Venture capital financed investments in intellectual capital

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  • Journal of Economic Dynamics & Control 30 (2006) 23392361

    Venture capital nanced investments

    partially nanced by venture capital. Among the questions that the paper addresses are: how


    Corresponding author. Department of Econometrics & Operations Research and CentER, TilburgUniversity, P.O. Box 90153, 5000 LE Tilburg, The Netherlands. Tel.: +31 13 4662062;0165-1889/$ - see front matter r 2005 Elsevier B.V. All rights reserved.


    fax: +3113 4663280.

    E-mail address: (P.M. Kort).much venture capital should be acquired to help nance the development of the rm? How

    should a wish to grow, with the aim of making a breakthrough in the IT area, be balanced

    against the stockholders wish to consume? The problem is studied as an optimal control

    problem with a random time horizon and we derive a series of prescriptions for investment

    and nancial decisions.

    r 2005 Elsevier B.V. All rights reserved.

    JEL classification: D92; G24; O32

    Keywords: Intellectual capital accumulation; Investment; Dividends; Venture capital; Stochastic optimal

    controlin intellectual capital

    Steffen Jrgensena, Peter M. Kortb,c,, Engelbert J. Docknerd

    aDepartment of Business and Economics, University of Southern Denmark, Odense, DenmarkbDepartment of Econometrics & Operations Research and CentER, Tilburg University,

    Tilburg, The NetherlandscDepartment of Economics, University of Antwerp, Antwerp, Belgium

    dDepartment of Finance and Vienna Graduate School of Finance, University of Vienna, Vienna, Austria

    Received 29 March 2004; accepted 11 July 2005

    Available online 29 September 2005


    The paper considers a new company in the IT industry, founded by a management team and


    S. Jrgensen et al. / Journal of Economic Dynamics & Control 30 (2006) 2339236123401. Introduction

    The information technology (IT) industry has been characterized by a rapidgrowth of the number of new rms entering the industry. New product and serviceinnovations are being developed and marketed in increasing numbers. Growth hasbeen fast in software development, e-business, internet services, and web design, butalso the telecommunications industry has seen a rapid increase in new equipmentand services. Many new rms have experienced a fast growth in terms of the numberof employees, but the growth has necessarily not been nancially sound. Somecompanies have used substantial parts of their equity, and the venture capital theyattracted, to cover losses incurred by attempts to grow rapidly, and others headedfor bankruptcy due to severe operating losses. Quite a few businesses were liquidatedwithout having generated a single dollar of revenue.This paper sets up a model of investment and nancial decision making in a new

    rm, and derives a series of prescriptions for its growth and nancing. Suppose thatthe company is founded at time t 0, by acquiring another rm in the industry. Therm thus acquires a stock of intangible assets: specialized employee skills,knowledge, expertise, experience, and information. It has been argued that weare entering the knowledge society in which the basic economic resource is no longercapital. . . but is and will be knowledge (Drucker, 1995). Zingales (2000) positedthat during the last decade, knowledge has replaced capital stocks as the main assetof a rm. Supposing knowledge can be capitalized, we summarize the rmsintangible assets in a stock of intellectual capital (IC) (see also McAdam andMcCreedy, 1999).We consider a particular objective of the rm, being the development of a specic

    innovation (an IT product or service) which will make a breakthrough in its specicarea. The date of the innovation, T, is unknown at time zero where the rm mustmake a plan for its investments in IC. During the time period until T , makinginvestments in its stock of IC will increase the probability that the innovation ismade by time T. At the initial instant of time, the rm, represented by a team ofentrepreneurs who manage the rm, can attract venture capital. The purpose of thisis to increase the stock of IC that is acquired at the initial instant of time.The venture capitalist in our model plays no active role in the sense that she

    neither is involved in the management of the rm nor does she choose the exit timestrategically. The venture capitalist in our model is a stockholder of the rm who hasa predetermined exit strategy. She either exits when the breakthrough is made andthe reward is divided up among stockholders, or she exits at a predetermined latestexit time where she receives a xed return on her invested capital.The paper deals with two main problems, essentially seen from the point of view of

    the entrepreneurs/founders. The rst problem concerns how much, if any, venturecapital should be attracted initially. The second problem is how to design a strategyfor the rms later investments in IC, in order to raise the probability of making thediscovery. Each of the two topics is very interesting on its own. Our analysis hereinterlinks both so that we can get some understanding of what the impact of venture

    capital nancing on innovations and research and development is.


    S. Jrgensen et al. / Journal of Economic Dynamics & Control 30 (2006) 23392361 2341Although the rst US-based venture capital rm was established shortly after thesecond world war, academic research started to focus on venture capital nancingonly 1015 years ago. Central to academic research is the simple setup where abusiness founder (entrepreneur) is looking for outside equity holders. Since such anancing-relationship is characterized by contracting under asymmetric informationmost of the theoretical research on venture capital nancing focusses either onadverse selection or moral hazard (see Amit et al. (2000) for a survey of VC-modelswith asymmetric information). The role of asymmetric information in venture capitalnancing is widely recognized and dominates theoretical research. Sahlman (1988,1990) argued that contracting practises in the venture capital industry reectuncertainties about future payoffs and informational asymmetries betweenentrepreneurs and venture capitalists. Moreover, the lack of operational history ofthe rms aggravates the adverse selection problem.Admati and Peiderer (1994) deal with the venture capital cycle and characterize

    the contract that allows optimal continuation decisions with staged nancing (seealso Kaplan and Stromberg, 2003). Bergemann and Hege (1997) analyze a situationin which there is a link between moral hazard and gradual learning about the projectquality. Withholding effort (moral hazard) in such a setting not only puts the ventureat risk but causes the entrepreneur and the VC to learn differently about the quality(payoffs) of the project. They propose a dynamic sharing rule that mitigates theproblems. The dynamic aspect of their model is in line with our approach here.Most of the empirical literature on venture capital nancing is summarized in

    Gompers (2005). He analyzes in detail the venture capital investment processincluding empirically observed exit strategies and the relationship between venturecapital nancing and innovation.In the area of research and development investments Schwartz and Zozaya-

    Gorostiza (2003) study a setup in which an organization undertakes an ITinvestment project, with a random completion date. The project involves an optionof spending initially an amount of money to acquire an IT asset. After theacquisition, the organization starts to receive a (random) cash ow and can invest inthe development of the asset. The methodology used to evaluate the project is realoptions, using stochastic differential equations and HamiltonJacobiBellmanequations. The nancial aspects are, however, ignored. Venture capital backedstart-ups are studied in a recent paper by Meng (2004). She uses a strategic realoptions model to analyze equilibrium investment strategies when rms are engagedin a patent race. Using numerical simulations she nds that strategically competingrms are likely to overinvest in equilibrium.The relationship between investment in human capital, innovation and competi-

    tion in the product market is studied in a paper by Fulghieri and Sevilir (2005). Theyformulate a model in which the incentives to acquire human capital, a necessarycondition to innovate, depends on the level of competition in the product market.Workers have a higher incentive to invest in human capital in a competitive (related)environment, because the relatedness of the industry gives them a higher exibility tomove from one rm to the other and hence greater ability to extract rents from their


  • 2.2. Financing


    S. Jrgensen et al. / Journal of Economic Dynamics & Control 30 (2006) 233923612342We suppose that after having obtained the venture capital L0, the rm can attractno more capital. Thus, the rm must be self-nanced for t40. This approach tonancing differs sharply from one in which a rm can attract external funds (equityand/or debt) at any instant of time (e.g., Schworm, 1980; Bensoussan and Lesourne,1981). On the other hand, Kamien and Schwartz (1982) argued that R&Dinvestments, which are in many respects comparable to investments in IC, shouldbe entirely self-nanced.It is also important to note that the assumed, one-shot venture capital nancing

    differs from the common practice in which ventures are nanced stagewise (see, e.g.,Finally there is a stream of literature in the area of R&D that studies stochastic,dynamic investment problems. Examples are Reinganum (1981, 1982), Kamien andSchwartz (1982), Fudenberg et al. (1983)