Paper to be presented at the DRUID-DIME Academy Winter 2009 PhD Conference

on

ECONOMICS AND MANAGEMENT OF INNOVATION, TECHNOLOGY AND ORGANIZATIONAL CHANGE

Hotel Comwell Rebild Bakker, Aalborg, Denmark, January 22 - 24, 2009

VC FINANCING AND PATENTING IN NEW TECHNOLOGY-BASED FIRMS: AN EMPIRICAL STUDY

Diego D'adda Politecnico di Milano diego.dadda@polimi.it

Abstract: VC financing and patenting in new technology-based firms: an empirical study Diego D'Adda Politecnico di Milano Year of enrolment: 2007 Expected final date: 2010 diego.dadda@polimi.it The aim of this paper is to analyse empirically the impact of Venture Capital (VC) financing on the patenting activity of new technology-based firms (NTBFs). In particular, we compare the patenting rates of VC-backed and non VC-backed NTBFs to investigate whether VC financing really spurs patenting activity of portfolio firms. We further want to assess whether the typology of investors has a different influence on the patenting activity of VC-backed firms. Venture capital (VC) financing is generally considered by both academics and practitioners as a more suitable financing mode for NTBFs than bank loans. In fact, it is contended in the financial literature that this financing mode offers a fundamental contribution to the success of high-tech entrepreneurial ventures (see for instance Denis 2004).

JEL - codes: D92, G24, O39

VC financing and patenting in new technologybased firms: an empirical study

Fabio Bertoni, Massimo G. Colombo, Diego DAdda** Department of Management, Economics and Industrial Engineering Politecnico di Milano Abstract The aim of this paper is to analyse empirically the impact of Venture Capital (VC) financing on the patenting activity of new technology-based firms (NTBFs). In particular, we compare the patenting rates of VC-backed and non VC-backed NTBFs to investigate whether VC financing really spurs patenting activity. We further want to assess whether the typology of investors, i.e. Independent Venture Capitalists (IVCs) and Corporate Venture Capitalists (CVCs), has an influence on the patenting activity of VC-backed firms. We expect the effect of CVC financing to be greater than that of IVC financing, due to different objectives characterizing the two typology of investors. To test these hypotheses, we consider a unique longitudinal dataset composed of 197 Italian NTBFs operating in manufacturing sectors. Sample firms were established in 1980 or later, remained independent up to the end of 2003, and are observed from 1994. To analyse the determinants of firm patenting activity, we estimate different panel data models. The results show that Venture Capital financing positively affect subsequent patenting activity and that VC-backed firms do not exhibit such a high patenting propensity before receiving VC. The findings also reveal that IVC and CVC financing does not seem to differently influence patenting propensity, but further investigation is necessary since that these results could be determined by the dramatic decrease in the number of useful observation when distinguishing VC by source.

** Corresponding author: Diego DAdda, Politecnico di Milano, Department of Management, Economics and Industrial Engineering, Piazza Leonardo da Vinci, 32, 20133, Milan, Italy. ph: +39-02-2399-3974; fax: +39-02-2399-2710. E-mail address: diego.dadda@polimi.it.

.Introduction
Since the seminal work by Jaffee and Russell (1976) and Stiglitz and Weiss (1981), the argument that there are frictions in capital markets that make it difficult for firms to obtain external financing and constrain their investment decisions has increasingly been gaining ground in the economic and financial literature (see Fazzari et al. 1988 and the studies mentioned by Hubbard 1998). New technology based firms (NTBFs) are those most likely to suffer from these capital market imperfections. In turn, the fact that poor access to external financing may limit the growth and even threaten the survival of NTBFs is worrisome because of the key role these firms play in assuring dynamic efficiency and employment growth in the economic system (Audretsch 1995, Acs 2004). The above arguments especially apply to bank loans (Carpenter and Petersen 2002). In fact, banks generally do not possess the competencies required to evaluate ex ante and monitor ex post the investment projects proposed by young high-tech firms that lack a track record. In principle, the above mentioned adverse selection and moral hazard problems can be alleviated through the recourse to collateralized loans (Berger and Udell 1998). Nonetheless most of high-tech investments is in intangible and/or firm-specific assets that provide little collateral value. Venture capital (VC)1 financing is generally considered by both academics and practitioners as a more suitable financing mode for NTBFs than bank loans. In fact, it is contended in the financial literature that this financing mode offers a fundamental contribution to the success of high-tech entrepreneurial ventures (see for instance Sahlman 1990, Gompers and Lerner 2001, Kaplan and Strmberg 2001, Denis 2004). Nonetheless, whether access to VC financing fosters the innovative activity of portfolio companies is a matter of empirical test. Previous evidence, deriving mainly from industry level analysis (Kortum and Lerner 2000, Tykvova 2000, Ueda and Hirukawa 2006), demonstrates a positive relation between venture capital financing and patenting
The term VC is referred here to equity (or equity-like) financing provided by external investors to high-tech entrepreneurial firms in the early stages of their life. It includes seed, start-up and expansion capital. The source of financing may be independent financial intermediaries, diversified financial firms, and non-financial firms (i.e. corporate venture capital). 2
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activity. Fewer studies analyze the effect at firm-level and find mixed evidence (Engel and Keilbach 2002, Baum and Silverman 2004). In this work we resort to a hand-collected 10 year long longitudinal dataset composed of 197 Italian NTBFs to analyze the effect of VC financing on firms patenting in the years that follow the first round of financing. In addition, we distinguish VC-backed firms according to whether VC financing is provided by independent VC firms (i.e. IVC) or non-financial firms (i.e. corporate venture capital, CVC).2 Italian NTBFs provide a very interesting testbed of the beneficial effects of VC financing on portfolio companies as in Italy the VC industry is quite undeveloped and VC investors operate in a quite unfavorable environment. Sample firms were established in 1980 or later, survived as independent firms up to January 2004, and are observed from 1993 up to 2003. They operate in high-tech sectors of manufacturing. Most of them are privately held. In order to capture the effect of VC financing on firms innovative activity, we estimate econometric models that capture the propensity of the firm to patent. The results of the estimates strongly support the view that VC financing has a dramatic positive effect on firms innovative activity even though, contrary to our expectations, no difference arises between IVC- and CVC-backed firms. The paper is structured as follows. In the next section we survey the literature on the effects of VC financing on firms performance; we also consider differences between IVC and CVC. In Section 3 we describe the sample of firms that are considered in the empirical analysis. In section 4 we illustrate the empirical methodology. Section 5 reports the results. Section 6 concludes.

In Italy US-style independent VC firms that exclusively focus on early stage financing of high-tech start-ups are rare. So most firms included in the IVC category operate both in the early stage and late stage equity capital financing segments. Non financial firms invest in high-tech start-ups either directly or through affiliated subsidiaries. Both types of investment are included in the CVC category. Conversely, investments in high-tech start-ups on the part of other financial intermediaries such as banks and insurance companies are almost inexistent in Italy. They are included neither in the IVC nor in the CVC categories (while they are included in the VC category). 3

.Literature review
In this section we review the literature on the effects of VC financing on firms performance (Section 2.1) and, in particular, on firms innovation (Section 2.2). Finally, in Section 2.3, we analyze how different VC players (and in particular Independent Venture Capital Funds and Corporate Venture Capital) might lead to dissimilar impacts on firms performance. 1. The value added of VC financing

The financial literature highlights several motives explaining why access to VC financing stimulates the performances of invested companies. First of all, intermediaries that provide external equity financing to NTBFs generally focus on specific industries (see among others Gompers 1995, Amit et al. 1998, Bottazzi and Da Rin 2002). Due to their sectoral specialization, these investors allegedly develop contextspecific screening capabilities that make them capable to judge quite accurately the hidden value of entrepreneurial projects and the entrepreneurial talent of the proponents (Chan 1983, Amit et al. 1998). Therefore, they are able to deal effectively with the adverse selection problems that otherwise would prevent great hidden value firms from obtaining the financing they need.3 Second, VC firms are no silent partners (Gorman and Sahlman 1989, Barry et al. 1990). On the one hand, they actively monitor the behavior of entrepreneurs of portfolio companies. For instance, Kaplan e Strmberg (2003) show that VC firms control 41.4% of the seats of the boards of directors of the US VC-backed companies that are
A rich stream of the empirical literature has examined the criteria that VCs use to select portfolio companies. Generally these studies rely on interviews with VCs and other qualitative methodologies (Tyebjee and Bruno 1984, Mac Millan et al. 1985, 1987, Hall and Hofer 1993, Fried and Hisrich 1994, Murzyka et al. 1996, Zacharakis and Meyer 1998, 2000, Sheperd et al. 2000). For an analysis of the selection criteria of VCs based on documented evidence see Kaplan and Strmberg (2004). It is important to emphasize that VCs may prove unable to separate talented entrepreneurs from other entrepreneurs. Under these circumstances, NTBFs with great hidden value will be unlikely to obtain VC financing due to adverse selection problems (Amit et al. 1990). 4
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considered in their study; in 25% of the companies they control the majority of board seats. Bottazzi et al. (2004) document that in 66% of the deals of European VC firms they consider the VC investor sat on the board of the investee company. Moreover Lerner (1995) highlights that the number of VC investors who sit in the board of directors is more likely to increase between two financing rounds if during the same period the top manager of the participated firm is replaced, that is in situations where monitoring is most important. On the other hand, VCs make use of specific financial instruments and contractual clauses (e.g. stage financing) that protect their investments from opportunistic behaviour on the part of entrepreneurs and create high powered incentives for them (Sahlman 1990, Gompers 1995, Hellmann 1998, Kaplan and Strmberg 2003, 2004). Third, VCs perform a key coaching function to the benefit of investee firms (Gorman and Sahlman 1989, MacMillan et al. 1989, Bygrave and Timmons 1992, Sapienza 1992, Barney et al. 1996, Sapienza et al. 1996, Kaplan and Strmberg 2004)4. In fact, they provide portfolio companies with advising services in fields such as strategic planning, marketing, finance and budgeting, and human resource management, in which these firms typically lack internal capabilities. Accordingly, Hellmann (2002) documents that VCs favor the recruitment of external managers, the adoption of stock option plans, and the revision of human resource policies by invested firms, thus contributing to their managerial professionalization. Bottazzi et al. (2004) show that European VC firms helped portfolio companies in recruiting outside directors and senior managers in 40.8% and 48.4% of the deals they analyze. Moreover, portfolio companies take advantage of the network of social contacts of VCs with potential customers, suppliers, alliance partners, and providers of specialized services like legal and accounting services, head hunting services, and public relations (Lindsey 2002, Hsu 2006). Lastly, VC financing signals the good quality of a NTBF to third parties; therefore invested companies find it easier to get access to external resources and competencies that would be out of reach without the endorsement of the VC (Stuart et al. 1999). In accordance with the existence of a certification effect, Megginson and Weiss (1991) find that VC-backed IPOs exhibit smaller underpricing than non VC-

Recent theoretical models on this issue are those by Casamatta (2003), Inderst and Mller (2004), Repullo and Suarez (2004). 5

backed ones that are matched by sector and IPO size.5 Moreover, Hsu (2004) suggests that NTBFs place considerable value on the certification effect and coaching services provided by high reputation investors; accordingly, he shows that financing offers by VCs with high reputation are more than three times more likely to be accepted from recipient firms than other offers; in addition, these investors obtain a discount on the purchase price of the participation ranging between 10% and 14%. Nonetheless, it is important to acknowledge that the agency relation between the VC investor and the entrepreneurs of portfolio companies may engender conflicts, leading to a deterioration of the performances of these latter companies. In fact, entrepreneurs and external investors may have different strategic visions; disagreements may absorb the entrepreneurs effort and attention to the detriment of the pursuit of business opportunities (Dushnitsky and Lenox 2006). Even if no conflict arises, the need of investors to monitor managerial decisions by the investor may increase bureaucracy and formalization of decision processes, and hamper firms flexibility. Furthermore, as VCs are competent investors, they may be able to expropriate entrepreneurs of their innovative business ideas and exploit them also in their absence (Ueda 2004). The associated appropriability hazards may induce entrepreneurs to take decisions that are detrimental to firms performances. 2. The effect of VC financing on the innovation of portfolio companies: survey of empirical literature

A growing stream of empirical literature has analyzed the effects of VC financing on the performances of investee companies. Here we focus attention on the effects on innovative performances and patenting activity. One of the first studies dealing with the impact of venture capital on innovation is that one of Kortum and Lerner (2000). They analyze patents data and venture financing across twenty manufacturing industries between 1965 and 1992 in United States. They use a patent proWang et al. (2003) use the same methodology to study Singapore IPOs and find similar results. Nonetheless, the literature is not unanimous on this issue. For instance, Lee and Wahal (2004) analyse a large sample of IPOs, more than a third of which are VC-backed. They differ from previous work in that they control for the endogenous nature of VC financing (on this issue see section 2.2); they highlight that underpricing is larger for VCbacked firms. 6
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duction function at industry level, controlling for the arrival of technological opportunities that could lead to a spurious relation between venture capital and patenting activity6. They find that VC does spur patenting activity, even with more efficacy than traditional corporate R&D. They also conduct a firm level analysis between 122 VCbacked and 408 non VC-backed companies to control whether the effect of VC derives only from change in patent propensity, i.e. to patent more in lieu of relying on different appropriability mechanisms. The results suggest that VC-backed companies i) have patents that are more frequently cited, i.e. their quality does not decrease, and ii) engage more in trade secret litigations than non VC-backed, i.e. they dont make less use of other innovations appropriability mechanisms like trade secrets. In a similar study, Tykvova (2000) finds through a patent production function that venture capital has highly significant positive effect on patenting activity in a sample of ten industry sectors observed between 1991 and 1997 in Germany. The effect of VC, in respect to corporate R&D, seems to be lower than for Kortum and Lerner (2000), but Tykvova asserts that it could be underestimated due to the inclusion in the analysis of form of private equity financing different from classical VC. Ueda and Hirukawa (2006) exploit the same methodological framework at industry level as well, extending data used by Kortum and Lerner (2000) up to 2001 to include also the NASDAQ bubble period. Using patents as dependent variable they confirm Kortum and Lerner (2000) results. However they argue that these results could be explained by a different patent propensity between VC-backed and non VC-backed companies, and that the use of total factor productivity (TFP) growth, as a measure of innovative activity alternative to patents, may rule out this problem. They do not find support that venture capital investments have a positive impact on productivity growth. In a previous work, Ueda and Hirukawa (2003) address the causality concern between VC investments and innovations: they investigate whether it is VC that spurs innovation or if it is an arrival of new technology that increases demands for venture capital by driving new start-up firms. Using TFP as measure of innovation they find support for both of these hypothesis in computer and communication indusThey use i) R&D expenditures to control for the arrival of technological opportunities that could be anticipated only by economic actors at that time and ii) a policy shift, that was unlikely to be related to the arrival of opportunities, in an instrumental-variable regression. 7
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tries, on the contrary they find a negative relation between VC and TFP growth in drugs and scientific instrument industries. Unlike above mentioned studies that are conducted at industry level, other scholars move to the firm level for a more in depth comprehension of the relationship between venture capital and innovative activity and of the causality direction. Hellmann and Puri (2000) analyze the type of financing, and its impact on product market behavior, of 173 start-up companies that are located in Silicon Valley. They find that pursuing an innovator strategy7 positively affects the probability of obtaining venture capital financing; moreover VC financing reduces time to market especially for innovator firms, thus affecting its ability to secure first-mover advantages. Engel and Keilbach (2002) rely on a matched pair technique to study growth rates of employment and innovative output of a sample of 142 German VC-backed companies that were established 1995 and 1998. Focusing on the very early stage of venture capital investment, i.e. within one year since the foundation, they show with Probit estimation that pre-foundation patenting behavior and human capital characteristics do affect the probability of VC involvement. They then resort to the propensity score method, based on the previous mentioned estimation, to build their control sample; more precisely they apply the nearest neighbor criterion with the additional constrain that twin firms operate in the same sector and have been established in the same year as the corresponding VC-backed firms. The test on the differences shows that the average number of patents is only weakly significant higher for VC-funded group in respect of the non funded control group. Baum and Silverman (2004) directly address the causality issue, i.e. whether venture capitalists really enhance innovation output and patenting activity of investee companies or if the differences in innovation between VC-backed and non VC-backed companies can be explained by the scouting ability of venture capitalists, that allow them to select the more innovative firms. Their sample is composed of 204 biotechnology start-ups in Canada. Relying on time series regression techniques, they find that the amount of pre-IPO financing is positively affected by patent applications and patents granted in the year
They measure innovator ex-ante strategy through interviews, trying to capture if firms are introducing a new product or service that i) is not a close substitute of a product/service already offered on the market, ii) is expected to outperform product/services already offered in the market, or iii) satisfies either of the two criteria above. 8
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before the financing, as well as by human capital characteristics and alliances. They argue that for biotechnology start-ups patenting is a signal of innovative capabilities and of the amount of probable future returns, given the strong appropriability regime surrounding biotech patents. Furthermore they do not find support for the hypothesis that patenting activity, measured both by patent application and patent granted, is positively related to the amount of VC financing in the previous year. To sum up, above mentioned studies are not unanimous as to the positive effect of VC financing on firms patenting activity and to the causality direction between the two. Industry level studies seem to find a robust positive relation with patent activity (Kortum and Lerner 2000, Tykvova 2000, Ueda and Hirukawa 2006) but not with another innovation measure like productivity growth (Ueda and Hirukawa, 2006), furthermore they find differences across different industries (Ueda and Hirukawa, 2003). At firm-level, studies show that patenting activity positively affects VC involvement (Engel and Keilbach, 2002; Baum and Silverman, 2004), but results of VC on innovation are controversial: Hellman and Puri (2000) and Engel and Keilbach (2002) find a positive relation, on the contrary Baum and Silverman (2004) do not find any significant influence. Studies at firm level that rely on longitudinal datasets are rare, only Baum and Silverman (2004) estimate random effects panel data models but they include lagged dependent variable among the regressors, that can be correlated with error term thus leading to distorted estimation, and moreover they do not resort to a distributed lags in order to capture the influences of VC financing that go beyond the first year. Furthermore their sample is not cross sectorial, so their results may suggest differences among different industries. Another weakness of previous studies on venture capital financing is that they fail to take into account VC investors heterogeneity, that may moderate the subsequent effect on innovation. We will face this issue in the next paragraph. 3. The role of the type of investor: IVC vs. CVC

Recently it has been argued in the literature that, especially in Europe, there is great heterogeneity across VC investors (Bottazzi et al. 2004). In turn, the different characteristics of VC investors differently affect their behavior and the effect that VC financing has on the performances of portfolio companies. In this paper we focus attention on the distinction between financing provided by independent financial
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intermediaries (IVC) and that provided by non financial firms (corporate venture capital, CVC). As will be explained below, these two categories of investors differ along several dimensions. As a result we expect the effects on innovative performances of their presence as shareholders in the equity capital of portfolio companies to differ as well. First of all, IVC and CVC are likely to pursue different objectives. The aim of IVCs is to realize the greatest possible capital gain in the shortest possible time. For this purpose, they are interested in boosting the growth of invested companies. Conversely, previous studies highlight that CVCs often pursue strategic objectives in addition to or even in substitution of financial objectives (Chesbrough 2002, Dushnitsky and Lenox 2005a). In a pioneering work on CVC, Siegel et al. (1988) show that according to the surveyed parent corporations, exposure to new technologies and markets is the most important motive for them to engage in CVC. Similarly, Ernst et al. (2005) document that CVC is used by large German firms for technology window purposes; in fact, it allows parent companies to closely monitor the development of promising technological innovations related to their core business on the part of young firms and then possibly to acquire them. In accordance with the view that CVC is mainly used by incumbent firms as a technology learning device and it is not merely driven by financial objectives, Dushnitsky and Lenox (2005a) while analyzing a large sample of US public firms observed over a 10 years period (19901999), show that CVC investment is mostly attracted by industries which exhibit great technological ferment, weak protection of intellectual property rights, and an intermediate level of technology proximity with the knowledge base of the corporate investor. Gompers (2002) highlights that in the USA, CVCs have increasingly oriented their investments towards industries that are related to the core business of parent companies. Dushnitsky and Lenox (2006) find that CVC investments creates value for the corporate investor, measured by the contextual increase in the Tobins q, only if CVC is pursued for strategic reasons (i.e. gaining a window on the novel technologies developed by portfolio firms). Even more importantly for the purpose of the present work, Dushnitsky and Lenox (2005b) document that CVC investments substantially boost the citation-weighted patent output of the corporate investor in the five years that follow the investment and that this effect is more pronounced when the investor has both great absorptive capacity (Cohen and Levinthal 1990) proxied by the level of R&D expenses, and an intermediate technology proximity with
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portfolio firms (see also Winters and Murfin 1988, Sykes 1986, 1990, Block and MacMillan 1993, Gompers and Lerner 1998, Chesbrough 2000, 2002, Ernst and Young 2002). Dushnitsky and Lenox (2005b) results suggest moreover that different objectives lead to different investment strategies, CVC financing is higher in industries characterized by low appropriability regimes due to their technology windowing purpose8 (Dushnitsky and Lenox 2005a). In contrast whoever is interested mainly in financial returns would look for investee firms that can appropriate of the larger part of returns from their innovations, thus increasing their value and financial returns of investors. Second, as was explained in section 2.1, the alleged superior performances of VC-backed firms relative to their non VC-backed counterparts depend on the scouting, monitoring and coaching activities carried out by external investors and the certification effect engendered by reception of VC financing. We also mentioned that the agency relation between the external investor and the entrepreneur may lead to inefficiencies. The extent of these positive and negative effects on the innovation of portfolio firms is likely to depend on the type of the external investors and the different objectives they pursue (Hellmann 1998). Siegel et al. (1988) find that the strategic objectives of CVC investors often diverge from those of the entrepreneurs of portfolio firms. This possibly leads to conflicts between entrepreneurs and CVC investors that absorb entrepreneurs time and energy to the detriment of firm performances (Chesebrough, 2000). Appropriability hazards also are greater with CVCs than with IVCs, especially if the parent company of the CVC operates in the same sector as the portfolio firm or in a closely related one (Block and MacMillan, 1993). Fear of expropriation may induce entrepreneurial firms with the most promising novel technologies to look elsewhere for external financing.9 In addition, CVC may suffer from organisational deficiencies. Early stage financing of high-tech firms is the core business of IVC firms, while it is an ancillary activity for the parent company of CVCs. As a corollary, CVC investors are likely to benefit from learning by doing to a more
In weak intellectual property protection regimes, venture may not be able to put a stop to knowledge spillovers to CVC investors, thus increasing returns from CVC investments (Dushnitsky and Lenox 2005a). 9 For the same reason, CVC investors may be disadvantaged in reducing information asymmetries relative to IVC investors, as high-tech startups looking for external financing may be less inclined to reveal proprietary information (Dushnitsky 2005a). 1 1
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limited extent than IVC firms. It may also be rather difficult for CVC parent companies to design an incentive structure for managerial personnel apt to attract highly qualified individuals (Block and Ornati 1987). Hence the scouting, monitoring and coaching capabilities of CVC investors are likely to be inferior to the those of IVC firms. On the other hand, some empirical studies (Holmstrom 1989, Zwiebel 1995, Aghion et al. 1997, Czarnitzki and Kraft 2004) suggest that firms controlled by managers have lower incentives to invest in R&D activities than companies controlled by the owners due to the risk aversion and the short-termism of managers, this is particularly relevant in case of an entrepreneurial NTBF involved in VC financing. Moreover, severe changes in internal control system may occur if VCs put more emphasis on financial rather than strategic control. This may stifle the incentives to innovate since it focuses more on short run ROI targets with less emphasis on long run projects (Hitt et al., 1996). Due to the strict financial objectives, IVCs are likely to induct greater changes in management and internal control system of funded companies than CVC investors. Moreover, the presence of a CVC investor in the equity capital of a high-tech start-up may engender benefits that cannot be provided by IVC firms, with this leading to superior firm innovative performances. In fact, through the CVC invested firms may obtain access to the specialised irreproducible resources and distinctive competencies of the parent company (e.g. distribution channels, brand, production capacity, complementary technological competencies. See Block and MacMillan 1993, Dushnitsky 2004). In addition, portfolio firms can benefit from the network of industry-specific contacts with potential customers and suppliers of the parent company of the CVC investor. Endorsement by a highly reputed firm also is very valuable and may help portfolio firms establish business relations with third parties (Stuart et al. 1999, Maula 2001, Maula and Murray 2001). To sum up, whether CVC financing has greater beneficial effects on portfolio firms than IVC financing is controversial. As far as we know, no previous study has analysed differences between the effects of IVC and CVC financing on firms patenting activity.

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.The sample
In this paper we use a unique, hand collected longitudinal dataset relating to a sample composed of 197 Italian NTBFs that are observed over a ten years period (1993-2003) and operates in manufacturing sectors. Most sample firms are privately held. They were established in 1980 or later, were independent at founding time and have remained so up to the end of 2003 (i.e. they are not controlled by another business organization even though other organizations may hold minority shareholdings). They operate in the following high-tech sectors in manufacturing10: computers, electronic components, telecommunication equipment, optical, medical and electronic instruments, biotechnology, pharmaceuticals, advanced materials, robotics, process automation equipment. The sample of NTBFs was extracted from the 2004 release of the RITA (Research on Entrepreneurship in Advanced Technologies) database. Developed at Politecnico di Milano, RITA is the most complete source of information on Italian NTBFs. It was created in 2000 and it is updated every two years. The development of the database went through a series of steps. First, Italian firms that complied with the above mentioned criteria relating to age and sector of operations were identified. For the construction of the target population a number of sources were used. These included lists provided by national industry associations, on-line and off-line commercial firm directories, and lists of participants in industry trades and expositions. Information provided by the national financial press, specialised magazines, other sectoral studies, and regional Chambers of Commerce was also considered. Altogether, 1,974 firms11 were selected for inclusion in the database. For each firm, a contact person (i.e. one of the ownermanagers) was also identified. Unfortunately, data provided by official national statistics do not allow to obtain a reliable description of the universe of Italian NTBFs.12 Second, a questionnaire was sent to
In the total sample extracted from the 2004 release of RITA there are 550 firms operating in high-tech sectors in manufacturing and services. We decided to consider only the 197 manufacturing firms in this study because the dependent variable is based on patent that doesnt seem to be a valid indicator of innovative output for service firms. 11 Operating both in high tech sectors in manufacturing and services. The main problem is that in Italy most individuals who are defined as self-employed by official statistics actually are salaried workers with 13
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the contact person of the target firms either by fax or by e-mail. The first section of the questionnaire provides detailed information on the human capital characteristics of firms founders. The second section comprises further questions concerning the characteristics of the firms including access to external equity financing, the identity of external investors, and the evolution over time of firms employees and sales. Lastly, answers to the questionnaire were checked for internal coherence by educated personnel and were compared with and supplemented by published data (i.e. data provided by firms annual reports and financial accounts) when they were available. In several cases, phone or face-to-face follow-up interviews were made with firms owner-managers. This final step was crucial in order to obtain missing data and ensure that data were reliable.13 The total sample consists of the 550 RITA firms that returned the questionnaire. 2 tests show that there are no statistically significant differences between the distributions of the sample firms across industries and the corresponding distribution of the population of 1,974 RITA firms from which the sample was drawn (2(4)=1.085). The sample is large and as will be shown in section 4 quite heterogeneous. Note, however that there is no presumption here to have a random sample. First, in this domain representativeness is a slippery notion as new ventures may be defined in different ways (see for instance, Birley 1984, Aldrich et al. 1989, Gimeno et al. 1997). Second, as was mentioned above, absent reliable official statistics, it is very difficult to identify unambiguously the universe of Italian NTBFs. Therefore, one cannot check ex-post whether the sample used in this work is representative of the universe or not. Third, as in most previous studies, only firms having survived up to the survey date could be included in the sample. In principle, attrition generates a sample selection bias that may distort the estimates. Some authors (see for instance Manigart and Hyfte 1999) argue that the likelihood of bankruptcy of VC-backed firms may exceed that of their non VC-backed counterparts. Under these circumstances lack of control for firms that
atypical employment contracts. Unfortunately, on the basis of official data such individuals cannot be distinguished from entrepreneurs who created a new firm. 13 Note that for only 3 firms the set of owner-managers at survey date did not include at least one of the founders of the firm. For these firms information relating to the human capital characteristics of the founders was checked through interviews with firms personnel so as to be sure that it did not relate to current owner-managers. 14

ceased activity would result in an upward bias of the effect of VC financing on firms growth. Conversely, suppose that more innovative firms are more likely to become the target of an acquisition, loose independence and exit the sample. Therefore, if VC financing spurred firms patenting activity, the resulting sample selection bias would lead to a downward bias in the estimates. As a matter of facts, it is very difficult to control for the selection bias. In order to check its extent, we focused attention on the RITA 2000 sample. This sample is composed of 401 NTBFs (see Colombo et al. 2004) out of which 31 where VC-backed at the beginning of year 2000. We examined the exit rate of these firms in the 2000-2003 period due to bankruptcy. 4 VC-backed firms ceased activity in this period representing 12.9%. The corresponding percentages for non VC-backed firms is fairly close (12.2%). A 2 test shows that the difference between the two values is not statistically significant at conventional confidence level. Therefore, while it is fair to acknowledge that our sample suffers from a survivorship bias, we are quite confident that this does not greatly influence the results of the estimates that will be illustrated in the following sections. To sum up, the sample analysed in this work has several strengths in comparison with previous studies. As far as we know this is the first study that relies on a large longitudinal dataset relating to privately held NTBFs to distinguish the effects on firms innovative activity of IVC and CVC financing. Second, Italy has a bank-based financial system and the VC industry is quite undeveloped (Bertoni et al. 2006). Hence, Italian NTBFs offer an interesting testbed of the alleged positive effects of VC financing on firms performance even in an adverse environment. Table 1 shows the sectoral distribution of the whole sample, of VC backed firms (further distinguished by the identity of the investor, namely IVC and CVC) and of firm patenting at least one during the period of observation. Out of the 197 firms that are considered in this work, 22 obtained VC financing (i.e. 11.17%). Biotechnology, pharmaceutics exhibit the greatest share of VC-backed firms (18.18%), ICT manufacturing shows a lower percentage (11.38%), while firms that operate in robotics and automation are those that are less likely to obtain VC financing (7.69%).

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Table 1 - Distribution of sample firms by industry, typology of investors, and patenting activity
Industry ICT manufacturing Biotechnology & Pharmaceutics Automation Robotics Total & 52 197 4 22 7.69 11.17 1 9 1.92 4.57 1 9 1.92 4.57 3 30 5.77 15.23 Number of firms Total VCbacked firms N % 14 4 11.38 18.18 IVCbacked firms N % 7 1 5.69 4.55 CVCbacked firms N % 6 2 4.88 9.09 Total Patenting N % 21 6 17.07 27.27

123 22

Table 1 highlights the geographical and sectoral distribution of IVC- and CVC-backed sample firms: IVC- and CVC-backed firms are equal in terms of number and similar in terms of sectoral distribution14. Table 1 also shows the sectoral distribution of number of firms which apply and are granted at least one patent during the observation window. The average number of firms patenting is 15.23% with some significant difference across sectors: firms in Biotechnology and Pharmaceutics are the most likely to patent (27.27%) while the opposite happens for firms in Robotics and Automation (5.77%). As a preliminary evidence of the relationship between VC and patenting it is interesting to check whether the likelihood to patent is equal between VC-backed and non VC-backed firms. Table 2 shows that of the 175 non VC-backed firms 154 do not patent in the period under analysis while this happens for only 13 out of the 22 VC-backed firms. The difference between the two distributions is statistically significant (2=17.31). Moreover, among the 9 VC-backed patenting firms only one deposited a patent before being invested by VC. This suggests that the increase in patenting activity of VC-backed firms occurs after the investment.

Of the 20 VC-backed firms, 4 are neither IVC- nor CVC-backed since they receive financing from financial intermediaries (e.g. banks) or non-independent (e.g. Public) VC funds. 16

14

Table 2 Venture Capital financing and patenting activity

Non-VC-backed 154 21 175 VC-backed 13 9 22 Total 167 30 197

Not-patenting Patenting Total

Note however that this results do not check for firm-specific characteristics (individual heterogeneity) that are likely to affect both the likelihood to obtain VC and the patenting activity; such features can be both observable (e.g. the sector in which they operate) or unobservable (e.g. the quality of their R&D). Thus a more systematic analysis is needed, as shown in the next section.

17

.Methodology
In this work we study the relationship between innovative activity (measured as patenting) and VC financing. We estimate two panel-data models to capture firms patenting activity. Table 3 shows the dependent and explanatory variables included in the models.
Table 3 Dependent and explanatory variables of patenting activity

Variable N. patents(t)

N. patents(t)>0

Patent stock(t-1)

Employees(t-1)

Age(t) VC-backed(t-1)

IVC-backed(t-1)

CVC-backed(t-1)

Description Number of patent applications of the firm which are later granted by the patent office Dummy variable equal to 1 when firm applies for at least one patent in year t Firms patent stock in year t computed as # patents(t-1)+0.85 Patent stock(t-2) Logarithm of the size of the firm at t-1 measured by the number of employees (including owners that have an active role in the management of the firm) Logarithm of firms age Dummy variable equal to 1 if firm received VC financing in or before year t-1 Dummy variable equal to 1 if firm received IVC financing in or before year t-1 Dummy variable equal to 1 if firm received CVC financing in or before year t-1

The first two variables shown in Table 3 (N. patents(t), N. patents(t)>0) are the dependent variables of the econometric models that we estimate. N. patents(t) measures the number of patent applications of the firm in year t which are later granted by the patent office. We
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estimate the conditional distribution of N. patents(t) using a Population Averaged Generalized Estimating Equations (GEE) Logit model with Exchangeable correlation structure. Second, we estimate a Population Averaged Generalized Estimating Equations (GEE) Negative Binomial model with Exchangeable correlation structure with dependent variable N. patents(t)>0, that is a dummy variable equal to 1 when firm applies for at least one patent in year t. Control variables include measures of size and age alongside firmspecific effects (capturing time-invariant individual heterogeneity) and year dummies (capturing time-variant common effects). Moreover we include in the regressions a variable that measures firms patent stock, Patent stock(t), and that captures, at least partially, unobservable heterogeneity between observations (see Blundell et. al. 1995). Previous studies examining patenting rates have used similar measures (Ahuja and Katila 2001, Dushnitsky and Lenox 2005b). To test the effect of VC on patenting activity we include a dummy variable, VC-backed(t1), which is equal to 1 if firm received VC financing in or before year t-1. Similarly we discriminate the effect of different types of VC replacing VC-backed(t-1) with two dummy variables which capture respectively IVC, IVC-backed(t-1), and CVC, CVC-backed(t-1). To assess the difference between the effect of this two sources of VC we test, in each of the three regressions, the null hypothesis of the two coefficients being equal.

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.Results
Table 4 shows the results for the two econometric models analyzing the relationship between patenting activity and Venture Capital.
Table 4 Effect of Venture Capital on patenting activity
N. Patent apps(t) 0.1185 (0.0608) * 0.5818 (0.2067) *** 0.0288 (0.3267) 1.3892 (0.5549) ** N. Patent apps(t)>0 0.4507 (0.12) *** 0.5723 (0.2014) *** -0.1716 (0.2873) 1.2435 (0.4095) ***

Patent stock(t-1) Employees(t-1) Age(t) VC backed(t-1)

Year dummies Yes Yes Firm effect Yes Yes Model Negative Binomial Logit Observations 1314 1314 Groups 195 195 Note: ***, ** and * denote respectively significance level below 1%, 5% and 10%. Negative Binomial and Logit regressions are estimated using GEE with exchangeable correlation structure. All models are Population Averaged. Standard errors in brackets.

In each model the coefficient associated to VC backed(t-1) is positive and significant. When an average firm receives VC its patenting activity (measured as Number of patents applied and likelihood of applying for a patent) increases significantly even when controlling for time-invariant heterogeneity and common exogenous shocks. Table 5 shows the results for the three econometric models analyzing the relationship between patenting activity and different sources of VC, namely IVC and CVC. We do so by splitting the VC backed(t-1) dummy variable in two separate dummies that differentiate IVC and CVC-backed firms, respectively IVC backed(t-1) and CVC backed(t1). Table 5 shows that, overall both IVC and CVC have a significant effect on firms patenting activity. However, contrary to our expectations, their effect does not differ significantly: in both regression we cannot reject the hypothesis that IVC and CVC coefficient are equal.

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Table 5 Dependent and explanatory variables of patenting activity

N. Patent apps(t) 0.111 (0.0832) 0.6322 (0.2254) *** -0.0899 (0.3233) 1.2805 (0.6577) * 1.5818 (0.6522) ** N. Patent apps(t)>0 0.4617 (0.1185) *** 0.6083 (0.2143) *** -0.2303 (0.2865) 1.2866 (0.4732) *** 1.168 (0.5476) **

Patent stock(t-1) Employees(t-1) Age(t) IVC backed(t-1) CVC backed(t-1

Year dummies Yes Yes Firm effect Yes Yes Model Negative Binomial Logit Observations 1314 1314 Groups 195 195 0.13 0.04 2(IVC=CVC) Note: ***, ** and * denote respectively significance level below 1%, 5% and 10%. Negative Binomial and Logit regressions are estimated using GEE with exchangeable correlation structure. All models are Population Averaged. Standard errors in brackets. Last row reports the 2 value of the Wald test on the null hypothesis that IVC and CVC coefficient are equal.

21

.Conclusions
In this work we analyze the effect of VC on innovative activity using firm-level data on a sample of 197 manufacturing Italian NTBFs. We find significant evidence that VC increases firms innovative activity measured by patenting. Firms propensity to patent increase significantly after they receive VC financing. Notably VC-backed firms do not exhibit such a high patenting propensity before receiving VC. We also analyze whether the identity of the VC matters, and IVC and CVC have different effect on firms innovative activity. Interestingly, previous evidence on Italian NTBFs showed that IVC-backed firms grow significantly more and are less financially constrained than their CVC-backed counterparts. However no difference between IVC and CVC is found relative to their effect on patenting: we cannot reject the null hypothesis that the two sources of VC do not differ to this extent. It should be pointed out that when distinguishing VC by source the number of useful observation decreases dramatically. Future research will be aimed at extending the sample to a larger number of NTBFs, thus allowing more robust estimates on the differential effect of IVC and CVC.

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