 The history of U.S. venture capital is a lens through which we can view the dynamics of technological innovation. Now there's a certain heroic myth about venture capital, usually propagated by venture capitalists, as the unique engine for driving innovation and consequent economic growth. These lectures will put that myth into context. As we'll see, the economic impact and financial success of venture capital has depended on two institutions that exist before and beyond the activity of venture capitalists themselves and of the entrepreneurs whom they back. First, a mission-driven, economically engaged state and second, episodic waves of financial speculation. Let's begin by recognizing the economic significance of venture capital over recent decades. Almost 50% of all U.S. public companies founded since 1995 have had venture capital backing. These companies accounted for more than 75% of the market capitalization of the stock market as a whole and more than 50% of the net income of public companies. But note especially that they were responsible for more than 85% of all R&D spending. And the total amount and share of R&D has risen monotonically over this period. Now let's explore the domain where venture capitalists operate. We are in the world of Keynesian uncertainty and Zach Hauser's unique extension of it. Three outstanding scholars of venture capital, William Kerr, Ramana Nanda and Matt Rhodescroft have appropriately framed the challenge facing entrepreneurs and the VCs who back them as experimentation. Experimentation by venture capitalists is characterized by an enormous skew in the outcomes. Many failures, a few huge successes. Experimentation at the level of the economy as a whole has systemic consequences. At the level of the individual venture, each investment is a unique experiment dependent on idiosyncratic factors. The authors provide an illustration, a misleading illustration in fact, of the value of an experiment. Here they lay out how discovering that the likelihood of success for the venture is 10%, not 1%, then conducting an experiment that costs less than the increase in the expected value of the venture is worthwhile. But of course, the illustration is misleading. Who constructed the specified distribution of expected returns? A different way to think about the problem is in terms of, first, the scale of the addressable market. Is it bigger than a bread box? Second, what can be learned at what cost by conducting the experiment? The excessive precision of the example distorts the useful underlying message. Innovation proceeds by trial and error and error and error at both the systemic, economy-wide level and at the level of the individual venture. Standard contracts between venture capitalists and entrepreneurs map to that process of experimentation. This is the canonical venture capital model. Staged investments, funding forward for a reasonably short period of time. Multiple investors per stage checking on each other's judgment. Appropriate for funding experiment at the frontier, but this model necessarily generates governance issues and conflicts of interest that can compromise the process. You have multiple sets of investors who have different cost bases on their investments, who are in different internal funding cycles with respect to their own venture capital funds, and may indeed be short of money when the next round is required or when the choice has to be made between continuing to back the venture and declaring victory by selling it for what can be obtained at the time. Seen in the realm of such infamous unicorns as Uber and WeWork, the potential for conflict both amongst investors and between investors and the founding entrepreneur, those conflicts are built into the model. Each round of investment, the venture is exposed to capital market risk to whether in fact the capital markets will be excited about funding new ventures. And building a new business in part by acquisition is very difficult to execute. You can't go to the owner of a big company and say, we want to buy this asset from you, but sit tight. Don't do anything. We'll be back to do a deal as soon as we raise our next round. Finally, Curran Nanda and Rhodes Krop accurately characterize the factors that render a technological opportunity appropriate for venture capital, capital efficiency, and the potential for big returns in a short period of time. Now this is good as far as it goes, but it does not go far enough. It explains the retreat of venture capital from renewable energy, but it does not explain the continuing commitment of venture capital to biotech investing, where total cash required is enormous and the cost of experimentation rises exponentially. This is the biotech paradox which we will shortly explore. It also does not address the correlation between the limited scope of venture capital investing and the prior focus of state investments in research and development. This is the second stylized fact about venture capital that has been almost completely ignored in the academic literature. Venture capital investment has been closely mapped to prior investments in research by the state. This is critical for understanding the dynamics of the innovation economy. So biotech is second only to information technology, representing consistently 20 to 25% of venture capital investments. The maturation of the digital revolution has been confusing categories since about 2010. For example, Uber was classified as, quote, social platform software, unquote, and so in IT. But Airbnb was classified as other restaurants, hotels and leisure, which rolls up to consumer goods and recreation, which rolls up to other. Now, the venture investing and entrepreneurial landscape in IT and beyond IT has been transformed by the availability of free open source software tools plus computing resources in the cloud that are available to be rented on a pay-as-you-go basis, radically reducing the cost of developing and deploying software. Consumer-focused software benefits as much as enterprise software. The cost of initial development has been reduced to the opportunity cost of undergraduates' times. In fact, I always tell my students, they don't need their parents' credit cards to fund their startup. They can do it themselves without any help from anybody else. And the response of venture capitalists has been appropriate. Think about a venture capital investment as represented in exchange of two different securities. The startup issues a real equity instrument, typically convertible preferred stock, to the venture capitalist and gets cash back. But the venture capitalist, in addition to the cash, issues a virtual call option on time and energy. Spray and pray delays the venture capitalist issuance of that option until the entrepreneurs offer evidence of traction from the first small commitment. Now, biotech is different from this kind of startup software company. There's very high technology risk and a very long time to generate any cash flow, let alone cash flow that will cover all the expenses of the venture. Longer than any venture capitalist fund life, which is only 10 to 12 years. In the face of these facts, why have there been such large and persistent investments in biotech? Explanation, tactical immediate explanation, almost continuous access to the public market for initial public offerings. And here is the data. Since 2004, there have been more pharma biotech IPOs than software IPOs every year but 2011 and 2012. Since 2014, pharma and biotech, plus healthcare devices and services, dominate venture capital backed IPOs. But why have public market investors bought biotech IPOs with such regularity? Gary Pizzano of the Harvard Business School offers an explanation from behavioral finance. Investor expectations are anchored on past winners. But there's another explanation that actually derives from mainstream finance theory. Given the lack of market risk, it is distinctively possible, uniquely possible, to evaluate the potential return of a biotech investment at the time of startup. This explanation of the biotech part paradox suggests that market risk dominates technology risk in the calculus of venture capitalists. There are multiple technical alternatives for addressing any perceived market opportunity. But if the perception of opportunity is false and no market exists for any of the alternatives, the return is zero. Note that this explanation is dependent on the existence of an inefficient market characterized by third party financing of demand that enables a knowable, a quasi vertical demand curve. So don't get carried away with reliance on the theory of efficient markets. Investor motivation is reinforced by, first, the low and declining productivity of big pharma's research efforts. Increased acquisitions by big pharma of biotech startups as a result. So investors in a biotech IPO can also speculate on acquisition before having to find out whether or not the venture succeeds in its own terms. A recent study of MIT's Venture Monitoring Service emphasizes the salience of market risk. Experts evaluate ventures submitted to the service and indicate whether they are interested in providing mentoring. Their indication of interest reflects a, quote, subjective evaluation of the venture. Only 4.4% of ventures gain an indication of interest. 54% of entrepreneurs pursue their venture and 28% of total ventures achieve commercialization. So how well the positive evaluations match commercial success? The accuracy of experts evaluation is high when assessing technical risk is what matters. The accuracy of an expert's evaluation disappears when it is market risk that really matters. Away from information technology in biotech, venture capital has struggled. Silicon is the only material in whose commercialization venture capitalists successfully invested. But that was under the direct and massive sponsorship of the United States Department of Defense, as we shall see in lecture four. With respect to the most strategically needed innovations, clean renewable energy, Hargedon and Kenny provide a comprehensive obituary. In addition to the enormous required scale of investment, they point to the value embedded in the existing energy system and the extent to which that value is reflected in and protected by regulation. In addition, any energy investments conventional and unconventional are exposed to extreme commodity price risk. No surprise that venture capital has been missing in action. Compared to the billions of dollars invested in IT and software and in biotech, these numbers are miserably low. It's no surprise because the US government is also missing in action, failing to provide the support of a politically legitimized mission, very much unlike China, as we shall see in the last lecture. Finally, let's turn to the problematic relationship between the venture capitalist and the entrepreneur. Some payers agent who loses other people's money. In a canonical paper, Bob Hall and Susan Woodward argue that the venture capitalist not only starts with the gold, but in the vast majority of cases ends with the gold. They visualize here the enormous skewin returns from venture capital back startups. 75% of all startups generate zero value to the entrepreneur. Returns to the entrepreneur greater than $100 million, the home run, account for only 2% of all venture capital back startups. From this analysis, they suggest that most entrepreneurs face an unattractive prospect. It appears that the entrepreneur bears the risk. The certainty equivalent return that they cite is a function of the entrepreneur's salary from secure employment in a big company, the initial wealth that she starts with, and his or her risk aversion. But recently, Mike Uens of MIT and his co-authors, Ramana Nanda and Chris Stanton of the Harvard Business School, have questioned Hall and Woodward's analysis, arguing that success in hitting milestones and reducing uncertainty increases CEO compensation substantially, shifting the calculus in favor of the entrepreneur and rendering it far more reasonable for entrepreneurs to accept the startup challenge. Entrepreneurs may be driven, they may be difficult, they may be willful, but they're not necessarily crazy. A recent comprehensive survey of venture capitalists offers insight into how VCs themselves characterize their work and the sources of success and failure. The core issue is the importance of selection, choosing which ventures to back, versus treatment, the contribution the venture capitalist makes to the success or not of the venture. First, selection. The venture capitalist network is a critical resource and it is effective when it is embedded in a specific investment domain, such as enterprise software or particular types of biotechnology. Waiting for the knock on the door ensures failure. Look at the last row in the slide. Across all the categories of venture capitalists, the ratio of closed deals, closed investment deals to the total of all deals looked at is only about three to five percent. Now much debate takes place about whether the quality of the horse, the business idea embodied by the venture and the technology that drives it, is more important than the jockey, the entrepreneurial team in charge. The survey results are unequivocal. It's the jockey that matters. The team matters. Here's the data. The team matters most for early stage investors. It matters less for late stage investors when it becomes more possible to evaluate business accomplishments. The team matters less for healthcare investors. What matters there is the technical promise of the project. For success, the team dominates. Compare the credit given to the team, 94 to 97 percent as an important factor and about 50 percent as the most important factor with the credit given to my, my own contribution. 20 to 30 percent is important and never the most important factor. That result, that result gives real credibility to this survey. One additional survey result illuminates the irrelevance of much modern finance theory to venture capital that limited extent to which venture capitalists actually try to forecast cash flows. And of course, it's forecast cash flows that are discounted to calculate that famous net present value, the fundamental value of the investment. 31 percent of early stage venture capitalists do not forecast at all. In fact, you could ask the real question. What do the 69 percent think they're accomplishing? And note that fewer than 30 percent of ventures actually meet their projections. For all the emphasis on the entrepreneurial team, there is evidence that venture capitalists do contribute above and beyond selecting better ventures to back. The authors of this paper matched venture capital backed firms with non VC backed firms and followed their progress. Prior to venture capital investment, the two samples matched. Same employment growth, virtually identical. But over the next 10 years, the VC backed firms had double the employment growth of non VC backed firms. VC backed firms grew their patent stock by 11 times versus only 4.4 times for matched non venture capital backed firms. And high quality venture capitalists matter more. You're a high quality venture capitalist at the number of deals you're involved in over the entire sample period is in the 90th percentile of the distribution over the total number of deals by venture capitalists. Over 10 years from funding, employment and firms backed by high quality venture capitalists grow by about 400 percent versus 320 percent in firms backed by low quality venture capitalists. Firms backed by high quality venture capitalists grow their quality adjusted patents 50 times over 10 years from first funding firms backed by low quality venture capitalists grow their patent stock by only 19 times. So the venture capitalists deserve the big bucks. The subject of the next lecture is evaluating venture capital performance. We're going to dig deep into answering that question.