Self‐selection of entrepreneurial firms in thin venture capital markets: Theory and empirical evidence

• Published date: 01 March 2019
• Author: Luca Grilli,Fabio Bertoni,Diego D'Adda
• DOI: http://doi.org/10.1002/sej.1280
• Date: 01 March 2019

RESEARCH ARTICLE

Self-selection of entrepreneurial firms in thin

venture capital markets: Theory and empirical

evidence

Fabio Bertoni

1

| Diego D’Adda

2

| Luca Grilli

3

1

Department of Economics, Finance and

Control, Research Center in Entrepreneurial

Finance, emlyon business school, Ecully,

France

2

Dipartimento di Ingegneria dell'Informazione,

Università Politecnica delle Marche, Ancona,

Italy

3

Department of Management, Economics and

Industrial Engineering, Politecnico di Milano,

Milan, Italy

Correspondence

Luca Grilli, Department of Management,

Economics and Industrial Engineering,

Politecnico di Milano, Via Lambruschini 4/b,

20156 Milan, Italy.

Email: luca.grilli@polimi.it

Funding information

Seventh Framework Program, Grant/Award

number: SSH-2007-1.2.3-G.A. 217485

Research Summary: We develop a two-step selection model

between entrepreneurial ventures and venture capital

(VC) investors in a thin VC market. The model predicts that in a

thin VC market, the availability of VC reduces the propensity of

firms to self-select into the market for VC (demand-side selection)

but not the probability that firms entering the market for VC will

receive financing (supply-side selection). We test these predictions

using survey-based data on 190 new technology-based firms in

Italy during the late 1990s and early 2000s. The empirical evi-

dence supports the predictions of the model.

Managerial Summary: Venture capital (VC) is an important ingredi-

ent of an environment that is conducive to the birth and the

growth of entrepreneurial ventures, but VC markets are often

highly local and thin in terms of participants. We show that the

scarcity of VC supply may cause a drop in the demand for VC

because entrepreneurs, anticipating that competition for VC

money will be tough, will not seek VC in the first place. The more

a market is thin, the more the demand-side selection is likely to

become more important than the supply-side selection of VC

investors. Demand-side selection may involve a significant number

of otherwise good targets for VC investment, which will not be in

the radar of VC investors. In turn, this may deter new VC investors

from entering the local market, thus creating a vicious cycle that

raises concerns for both policy makers and VC general partners.

KEYWORDS

entrepreneurial firms, high-tech entrepreneurship, market

thinness, selection, venture capital

Received: 21 October 2013 Revised: 19 September 2017 Accepted: 20 September 2017

DOI: 10.1002/sej.1280

Copyright © 2017 Strategic Management Society

Strategic Entrepreneurship Journal. 2019;13:47–74. wileyonlinelibrary.com/journal/sej 47

1|INTRODUCTION

Venture capital (VC) is commonly considered by academics, practitioners, and policymakers to be the most suitable

mode of financing for high-tech entrepreneurial ventures (or new technology-based firms, NTBFs), which are

acutely exposed to capital market imperfections. Banks usually do not possess the competencies required to evalu-

ate and monitor NTBFs (Carpenter & Petersen, 2002; Himmelberg & Petersen, 1994). While, in principle, adverse

selection and moral hazard problems could be alleviated by collateralized loans (Berger & Udell, 1998), these instru-

ments are extremely inefficient for NTBFs, the value of which is mostly in intangible assets that can hardly be

pledged as collateral. Difficult access to external financing may limit the growth and even threaten the survival of

NTBFs. This is a key policy issue, as NTBFs are deemed to play a crucial role in the static and dynamic efficiency of

economic systems and, ultimately, are an important engine for the growth of modern economies (Carlsson, Acs,

Audretsch, & Braunerhjelm, 2009; Kane, 2010).

However, entrepreneurs located in different countries or in different regions of the same country face very dif-

ferent conditions in their ease of access to VC. This is due to the concurrence of three factors. First, VC investors

are not evenly distributed geographically, but are concentrated in some regions (Chen, Gompers, Kovner, & Lerner,

2010; Cumming & Dai, 2010; Sorenson & Stuart, 2001). For instance, U.S. venture capitalists are concentrated

mainly in three specific geographical areas (California, Massachusetts, and New York). Second, VC investors tend to

invest locally because of their hands-on investment approach, which requires spatial proximity. In fact, closeness

improves coaching and monitoring by allowing more frequent contact (Bernstein, Giraud, & Townsend, 2016; Ler-

ner, 2009). As a result, evidence from the U.S. (Chen et al., 2010; Gompers & Lerner, 2004; Sorenson & Stuart,

2001) and Europe (e.g., Bertoni, Colombo, & Quas, 2015; Lutz, Bender, Achleitner, & Kaserer, 2013) shows that

most investee firms are located close to their VC investors. Moreover, a lack of local investors is not easily compen-

sated by outside VC investors because the latter typically need the screening and monitoring capabilities of local

partners when they invest outside of their local environments (Devigne, Vanacker, Manigart, & Paeleman, 2013;

Mäkelä & Maula, 2008). Third, entrepreneurs have a strong tendency to locate their businesses in their home

regions (Dahl & Sorenson, 2009, 2012; Michelacci & Silva, 2007), which are not necessarily regions in which VC is

particularly abundant. In summary, both entrepreneurs (who are reluctant to establish their companies outside their

home regions) and VC investors (who are reluctant to invest outside the regions where they operate) are character-

ized by location biases. The result is that entrepreneurs in different countries, and in different regions within the

same country, may face substantially different local VC markets.

These location biases ar e likely to be influenced by th e thinness of the VC market. F ollowing Gans and

Stern (2010), we consider the VC market to be thin when it is characterized by a limited number of buyers

(i.e., VC investors) an d sellers (i.e., firms ac tively seeking VC). Ge nerally speaking, a thi n market is less function al

than a thick market (e.g., Gans & Stern, 2010; Roth, 2007). Specifically, we expect local biases to be even more

pronounced in thin markets than in thick markets. In a thin VC market, the transmission of information about

possible investment prospects is limited (Sorenson & Stuart, 2001) and because this information is often geo-

graphically bounded (Ragozzino & Reuer, 2011), market thinness will result in a stronger location bias of VC

investors. As we will show l ater, market thinness i n a country can also reinfo rce the home bias of entrepr eneurs

by discouraging movemen ts from regions where VC is bel ow average toward region s where VC is above aver-

age (yet still scarce).

In this article, we focus on the demand-side and supply-side elements of the two-step selection process

between entrepreneurial ventures and VC investors in thin VC markets. In these markets, which represent the rule

rather than the exception at a global level (see, e.g., European Parliament, 2012; EY, 2014), a non-negligible fraction

of entrepreneurial ventures often does not actively seek VC (e.g., Bank of England, 2001; Bertoni, D’Adda, & Grilli,

2016; Colombo & Grilli, 2010; see Cressy & Olofsson, 1997 for an earlier discussion of demand-side constraints). In

this article, we argue that the scarcity of local VC investors, coupled with the existence of entry costs, discourages

firms from seeking VC. An entrepreneur establishing his/her company in an area where VC is scarce will anticipate

48 BERTONI ET AL.