Follow the Money
Understanding how money makes its way from institutional investors to venture capitalists to entrepreneurs.
(originally published by Booz & Company)
Title: The Capital Flow from Institutional Investors to Entrepreneurs
Authors: Alexander Peter Groh (University of New South Wales)
Date Published: February 2010
In speculative, high-growth industries such as biotechnology or information technology, where access to capital is critical for the development of breakthrough drugs or transformative technologies, understanding how the money flows from institutional investors through venture capitalists and ultimately to entrepreneurs is especially important. This paper takes a close look at what might be the least understood link in that value chain: the institutional investor.
By surveying more than 1,000 institutional investors worldwide and asking them to rank 23 factors related to their allocation of funds, the author was able to pinpoint how institutional investors determine which venture capital firms will place their money in the most promising startups. First and foremost, he found, they look for advantageous global geographic regions where entrepreneurial activity is expected to rise. Next, they consider vital criteria, such as the legal protection of property rights and corporate governance policies, the involvement of qualified general partners at target venture capital firms, the firms’ overall expected deal flow, and the likelihood of bribery and corruption at venture capital or startup firms resulting from weak legal systems in a developing region. Laws protecting investors, and the experience of the management team running the venture capital firm, were seen as additional keys to ensuring successful capital transactions. Another finding, perhaps unpleasant for policymakers, is that the least important of all criteria is the availability of public funding and subsidies.
Despite government programs that seek to spur new ventures, private money does not necessarily follow public money. Unexpectedly, cultural differences, including language barriers, were not viewed as obstacles to investment.
Bottom Line: The flow of capital from institutional investors to venture capitalists to startups depends on a wide range of criteria. Investors look first at location, then at legal and governance issues, and last at government support and culture.
- Matt Palmquist was a founding staff writer and is currently a contributing editor at Miller-McCune magazine. Formerly, he was an award-winning feature writer for the San Francisco–based SF Weekly.