Abstract

This paper identifies a new channel through which venture capital helps to promote innovative start-ups. Venture capitalists typically have access to a great deal of inside information about the innovative entrepreneurial start-ups they finance, and considerable opportunities to transfer valuable knowledge between different companies in their portfolio. The existing theoretical literature on venture capital has focused primarily on the potential negative consequences, namely expropriation of ideas by venture capitalists, and ways in which this problem might be reduced. The main novelty in our approach is to also consider the potential benefits of knowledge transfer implemented privately by the venture capitalist, and analyse the resulting trade-offs. We study first the simpler case of firms whose innovative knowledge does not fall in the category of intellectual property that can be protected by a patent. We then examine the case where patent protection is feasible in principle, but there is some uncertainty ex ante as to whether the innovation will succeed in obtaining a patent (e.g. whether it will satisfy the requirements of novelty and non-obviousness). In both cases we establish the conditions for an innovative start-up to prefer financing by a venture capitalist (VC) rather than a non-VC investor. The paper therefore adds a new rationale for VC financing to the ones that have already received considerable attention in the theoretical literature (monitoring, screening, and the provision of advice and support by the VC).