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Venture capital backed innovation

Prof. Dr. Christian Keuschnigg discusses his observations regarding venture capital during his work at the Institute of Economics (FGN-HSG)

Innovation drives growth. New products and services replace old ones. But this process of creative destruction can raise aggregate productivity only if capital and labor are reallocated. Less productive firms must exit and release resources for better use in new ventures. Venture capitalists and banks play a decisive role in steering capital to new uses to speed up the economy’s rejuvenation.

Venture capital is most important in financing the most innovative and riskiest start-ups with the largest growth potential. They intensively screen business plans and may select only five out of hundred proposals. They supply risk capital to firms, provide oversight and control, and offer strategic advice to promote the professionalisation of firms and create the next generation of business giants. Venture capital (VC) is most important in the earliest and riskiest phase of business growth. Typically, VC firms exit their investments after five to ten years to reinvest in the next wave of start-ups. If there were no venture capital, many of the most daring and promising new business ideas might never get started. An active VC industry plays an important role in financing the flow of new ideas.

Banks, in contrast, must limit their risk exposure to safeguard the depositors’ money, and predominantly finance more mature firms: business risk is much lower, and firms can offer collateral. They typically offer co-financing of risky start-ups only when a VC is present to intensively monitor and advise firms. Bank monitoring is more standardized and less intensive. Banks thus finance a much larger number of relatively safe firms and can better diversify credit risk. Still, many things can go wrong. The quality of the credit portfolio deteriorates when too many loans become ‘non-performing’. Banks should continue credit lines when difficulties are only temporary. If firms are no longer competitive, it is better to liquidate them and sell the good parts to other firms which are more productive. If banks are not alert, too many ‘Zombie’ firms survive and lock up the economy’s resources in unproductive uses.

Innovation by creative destruction has two ends, new firm creation and business destruction. Both activities are important drivers of productivity growth. Venture capitalists and banks play together to keep the cycle going.

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