VC driving forces

Despite this wide recognition of venture funds as key players underlying a country’s entrepreneurial performances, there are huge differences across industrialized countries in the relative amounts invested in VC. VC intensity is relatively high in the USA and Canada for instance, whereas it is very low in Japan. The diversity of national financial systems is undoubtedly one important factor underlying these international differences. Black and Gilson (1998) find a linkage between countries’ financial system and VC market. Active stock market is more appropriate to strong venture capital market than bank market because of the potential for VC exit through an IPO. An active VC market requires a liquid stock market.

Other factors also play an important role, as shown by Gompers and Lerner (1998), Jeng and Wells (2000) and Sherlter (2003). With a panel dataset of 21 countries Jeng and Wells show that labor market rigidities, the level of Initial Public Offerings (IPO), government programs for entrepreneurship, and bankruptcy procedures explain a significant share of cross country variations in VC intensity.

According to Black and Gilson (1998), active stock market is important for strong venture capital market because of the potential for VC exit through an Initial Public Offering. IPO is considered as being a very important determinant of VC. It is the strongest driver of VC according to Jeng and Wells (2000) because it reflects the potential return to VC funds.

Gompers and Lerner (1998) take it as a proxy for fund performance but cannot find any significant effect in their multivariate regressions. It seems that the IPO variable is strongly

Product (GDP), which is also a proxy for exit opportunities. GDP and Market Capitalization Growth (MCG) are part of the impact of IPOs and therefore turn out to be not significant for Jeng and Wells (2000). However the reverse is true for Gompers and Lerner who find a positive and significant impact of Equity Market Return and GDP on VC but no impact of IPO. Higher GDP growth implies higher attractive opportunities for entrepreneurs, which lead to a higher need for venture funds. Schertler (2003) uses either the capitalization of stock markets or the number of firms listed as measure of the liquidity of stock markets. He finds that liquidity of stock market has a significant positive impact on VC investments at early stages. However, as Jeng and Wells (2000), he finds that the growth rate of the stock market capitalization does not have significant impact on VC investments at early stages.

For Jeng and Wells (2000), getting the basic legal and tax structures into place appears to be an important factor influencing VC. Gompers and Lerner (1998) also recognize the importance of government decisions on the private equity funds. The labor market legislation is typically put in place to protect employees from arbitrary, unfair or discriminatory actions by employers. Some authors argue that venture financing can suffer from the rigidity of the labour market in Europe (e.g. Ramón and Marti, 2001). Jeng and Wells (2000) show that it does not significantly influence total VC but affects negatively the early stage of VC investment. According to Shertler (2003), labor market rigidities are significant and positive.

That can be the result of differences in the labor-capital ratio of high-technology enterprises.

He also argues that high-technology enterprises operating in rigid labor markets may demand more capital than comparable high-technology enterprises operating in flexible labor markets.

With the clarification of the Employee Retirement Income Security Act (ERISA) prudent man” rule of 1979, the share of money invested by pension funds had risen to more than 50

%. Jeng and Wells (2000) find that the level of investment by private pension funds in VC is a

use a proxy for the amendment of the “prudent man” rule to show the impact of pension regulation and reach a similar conclusion. After 1979, the additional capital provided by pension funds led to a dramatic shift in commitments to VC.

Concerning the impact of the Capital Gains Tax Rate (CGTR) on VC activity, Gompers and Lerner (1998) show that a decrease in CGTR has a positive and important impact on commitment to new VC funds. In fact, they confirm the result of Poterba (1989) who built a model of decision to become an entrepreneur. He found that decreases in CGTR might increase the raising of VC funds not through stimulation of the supply side (i.e., the potential fund providers) but rather on the demand side. Indeed, decreases in CGTR often encourage entrepreneurship and thus the desire of people to create their own firm and to engage in R&D activities. Anand (1996) also highlights the fact that the level and composition of investments appear to be negatively affected by increases in the CGTR but investments in one industry may be affected by myriad of other factors like technology shifts, tastes, etc.

Both industrial and academic R&D expenditures are significantly related to venture capital activity at the State level in the model of Gompers and Lerner (1998). For them, the growth VC fundraising in the mid-1990s may be due to increases in technological opportunities.

Shertler (2003) tests the number of employees in research and development and the number of patents as the approximation of the human capital endowment. He finds a positive impact of the number of R&D employees. Also, he highlights that the coefficients of the patent variable are positive and highly significant.

Concerning government programs for entrepreneurship, a main rationale of direct government intervention in the VC industry is the stimulation of economic growth.

Manigart and Beuselinck (2001) find some evidence that a good economic climate, high stock

to the VC industry. Some scholars have also focused on the micro determinants of VC. For Gompers and Lerner (1998) the individual firm performance and reputation, measured with the firm age and size, positively impact the capacity to raise larger funds. Hellmann and Puri (2000) use a probit model to show that the strategy of a company is one of the determinants of VC investment when controlling for the age of the company and its industrial sector. If the strategy is an innovative one (the company is the first to introduce a new product or service on the market), it has a higher probability to benefit from VC compared to companies that follow an imitation strategy (the company uses existing technologies to develop and improve products and processes). They also find that innovating companies are able to raise VC earlier in their life cycle than companies with a strategy of imitation. In other words, their analysis suggests that VC is stimulated by technological opportunities. However there is less evidence of such a relationship at the aggregate macroeconomic level.

In a nutshell, there are several potential determinants of VC. Some of them can be measured qualitatively or quantitatively at the macro level whereas others like the fund reputation and the strategy of the venture funded firms are microeconomic factors.

Romain and Pottelsberghe (2004) first develop a theoretical model which takes into account the factors that affect the demand and supply of VC. These factors include the growth of GDP, short-term and long-term interest rates, several indicators of technological opportunity, and of entrepreneurial environment. Second, they exploited a panel dataset composed of countries over an eleven years period. Third, they investigate to what extent the level of entrepreneurship and of labor market rigidities affect the impact of the GDP growth rate and the stock of available knowledge on VC intensity. The results showed that interest rates significantly influence VC intensity. The countries with lower labor market rigidities benefit from a higher impact of the GDP growth rate and the available stock of knowledge on the

relative level of VC. Higher levels of entrepreneurship – i.e., the percentage of people being involved in the creation of nascent firms – induce a positive and significant relation between the R&D capital stock and VC intensity. (Romain and Pottelsberghe, 2004)

A viable exit mechanism is extremely important to the development of a venture capital industry. Furthermore, an exit mechanism is essential to the entrepreneur for two reasons.

First, it provides a financial incentive for equity-compensated managers to expend effort.

Second, it gives the managers a call option on control of the firm, since venture capitalists relinquish control at the time of the IPO (Black and Gilson (1998). Jeng and Wells (2000) focused on IPOs as an exit mechanism for the following reasons. While there are many mechanisms to liquidate a fund, the literature shows that the most attractive option is through an IPO. A study conducted by Venture Economics 1988 finds that US$1.00 invested in a firm that eventually goes public yields a 195% average return or an average cash return of US$1.95 over the original investment for a 4.2-year average holding period. The same investment in an acquired firm only provides an average return of 40% or a cash return of only 40 cents over a 3.7-year average holding period. Also, if regaining control is important to the entrepreneur, IPOs are clearly the best choice, given that the other option, trade sales, frequently entails loss of control. Trade sales are sales of a startup company to a larger company also referred to as a strategic buyer.

Increased volume of IPOs should have a positive effect on both the demand and supply of venture capital funds. On the demand side, the existence of an exit mechanism gives entrepreneurs an additional incentive to start a company. On the supply side, the effect is essentially the same; large investors are more willing to supply funds to venture capital firms if they feel that they can later recoup their investment. (Jeng and Wells, 2000)

Labor market rigidities present an obstacle to venture capital growth. Sahlman (1990) discusses how labor market rigidities form a large barrier to the success of venture capital investing in countries such as Germany and Japan. In Japan, for instance, leaving a company is not only considered dishonorable, but departing individuals also lose valuable benefits of seniority. Also, should the individual fail in his new venture, it would be difficult for him to find new employment, which would lead to a further loss of social standing. Labor market rigidities are frequently cited as one important reason why venture capital is not more prevalent in Europe and Asia.

Labor market rigidity should impact the demand for venture capital funds negatively i.e., the higher labor market rigidity, the less demand for venture capital funds we would expect . Strict labor laws make hiring employees difficult for companies, because they deprive the company of the flexibility to let people go later on, should this become necessary. In addition, large benefits payments, which typically accompany more rigid labor markets, make it more expensive to hire in the first place. (Jeng and Wells, 2000)

In practice, the degree of labor market rigidity depends on how labor market regulations are implemented and enforced. From this point of view, it is the outcome of the regulations that matters, rather than their number. Different observers emphasize different outcomes though.

High minimum wages are a favorite candidate, as they mimic the standard textbook distortion of market equilibrium. Mandated benefits, such as old-age pension, health insurance or maternity leave, feature high in the list too. If workers do not “pay” for these benefits through lower wages, their burden falls on employers. Mandated job security and high firing costs are yet another typical example of a labor market distortion. Finally, the labor market can also be distorted when trade unions are large and powerful, or when governments employ a substantial share of the labor force. Note that distortions of this latter sort do not necessarily

stem from a “thick” labor code, which re-emphasizes the distinction between rigidity on paper and in practice. (Forteza and Rama, 2000)

The state of the country’s economy will also have an effect on venture capital. Acs and Audretsch (1994) suggested that macroeconomic fluctuations influence startup activity in general. Macroeconomic expansions are found to lead to an increase in the number of startups. Since an increase in startup activity increases demand for venture capital funds, we expect a positive relationship between macroeconomic expansion and venture capital investing. Jeng and Wells (2000) used GDP growth to measure macroeconomic fluctuations in their analysis and found this variable to be positively correlated with venture capital investment. Moreover, in their study Romain and and Pottelsberghe (2004) has also found a positive correlation with GDP fluctuations and VC industry.

Interest rates might also be an important factor influencing VC. Although Jeng and Wells (2000) do not take this factor into account into their cross country investigation, Gompers and Lerner (1998) show that it affects positively the demand for VC funds in the US. Economic theory would suggest a reverse relationship: if interest rates rise, the level of investment should fall. The positive impact estimated by Gompers and Lerner is probably due to the fact that they use a short-term interest rate. If short term interest rates increase, the attractiveness of venture financing versus credit through usual financial institutions increases from the entrepreneur’s viewpoint. The latest study conducted by Romainand and Pottelsberghe (2004) also showed short-term and long-term interest rates have a positive impact on VC intensity, which means that they affect more entrepreneurs than the supply of VC.

Government schemes for assisting private equity vary widely, from providing legal infrastructure to establishing funds that invest directly in private equity projects. We examine

Getting the basic legal and tax structures into place appears to be an important factor in aiding the development of private equity funds. For example, the US and the UK, which have good basic regulations, have high levels of private equity and venture capital investments as a percentage of GDP. Austria, on the other hand, lies on the opposite extreme of this spectrum.

With no special legal structure for private equity firms and no tax or other incentives aimed at the industry, private equity investment languishes and shows no sign of growth in the near future.

Portugal furnishes another example of the importance of providing an appropriate legal environment for private equity. In 1986, when Portugal had even lower levels of private equity investment (again measured as a proportion of GDP) than Austria, the Portuguese government created a new type of corporate structure, the venture capital corporation. These venture capital corporations were granted a number of tax benefits as follows: Exemption from the new company incorporation tax; Exemption from income tax and other taxes during the year of incorporation and the three following years; After this period, deduction from tax of the profits appropriated to reserves and reinvested in venture capital projects during the following 3 years. As a consequence, private equity investments in Portugal increased dramatically (by a factor of 38) between 1986 and 1987.

Governments can also play a strong role in influencing the growth of other sources of funds.

For example, Ireland experienced a large surge in new funds raised as a consequence of a government-recommended increase in private equity investments by pension funds. A commitment of IR £50 million (US$70.5 million) boosted new funds raised considerably, from IR £23 million (US$32.4 million) in 1993 to IR £150 million (US$232.1 million.in 1994).

Similarly, in the US around 1980, a large flow of new funds in venture capital was unleashed with changes in the Employment Retirement Income Securities (ERISA) that permitted venture capital investing for pension funds.

Between 1988 and 1992, Israel’s venture capital industry was still in its infancy with only one active venture capital fund of US$30 million. At this time, the major suppliers of capital to emerging companies were large established investment companies belonging to holding groups such Hapolain, IDB, Leumi, Israel, Koor, Clal and Elron Groups.

In 1992, the Likud government began to promote the venture capital industry. It set up the Yozma venture capital program to provide financing for venture capital funds and to invest directly in companies. Yozma also encouraged foreign and local corporations to coinvest in high technology startups. In 1993, Yozma provided US$100 million to establish nine venture capital funds. By 1996, Israel’s venture capital industry, which had raised more than US$1 billion, had experienced such phenomenal growth that the government decided to exit the market. However, to continue to foster its venture capital industry, the Israeli government enacted a temporary legislation allowing tax-free investing in Israeli venture capital funds by foreign venture funds which had tax-free status in their home countries. Currently, there are 32 venture capital funds with a total of US$500 million invested which represents 50% of raised capital. (Jeng Wells, 2000)

Table 5: The Previous studies and the variables that they have studied

Considering the previous studies, in this study the following determinants of VC industry will be used to compare two countries Taiwan and Turkey. First of all, initial public offering and stock market opportunities are combines as exit opportunities. The both variables are much correlated and examining these two variables under one variable will simplify the analysis.

Later this thesis will explore how market rigidities play a role in the difference between two countries venture capital industries. GDP growth and interest rates will be examined under macroeconomic variables, since these variables are indications of macroeconomic situation of a country. Next, to understand the innovation capacity of Turkey and Taiwan, the variables

‘industrial and academic R&D’ and ‘Number of Patents’ will be studied. Lastly, Private Pension Funds and Taxation rates will be considered as government policy, since these variables directly related to the regulations in a country. Moreover, financial reporting standards are omitted in this study, since a broad qualitative analysis is required, and

additionally it is difficult to draw a result from the obtained analysis. The following figure illustrates how the variables in the previous studies utilized in this study.

Figure 10: The Theoretical Framework of variables to be studied