leeds and Julie Sunderland, "Private Equity Investing in Emerging Markets," Journal of Applied Corporate Finance, Vol. 15 (Fall 2003), pp. 111-119.

[10] Annual disbursements naturally differ from total fund-raising since the total amount of money available for investment is the sum of realized investment returns (from IPOs and mergers of portfolio companies), net of returns of capital to fund investors, and new fund inflows.

[11] A number of academic studies have examined how various factors- especially the incidence and levels of personal and corporate taxation-influence the amount of money raised and invested by American venture capital funds each year. Paul Gompers and Josh Lerner found that decreases in capital gains tax rates appear to have a positive and important impact on commitments to new venture capital funds. This is actually rather surprising, since the dominant investors in VC funds are untaxed pension funds. They conclude that the relationship between taxation and VC commitments is an induced one-in that reductions in tax rates cause more entrepreneurs to start companies and thus demand private equity financing; see their article entitled "What Drives Venture Capital Fundraising?," Brookings Papers on Economic Activity-Microeconomics (1998), pp. 149-192. Other researchers have also suggested that the entrepreneurship entry decision is highly sensitive to tax rates; see William M. Gentry and R. Glenn Hubbard, "Tax Policy and Entrepreneurial Entry," American Economic Review, Vol. 90 (May 2000), pp. 283-287.

[12] Interestingly, these percentages are significantly lower for the leading countries in 2002 than was the case at the height of the boom in 2000. During that year, private equity financing was equal to more than 1.3% of GDP in Britain, Singapore, and America, and equaled an astounding 3.17% of Israel's GDP. For a case study analysis of the factors contributing to Israel's success as a market for venture capital fund raising and investment, see L.A. Jeng and P.C. Wells, "The Determinants of Venture Capital Funding: Evidence Across countries," Journal of Corporate Finance, Vol. 6 (September 2000), pp. 241-289. Their study highlights the catalytic role government policy can play in promoting VC spending, though their analysis of Germany's much less successful development program also points to the drawbacks of an active governmental role. As it happens, Israel's private equity market was hit harder than any other between 2000 and 2002, showing quite painfully that even successful venture capital innovators can be severely weakened by global recession and political turmoil.

[13] See Rafael La Porta, Florencio L¢pez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, "Legal Determinants of External Finance," Journal of Finance, Vol. 52 (July 1997), pp. 1131-1150, "Law and Finance," Journal of Political Economy, Vol. 106 (1998), pp. 1113-1150, and "Agency Problems and Dividend Policies Around the World," Journal of Finance, Vol. 55 (February 2000), pp. 1- 33.

[14] This result also holds, albeit less robustly, if China's extreme R&D to GDP ratio of 4.85% is excluded.

[15] Two other recent academic studies examining international differences in venture capital usage found that venture capital is much more important in countries with large domestic capital markets. See Bernard S. Black and Ronald J. Gilson, "Venture Capital and the Structure of Capital Markets: Banks versus Capital Markets," Journal of Financial Economics, Vol. 47 (March 1998), pp. 243- 277; and L.A. Jeng and P.C. Wells, "The Determinants of Venture Capital Funding: Evidence Across Countries," Journal of Corporate Finance, Vol. 6 (September 2000), pp. 241-289. The latter study in particular showed that later-stage VC funding levels are especially sensitive to the health and size of a country's IPO market, and their regression analyses show that venture financing is significantly less important in civil law than in common law countries.

[16] The angel capital market is discussed in Josh Lerner, "Angel Financing and Public Policy: An Overview," Journal of Banking and Finance, Vol. 22 (August 1998), pp. 773-783; John Freear, Jeffrey E. Sohl, and William E. Wetzel, Jr., "The Informal Venture Capital Market: Milestones Passed and the Road Ahead," in Donald L. Sexton and Raymond W. Smilor, Eds., Entrepreneurship 2000 (Chicago: Upstart Publishing Company, 2000); and Andrew Wong, "Angel Finance: The Other Venture Capital," Working Paper, University of Chicago (November 2001). Some of the pitfalls that can be encountered by entrepreneurs seeking funding are described in Stephanie Gruner, "The Trouble With Angels," Inc. (February 1998), pp. 47-49. The Financial Times cited a Global Entrepreneurship Monitor 2001 report suggesting that informal investors (angels) provide about $196 billion to startup and early stage companies in 29 countries each year ("Informal Financing Totals $196bn a Year," November 15, 2001, p. 31).

[17] The organizational forms of venture capital firms are described in detail in Stanley E. Pratt, "The Organized Venture Capital Community," in Pratt's Guide to Venture Capital Sources (New York: Securities Data Publishing, 1997), pp. 75- 80. A very helpful description of the organization and practices of the American VC industry is provided in the "Industry Overview" section of the National Venture Capital Association website (www.nvca.com).

[18] See Paul Gompers and Josh Lerner, "The Venture Capital Revolution," Journal of Economic Perspectives, Vol. 15 (Spring 2001), pp. 145-168.

[19] Gompers and Lerner (2001), cited earlier.

[20] See Laura Bottazzi, Marco Da Rin, and Thomas Hellmann, "The Changing Face of the European Venture Capital Industry: Facts and Figures," Working Paper, Bocconi University and Stanford University (2003). This is a summary report on the Survey of European Venture Capital, funded by a grant from the European Investment Fund.

[21] See www.evca.com.

[22] The industrial sectors attracting European PE investment during 2002 included industrial products and services (?4.7 billion), communications (?2.5 billion), computer-related sectors (?1.5 billion), medical/health-related (?1.6 billion), biotechnology (?1.1 billion), and financial services (?1.1 billion).

[23] Steven Kaplan and Per Str”mberg presented what is probably the most comprehensive academic analysis of how VCs contract with entrepreneurs to allocate cash flow and control rights between the firm and the VC fund in "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," Review of Economic Studies, Vol. 70 (April 2003), pp. 281-315. In another study, they described how the allocation of control rights between the venture capitalist and entrepreneur is determined, and they empirically examined the actual process of VC investment screening and decision-making and showed that many factors-market size, business strategy, the firm's technology and customer base, and potential competition-all influence the investment decision; see "Contracts, Characteristics, and Actions: Evidence from Venture Capitalist Analyses," Journal of Finance (forthcoming 2004). Malcolm Baker and Paul A. Gompers examined how board seats are allocated in "The Determinants of Board Structure at the Initial Public Offering," Working Paper, Harvard Business School (May 2001). Alistair Christopher described several important legal hurdles venture capitalists must confront when evaluating an investment opportunity in "VC and the Law: Potential Legal Hurdles Involved in Funding the Next Big Thing," Venture Capital Journal (February 2001), pp. 43-45.

[24] There is striking evidence of the impact of unusually heavy cash inflows into the VC industry. During the periods 1987-1990 and 1992-1995, large inflows significantly inflated target company valuations, and this impact was greatest in VCintensive regions (especially California and Boston) and for later-stage companies that could profitably employ larger cash infusions. See Paul Gompers and Josh Lerner, "Money Chasing Deals? The Impact of Fund Inflows on Private Equity Valuations," Journal of Financial Economics, Vol. 55 (February 2000), pp. 281-325.

[25] Entrepreneurs wishing to determine how much capital they should try to obtain from VCs should read the classic article by James McNeill Stancill, "How Much Money Does Your New Venture Need?," Harvard Business Review (May-June 1987), pp. 122-139.

[26] There are two classic examples of how staged financing should work in the development of private companies: Apple Computer and Federal Express. Apple received three rounds of private equity funding. In the first round, venture capitalists purchased stock at $0.09 per share, but this rose to $0.28 per share in the second round and then $0.97 per share in the third round. Needless to say, all of these investments proved spectacularly profitable when Apple went public at $22 per share in 1980. On the other hand, investors in Federal Express used staged financing with more telling effect during their three rounds of private equity financing. The investors purchased stock for $204.17 per share in round one, but the firm's early performance was much poorer than anticipated. In the second round, shares were purchased for $7.34 each, but the company's finances continued to deteriorate so a third financing round, at $0.63 per share, was required. As we know, FedEx eventually became a roaring success, and went public at $6 per share in 1978, but staged financing allowed venture capitalists to intervene decisively during the firm's problematic early development. See Paul A. Gompers, "Optimal Investment, Monitoring, and the Staging of Venture Capital," Journal of Finance, Vol. 50 (December 1995), pp. 1461-1489.

[27] Numerous theoretical studies have attempted to explain the use of convertibles by venture capitalists; see Anat Admati and Paul Pfleiderer, "Robust Financial Contracting and the Role of Venture Capitalists," Journal of Finance, Vol. 49 (June 1994), pp. 371-402; Thomas Hellmann, "The Allocation of Control Rights in Venture Capital Contracts," Rand Journal of Economics (Spring 1998), pp. 57- 76; Erik Bergl”f, "A Control Theory of Venture Capital Finance," Journal of Law, Economics and Organization, Vol. 10 (1994), pp. 447-471; and, most recently, Andreas Bascha and Uwe Walz, "Convertible Securities and Optimal Exit Decisions in Venture Capital," Journal of Corporate Finance, Vol. 7 (September 2001), pp. 285-306. To my knowledge, however, the only empirical academic study of convertible usage is by Paul A. Gompers and Josh Lerner, "Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities in Venture Capital Investments," Working Paper, Harvard Business School (September 1997).

[28] Since most existing stockholders are prohibited by law (Rule 144) or by their investment bankers from selling their shares during a firm's IPO and for up to two years thereafter, there is an additional reason to convert quasi-equity claims such as convertible debt and preferred stock into common stock well before the initial offering. Doing so starts the holding-period clock that much sooner.

[29] Bottazzi, Da Rin, and Hellman (2003), cited earlier.

[30] Gompers and Lerner (2001), cited earlier.

[31] See Charles R. Fellers, "Making an Exit: VCs Examine their Options," Venture Capital Journal (May 2001), pp. 40-42; and "With Companies Faltering, VCs Look at Redemption Exit," Venture Capital Journal (June 2001), pp. 34-38.

[32] See Gompers and Lerner (2001), cited earlier.

[33] See Christopher Barry, Chris Muscarella, John Peavy, and Michael Vetsuypens, "The Role of Venture Capital in the Creation of Public Companies: Evidence from the Going Public Process," Journal of Financial Economics, Vol. 27 (1990), pp. 447-471; William L. Megginson and Kathleen A. Weiss, "Venture Capitalist Certification in Initial Public Offerings," Journal of Finance, Vol. 46 (July 1991), pp. 879-902; Randolph Beatty and Ivo Welch, "Issuer Expenses and Legal Liability in Initial Public Offerings," Journal of Law and Economics, Vol. 39 (December 1996), pp. 545-602; and Peggy M. Lee and Sunil Wahal, "Venture Capital, Certification and IPOs," Journal of Finance (forthcoming).

[34] See Paul Gompers and Josh Lerner, "Venture Capital Distributions: Short- Run and Long-Run Reactions," Journal of Finance, Vol. 53 (December 1998), pp. 2161-2183; and Daniel J. Bradley, Bradford D. Jordan, Ha-Chin Yi, and Ivan C. Rohen, "Venture Capital and IPO Lockup Expiration: An Empirical Analysis," Journal of Financial Research, Vol. 24 (Winter 2001), pp. 465-492. According to an NVCA press release on October 16, 2001, the value of cash and stock distributed to limited partners by VCs grew from $1.88 billion during the first quarter of 1999 to an astounding $18.72 billion during the first quarter of 2000, but then fell steadily back to $2.10 billion during 2Q 2001.

[35] For an analysis of the reasons why German entrepreneurs decided to go public on the Neuer Markt, see Christoph Fischer, "Why do Companies Go Public? Empirical Evidence from Germany's Neuer Markt," Working Paper, University of Munich (May 2000). For a "law and finance" explanation of the ownership structures adopted by the entrepreneurs of all the Swedish IPOs executed over the past quarter-century, see Martin Holm‚n and Peter H”gfeldt, "A Law and Finance Analysis of Initial Public Offerings," Working Paper, Stockholm University (June 2001). Finally, Australia's vibrant VC industry is described in Grant Fleming, "Venture Capital Returns in Australia," Venture Capital: An International Journal of Entrepreneurial Finance, Vol. 6 (forthcoming 2004).

[36] See Seth Fineberg, "Canada's Labor Funds Adapt to Tighter Regs," Venture Capital Journal (March 1997), pp. 28-30.

[37] See Frank Packer, "Venture Capital, Bank Shareholding, and IPO Underpricing in Japan," in Mario Levis, Ed., Empirical Issues in Raising Equity Capital (Amsterdam: North Holland, 1996), pp. 191-214; and Yasushi Hamao, Frank Packer, and Jay Ritter, "Institutional Affiliation and the Role of Venture Capital: Evidence from Initial Public Offerings in Japan," Pacific-Basin Finance Journal, Vol. 8 (2000), pp. 529-558. A comparison of the investment practices of Chinese and foreign VC firms operating in mainland China is presented in Zhang Wei and Jiang Yanfu, "The Relationship Between Venture Capitalists' Experience and their Involvement in VC-backed Companies," Working Paper, Tsinghua University (Beijing, 2002) and a similar study of VC investment practices in Singapore is provided in Kangmao Wang, Clement K. Wang, and Qing Lu, "Differences in Performance of Independent and Finance-Affiliated Venture Capital Firms," Journal of Financial Research, Vol. 25 (Spring 2002), pp. 59-80.

[38] The historical evolution of China's venture capital industry is discussed by Steven White, Jian Gao, and Wei Zhang in "China's Venture Capital Industry: Institutional Trajectories and System Structure," Working Paper, INSEAD and Tsinghua University (2003).

[39] See Josh Lerner and Antoinette Schoar, "Transaction Structures in the Developing World: Evidence from Private Equity," Working Paper, Harvard University and MIT (2003).