Abstract
One common rationale supporting public financing programs for small firms is that initial public investment creates incentives for follow-on private investment. However, there does not appear to be a unified statement in the literature describing how initial public investment creates incentives for follow-on private investment. Focusing on external private investors, we use a two-stage net present value model to identify four effects from initial public investment on the private decision for follow-on investment. Our empirical analysis uses a sample of non-venture backed firms entering the SBIR program to examine how reduced risk, the number of SBIR awards, and size of initial public investment influence the likelihood of follow-on venture capital investment. We find the probability of follow-on venture capital investment is more likely when firms reach Phase II of the program, is less likely as firms win multiple Phase I and Phase II awards, and is more likely as the size of initial public investment in Phase I increases.
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Notes
David et al. (2000) review the literature examining whether publicly financed R&D complements or substitutes for a firm’s own private R&D investment but they do not consider how external financing agents respond.
The results from the theoretical model are not specific to venture capital investors, but apply to all external investors. See de Bettignies and Brander (2007) for an analysis of the entrepreneur’s choice between bank financing and venture capital financing.
Branscomb and Auerswald (2001) include a “financial gap” in their discussion of the challenges to crossing the “Valley of Death” between invention and innovation.
The possibility of the cross-effect being negative is not sensible in this model since initial public investment keeps the project alive. It would indicate that initial investment actually reduces the “effectiveness” of follow-on investment. In that case, no rational investor would provide follow-on financing.
There are currently eleven federal agencies implementing the SBIR program.
Further detail is available in the US Small Business Administration’s Handbook for SBIR Proposal Preparation, available at http://www.sba.gov/gopher/Innovation-And-Research/SBIR-Pro-Prep/.
The agency dummy variables also account for the situation in which firms win awards from multiple agencies. The US National Institutes of Health is dominant part of the US Department of Health and Human Services.
Data on SBIR applicants are not systematically available. Applicant data would allow more sophisticated statistical methods to be used to account for agency selection into the SBIR program.
This sequence assumes all venture capitalists use a homogeneous screening process over time. While not entirely realistic, evidence presented by Fried and Hisrich (1994) suggests it may not be unreasonable. It also assumes the nature of the uncertainties causing venture capital investors to delay investment can be addressed by participating in the SBIR program.
The presence of firms that never wanted VC investment (reason four) in the sample is not a cause for concern since their investor preferences should not be systematically related to their own firm’s success in the SBIR program such as winning a Phase II award.
Observing this in the data depends on efficient information communication to the venture capital community once a Phase I award is obtained. Researchers studying the venture capital decision making process note that some venture capitalists “aggressively seek out deals” (Fried and Hisrich 1994, p. 32). Moreover, the SBA Handbook states, “…some SBIR program managers send abstracts of Phase I awardees to large companies and venture capitalists…” (SBA 2007).
Given that our data are annual, we do not observe the exact dates of regarding when the firms submit their SBIR proposals. Further, to increase the confidence that follow-on venture capital investment is associated with SBIR participation, we restricted the lag between first SBIR award and follow-on VC to be less than nine years. It is also important to drop any SBIR awards won by firms after receiving venture capital since this could reflect the influence of venture capital investors.
While we do not focus on the “downstream” performance of firms receiving follow-on VC investment, Hsu (2006) explored this and found these firms perform better in terms of cooperative commercialization agreements and initial public offerings than SBIR firms without follow-on VC investment.
Of course, interpreting the Phase II dummy in the opposite direction indicates firms which never progress out of Phase I have significantly lower chances for follow-on VC investment. This makes sense because these firms never successfully reduce the technical and/or market uncertainties surrounding their new technologies.
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Toole, A.A., Turvey, C. How does initial public financing influence private incentives for follow-on investment in early-stage technologies?. J Technol Transf 34, 43–58 (2009). https://doi.org/10.1007/s10961-007-9074-7
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DOI: https://doi.org/10.1007/s10961-007-9074-7