Boom and Bust in the Venture Capital Industry and the Impact on Innovation

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Fourth Quarter 2002 T he past year has seen a dramatic decline in venture capital activity. As Chart 1 shows, investment activity has fallen by more than half in the past few quarters. Fund-raising by venture capital organizations has similarly undergone a sharp fall, and few observers expect a revival anytime soon. Already voices have been raised, expressing worry about the implications of this decline for technological innovation. If venture capital was really critical for America’s rapid economic growth, as many articles in the business press during the past decade have claimed, its sharp decline must surely be grounds for worry. For instance, Business Week recently noted, “Most venture capitalists are shelving the expensive change-the-world bets of the past few years. . . . The danger is that cutbacks will go too fast and too deep” (Greene 2001, E14). This paper seeks to understand the implications of the recent collapse in venture activity for innovation. It argues that the situation may not be as grim as it initially appears. While there are many reasons for believing that, on average, venture capital has a powerful impact on innovation, the impact is far from uniform. In particular, during boom periods, the prevalence of overfunding of particular sectors can lead to a sharp decline in terms of venture funds’ effectiveness. While prolonged downturns may eventually lead to good companies going unfunded, many of the dire predictions seem overstated. Boom and Bust in the Venture Capital Industry and the Impact on Innovation