Final Report Summary - RICAFE2 (Regional Comparative Advantage and Knowledge Based Entrepreneurship)
The main objective of the RICAFE2 project was to develop an advanced understanding and a comprehensive response to the questions of how the availability of risk capital contributes to the innovativeness of European firms and how current developments in the European models of provision of risk capital affect economic growth and shape policy options and priorities. The guiding principle of our work has been to provide an in-depth empirical and conceptual assessment of the working of the markets for risk capital in Europe which may serve as informed and well-grounded blueprint for the ongoing implementation of effective policies to foster the growth of innovative, entrepreneurial firms and therefore to increase EU-wide innovative capacity.
A number of major conclusions were reached. We analysed the factors, which positively affect the success of risk capital investments and the financing of innovative firms. We showed the influence of legal structures, taxation, organisational structures and characteristics of financiers on the ability to channel funds to promising new firms and to influence their successful development. We supported lower capital gains taxes favour risk capital financing of innovative firms. Tax exemptions provide incentives to financiers to successfully support and develop entrepreneurial projects. In volatile market settings, time-varying corporate and income tax policies may also help stabilise of the flow of funds. Enhancing the comparability of company accounts across markets and lowering the different degrees and forms of regulations in capital markets increases market transparency and raises the value creation ability of private risk capital financing. Regulators should also tackle how unrealised private equity investments should be accounted for at fund maturity.
Contractual structures in innovation financing
We discussed several aspects of the contractual structures and non-contractual instruments used by venture capital investors. We focused on the role of legal structures in affecting the ability of financing contracts to provide incentives to entrepreneurs and venture capitalists. Overall, we found that higher procedural complexities and lower quality of legal enforcement reduce the quality of risk capital financing. We studied also the role of contractual relationships in public policy for entrepreneurial financing.
The role of exit opportunities
We addressed one of the crucial determinants of successful venture financing: the ability of investors to exit their investments. Financiers and entrepreneurs use various contractual structures with a direct effect on the anticipated exit in later stages of their relationship. These structures enable the contracting parties to establish contingent payoff and control structures, which ensure the ongoing preservation of incentives and the provision of efforts. Our analysis calls for policy actions that impose strict standards on IPO processes that reduce the ability of banks and financial analysts to favour certain parties of the transaction. In particular, the allocation of shares in primary offerings should be guided by tight rules and transparent oversight. Additionally, our research calls for an acknowledgement of the different roles played by independent and captive VCs. More flexible regulation would improve the successful floatation of innovative companies on European stock exchanges.
The relationship between limited and general partners in VC funds. We discuss the provision of funds by investors to specialised intermediaries (venture capital and private equity funds), which channel capital to innovative firms. We discuss those aspects of governance of funds and agency problems, which are relevant for the successful development of an investor base in the asset class of risk capital investments. Several institutional and regulatory means are identified to foster this development.
Financing and the protection of intellectual property rights
The protection of intellectual property via patents is a crucial requirement for innovative activity in the first place. We link corporate innovation and financial instruments with the ability of firms to protect the rents arising from their innovation activities. While patent litigation insurance can help small firms to defend themselves against infringers, mandatory insurance of one kind either leads to excessive litigation or potential under-protection of some firms. The implication for policy-makers is to support the development of competitive insurance markets that will be able to provide efficient insurance contracts tailored to the individual needs and characteristics of innovators.
The European market for risk capital in international comparison
We provide an overview of major differences between the European market for risk capital and the United States market. Successful financing and development of European innovative firms depends strongly on the functioning of its capital markets. Whereas some policy measures unambiguously improve the value of innovation financing (such as increasing market transparency within markets but also across European markets), other means that affect capital market competition might create new imbalances. In particular, excessive supply of funds may occur due to public provision of funds, lowering of venture funds' entry cost or due to overly favourable tax treatments. Our analysis indicates that venture capital firms in Europe are more dealmakers and less active monitors than their American counterparts; they seem to be still lagging in their capacity to select projects and add value to innovative firms. A set of (complex) contractual structures and solutions to problems of asymmetric information has evolved in the mature United States market; these are yet to be fully developed in Europe. Therefore, fostering the professionalisation and maturation of European venture capital firms should be a more effective policy than trying to channel more funds into the industry.
Regulatory frameworks and conditions favouring risk capital financing
Our analysis covers an extensive set of factors, which our research identified to be highly relevant for successful risk capital financing. In particular, we focus on corporate governance rules. Our findings highlight the important role of venture firms as financiers, which allows them to influence the behaviour of the firms they invest in. Adequate corporate governance regulation and legal enforcement mechanisms are keys for these financiers to fulfil their role. Rules fostering good corporate governance emerge as a mechanism to strengthen the role of venture capital firms in Europe and to improve the attractiveness of this asset class for institutional investors. Such issues seem to have been so far overlooked, and our research put them back among policy relevant ones.
Public policy for risk capital
Public policy should foster the maturation of the European venture capital industry by encouraging the creation of independent venture capital firms and of the accumulation of human capital by venture patterns. While the public provision of funds appears to have helped in the development phases of Europe's risk capital market, there is no positive impact detectable any more. On the contrary, ill-designed fund provision can be detrimental as it reduces investors' ability to design appropriate contractual structures. We argue in favour of non-grant support schemes. Venture firms should be helped to recoup their funding after exits, which calls for the creation of active stock markets. The governance of venture firms should lead to incentive-based management compensation also in the public sector.
Public policy for entrepreneurial firms
Public support can be effective, but it needs to take into proper account the many agency and incentives issues which characterise the financing of innovative firms. Public private partnerships and grants to successfully developed entrepreneurial projects are effective instruments. Key success drivers for future initiatives are independence of public fund managers from political pressure; co-financing by private funds; clear investment guidelines on targets and policies; and performance-related compensation schemes. We argue that promoting innovation by increasing R&D expenditure will be more effective than stimulating the funding of the venture capital industry. Another way to enhance innovation and the creation of growth firms would be the support of regional innovation clusters.
A major strength of the project has been its ability to provide a rigorous assessment of the link between risk capital financing, innovation, and growth. While several studies existed which focus on one, or two, of these elements, we started off with the goal to offer a deeper understanding of the current changes in the EU by providing an empirical assessment and conceptual explanation of how all these factors interact. We have therefore developed theoretical work, which has provided guidance for the collection of data and helped interpret the results of the empirical analysis. However, the project has been mainly empirical in nature, and it produced an original set of evidence integrating financial and innovation data.
A number of major conclusions were reached. We analysed the factors, which positively affect the success of risk capital investments and the financing of innovative firms. We showed the influence of legal structures, taxation, organisational structures and characteristics of financiers on the ability to channel funds to promising new firms and to influence their successful development. We supported lower capital gains taxes favour risk capital financing of innovative firms. Tax exemptions provide incentives to financiers to successfully support and develop entrepreneurial projects. In volatile market settings, time-varying corporate and income tax policies may also help stabilise of the flow of funds. Enhancing the comparability of company accounts across markets and lowering the different degrees and forms of regulations in capital markets increases market transparency and raises the value creation ability of private risk capital financing. Regulators should also tackle how unrealised private equity investments should be accounted for at fund maturity.
Contractual structures in innovation financing
We discussed several aspects of the contractual structures and non-contractual instruments used by venture capital investors. We focused on the role of legal structures in affecting the ability of financing contracts to provide incentives to entrepreneurs and venture capitalists. Overall, we found that higher procedural complexities and lower quality of legal enforcement reduce the quality of risk capital financing. We studied also the role of contractual relationships in public policy for entrepreneurial financing.
The role of exit opportunities
We addressed one of the crucial determinants of successful venture financing: the ability of investors to exit their investments. Financiers and entrepreneurs use various contractual structures with a direct effect on the anticipated exit in later stages of their relationship. These structures enable the contracting parties to establish contingent payoff and control structures, which ensure the ongoing preservation of incentives and the provision of efforts. Our analysis calls for policy actions that impose strict standards on IPO processes that reduce the ability of banks and financial analysts to favour certain parties of the transaction. In particular, the allocation of shares in primary offerings should be guided by tight rules and transparent oversight. Additionally, our research calls for an acknowledgement of the different roles played by independent and captive VCs. More flexible regulation would improve the successful floatation of innovative companies on European stock exchanges.
The relationship between limited and general partners in VC funds. We discuss the provision of funds by investors to specialised intermediaries (venture capital and private equity funds), which channel capital to innovative firms. We discuss those aspects of governance of funds and agency problems, which are relevant for the successful development of an investor base in the asset class of risk capital investments. Several institutional and regulatory means are identified to foster this development.
Financing and the protection of intellectual property rights
The protection of intellectual property via patents is a crucial requirement for innovative activity in the first place. We link corporate innovation and financial instruments with the ability of firms to protect the rents arising from their innovation activities. While patent litigation insurance can help small firms to defend themselves against infringers, mandatory insurance of one kind either leads to excessive litigation or potential under-protection of some firms. The implication for policy-makers is to support the development of competitive insurance markets that will be able to provide efficient insurance contracts tailored to the individual needs and characteristics of innovators.
The European market for risk capital in international comparison
We provide an overview of major differences between the European market for risk capital and the United States market. Successful financing and development of European innovative firms depends strongly on the functioning of its capital markets. Whereas some policy measures unambiguously improve the value of innovation financing (such as increasing market transparency within markets but also across European markets), other means that affect capital market competition might create new imbalances. In particular, excessive supply of funds may occur due to public provision of funds, lowering of venture funds' entry cost or due to overly favourable tax treatments. Our analysis indicates that venture capital firms in Europe are more dealmakers and less active monitors than their American counterparts; they seem to be still lagging in their capacity to select projects and add value to innovative firms. A set of (complex) contractual structures and solutions to problems of asymmetric information has evolved in the mature United States market; these are yet to be fully developed in Europe. Therefore, fostering the professionalisation and maturation of European venture capital firms should be a more effective policy than trying to channel more funds into the industry.
Regulatory frameworks and conditions favouring risk capital financing
Our analysis covers an extensive set of factors, which our research identified to be highly relevant for successful risk capital financing. In particular, we focus on corporate governance rules. Our findings highlight the important role of venture firms as financiers, which allows them to influence the behaviour of the firms they invest in. Adequate corporate governance regulation and legal enforcement mechanisms are keys for these financiers to fulfil their role. Rules fostering good corporate governance emerge as a mechanism to strengthen the role of venture capital firms in Europe and to improve the attractiveness of this asset class for institutional investors. Such issues seem to have been so far overlooked, and our research put them back among policy relevant ones.
Public policy for risk capital
Public policy should foster the maturation of the European venture capital industry by encouraging the creation of independent venture capital firms and of the accumulation of human capital by venture patterns. While the public provision of funds appears to have helped in the development phases of Europe's risk capital market, there is no positive impact detectable any more. On the contrary, ill-designed fund provision can be detrimental as it reduces investors' ability to design appropriate contractual structures. We argue in favour of non-grant support schemes. Venture firms should be helped to recoup their funding after exits, which calls for the creation of active stock markets. The governance of venture firms should lead to incentive-based management compensation also in the public sector.
Public policy for entrepreneurial firms
Public support can be effective, but it needs to take into proper account the many agency and incentives issues which characterise the financing of innovative firms. Public private partnerships and grants to successfully developed entrepreneurial projects are effective instruments. Key success drivers for future initiatives are independence of public fund managers from political pressure; co-financing by private funds; clear investment guidelines on targets and policies; and performance-related compensation schemes. We argue that promoting innovation by increasing R&D expenditure will be more effective than stimulating the funding of the venture capital industry. Another way to enhance innovation and the creation of growth firms would be the support of regional innovation clusters.
A major strength of the project has been its ability to provide a rigorous assessment of the link between risk capital financing, innovation, and growth. While several studies existed which focus on one, or two, of these elements, we started off with the goal to offer a deeper understanding of the current changes in the EU by providing an empirical assessment and conceptual explanation of how all these factors interact. We have therefore developed theoretical work, which has provided guidance for the collection of data and helped interpret the results of the empirical analysis. However, the project has been mainly empirical in nature, and it produced an original set of evidence integrating financial and innovation data.
