Role of Venture Capital in Spurring Innovation and Entrepreneurship

By Ansari, Valeed A.; Mohd, Ahmar Uddin | Asia-Pacific Business Review, January-March 2009 | Go to article overview

Role of Venture Capital in Spurring Innovation and Entrepreneurship


Ansari, Valeed A., Mohd, Ahmar Uddin, Asia-Pacific Business Review


Introduction

Venture capital is an investment in the form of equity, quasi-equity and sometimes debt, straight or conditional (interest and principal payable when the venture starts generating sales), made in a new or untried technology, or high risk venture, promoted by a technically or professionally qualified entrepreneur, where the venture capitalist

* Expects the enterprise to have a very high growth rate

* Provides management and business skills to the enterprise

* Expects medium to long term gains

* Does not expect any collateral to cover the capital provided

The origins of modern venture capital can be traced to USA. After World War II, a set of intermediaries emerged in the U.S., who specialized in investing in young firms having the potential for extremely rapid growth. From its earliest beginnings on the East Coast of U.S., venture capital gradually expanded and became an increasingly specialized institution. During this period, the locus of the venture capital industry shifted from New York and Boston on the East Coast to Silicon Valley on the West Coast Florida (Richard and Martin Kenney, 1998). In India the discussion on venture capital started in 1972 when government examined strategies to promote small and medium enterprises (NASSCOM 2000). In 1975, Industrial Financial Corporation of India (IFCI) introduced venture capital financing in India with an aim to encourage professionals and technologist to form new industries. The Table 1 highlights the contribution of venture capital in India to innovative projects by entrepreneurs.

Problems faced by entrepreneurs in funding new and innovative projects

The literature on capital constraints documents that an inability to obtain external financing limits many business ventures (Glenn, 1996). Studies such as Hall, 1992; Hao and Jaffe 1993; Himrnelberg and Petersen 1994, show that capital constraints appear to limit research-and-development expenditures, especially in smaller firms. Entrepreneurs while raising capital face a number of problems. Funding of business ventures usually poses a dilemma for entrepreneurs because to begin with, many times entrepreneurs do not have funds to finance ventures from their own funds and then, in general private banks are also usually unwilling to lend money to a small and newly established firms (Rangarajan, 1980). Many studies have been conducted on the problems faced by entrepreneurs in raising funds. Researchers like Jensen and Mecklings (1976) have advanced the agency theory, they have demonstrated that conflict between the managers and investors can affect the problems faced by entrepreneurs in raising funds. The difficulties faced by entrepreneurs have been sorted out into four critical factors by Gompers and Lerner (2005).

Uncertainty in the potential outcomes for a company or a project, becomes wider with the dispersion.

Uncertainty can be due to reasons such as; whether the research program or new product will succeed, what will be the response of rival firms. Because of uncertainty the entrepreneur faces problems in raising funds.

(i) Asymmetric information-as the entrepreneur is involved in the day-to-day action he knows more about the company's prospects than the investors. Investors are worried that entrepreneur may take actions that are in his self-interest and it becomes difficult to distinguish between good and bad entrepreneur. Fearing such actions from the entrepreneurs the investors hesitate to invest.

(ii) Nature of firm's assets-firms that have tangible assets such as land, machinery may find it easier to raise funds. But when the assets are intangible it becomes relatively difficult to raise funds.

(iii) Conditions in the relevant financial and product market-if there is an intense competition or a great deal of market uncertainty about the size of the potential market, firms may find it difficult to raise capital. …

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Role of Venture Capital in Spurring Innovation and Entrepreneurship
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