Can a well-functioning venture capital industry spur innovation within local economies – an empirical comparison of the US, UK, IL and DK venture capital markets and investment approach?

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CROSS-COUNTRY DIFFERNECES IN
VENTURE CAPITAL FINANCING
APRIL
2013
MASTER THESIS
Author: Christian Scheel Tost – 221086-1109
Study program: MSc. Applied Economics and Finance
Course: Master Thesis
Supervisor: Jens Frøslev Christensen
Date of submission: 2013-04-19
Page count: 88
Word count: 36.404
Character count (with spaces): 226.329
Can a well-functioning venture capital industry spur innovation
within local economies – an empirical comparison of the US, UK, IL
and DK venture capital markets and investment approach?

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Contents
Contents.........................................................................................................................................................................................2
Executive Summary ...................................................................................................................................................................6
1. Introduction.............................................................................................................................................................................7
1.2 Research Objective.........................................................................................................................................................9
1.3 Research Method..........................................................................................................................................................10
1.4 Research Design............................................................................................................................................................12
2. Introduction: Venture Capital Financing of Start-Ups in Business Administration Theory........................13
2.1 Definition of Venture Capital...................................................................................................................................13
2.2 Equity Financing: Venture Capital Financing......................................................................................................13
2.2.1 Crowd Funding.......................................................................................................................................14
2.2.2 Institutional Venture Capital ................................................................................................................15
2.2.3 Independent Venture Capital (IVC)....................................................................................................16
2.3. Stages in the Financing Life Cycle of a Start-up................................................................................................17
2.3.1 Venture Characteristics in the Different Stages.................................................................................18
2.3.2 Structure of Independent Venture Capital Firms..............................................................................19
2.3.3 Role of Independent Venture Capital Firms in Start-ups ................................................................20
2.4 Theoretical Foundation for Explanation of the Behavior of Venture Capital Firms .............................21
2.4.1 Agency Theory Model: Asymmetric Information, Moral Hazard and Adverse Selection ..........22
2.4.2 Mitigation of Agency Risk.....................................................................................................................23
2.5 Typical Venture Capital Investment Process: VC Investment Cycle...........................................................24
2.5.1 Contact Phase .........................................................................................................................................24
2.5.2 Screening Investment Ideas..................................................................................................................25
2.5.3 Due Diligence.........................................................................................................................................26
2.5.4 Management Phase (Value Adding Services).....................................................................................30
2.5.5. Exit Phase...............................................................................................................................................32
3. Empirical Study on Explaining the Venture Capital Impact on Innovation and Economic Growth ......34

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3.1 Empirical Study and Definition of Innovation ...................................................................................................34
3.1.1 What is Innovation?...............................................................................................................................34
3.1.2 How to Measure Innovation ................................................................................................................35
3.2 Economic Growth With Innovation......................................................................................................................37
3.2.1 Managing and Facilitating Quality Innovations.................................................................................38
3.3 Literature Review: Does Venture Capital Spur Innovation?...........................................................................41
3.2.1 Does Venture Capital Create Innovative Incentive?.........................................................................41
3.2.1 Does Venture Capital Spur Sustainable Innovation?........................................................................42
4. National Innovation Systems: Macroeconomic Environment of the Venture Capital Industry in the US,
UK, IL and DK.........................................................................................................................................................................44
4.1 General Demographic, Economic Data and the Venture Capital Markets................................................44
4.2 Macroeconomic Attractiveness of VC Markets..................................................................................................46
4.2.1 Capital Availability..................................................................................................................................47
4.2.2 Entrepreneurial Capital .........................................................................................................................48
4.2.3 Entrepreneurial Culture.........................................................................................................................49
4.2.4 Nation Infrastructure.............................................................................................................................50
4.2.5 Regulative Environment........................................................................................................................51
4.3 Overview of attractiveness of DK, IL, UK, and US .........................................................................................51
5. Research Framework Model and Hypotheses Development.................................................................................55
5.1 Average Size of Investment.......................................................................................................................................55
5.1.1 Hypotheses Development: HA, HB, and HC ...................................................................................56
5.2 Venture Capital Investment Risk Strategy............................................................................................................57
5.2.1 Percentage of Start-ups in Pre-Revenue Phase (Had no Revenue) at Time of Investment........57
5.2.2 Me-Too Ventures, Risk Strategy and Level of Risk..........................................................................58
5.2.3 Portfolio Structure .................................................................................................................................59
5.3 Due Diligence................................................................................................................................................................60
5.3.1 Management Team Due Diligence......................................................................................................60
5.3.2 Market and Product/Service Due Diligence......................................................................................61

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5.4 Management Phase (Value Adding Phase)...........................................................................................................63
5.5 Exit Phase........................................................................................................................................................................65
6. Analysis and Comparison of Findings...........................................................................................................................67
6.1 Average Size of Investment: Investment Strategy..............................................................................................67
6.1.1 Average Size of Investment: Seed Stage.............................................................................................67
6.1.2 Average Size of investment: Startup Stage .........................................................................................69
6.1.3 Average Size of Investment: Growth Stage .......................................................................................71
6.1.4 Conclusion on Investment Strategy.....................................................................................................73
6.2 Investment Risk Strategy: Risk Strategy ................................................................................................................73
6.2.1 Pre-Revenue Investments .....................................................................................................................74
6.2.2 Investment in Proven Business Models..............................................................................................75
6.2.3 Investment Strategy ...............................................................................................................................76
6.2.4 Level of Risk ...........................................................................................................................................77
6.2.5 Portfolio Structure .................................................................................................................................78
6.2.6 Conclusion on Differences in Risk Strategy.......................................................................................79
6.3 Due Diligence: Limitation of Risk and Maturity of Market............................................................................80
6.3.1 Replacement of CEO – Management Team......................................................................................80
6.3.2 Differences in Market Due Diligence Approach...............................................................................81
6.3.3 Difference in Product Due Diligence Approach...............................................................................82
6.3.4 Differences in Due Diligence Approach Conclusion.......................................................................82
6.4 Management Phase: Value Adding Strategy.........................................................................................................83
6.4.1 Employee Mix.........................................................................................................................................84
6.4.2 Number of board seats per partner.....................................................................................................84
6.4.3 Time Used on Portfolio Companies ...................................................................................................85
6.4.4 Contact with Portfolio Companies (Non-Executive Level) ............................................................85
6.4.5 Conclusion: Differences in Value Adding Services...........................................................................86
6.5 Exit Phase........................................................................................................................................................................87
6.5.1 Exit Strategy: Channel and Geography...............................................................................................87

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6.5.2 Conclusion: Differences in Exit Strategy............................................................................................88
7. Discussion of the analysis and the impact on the impact on the innovation....................................................89
7.1. Investment Strategy, Risk Strategy, Due Diligence & Exit Phase (Spurring Innovation)....................89
7.2. Management Phase (Creating Sustainable Innovation) ...................................................................................90
7.3. Concluding remarks on innovation differences.................................................................................................91
8. Conclusion..............................................................................................................................................................................92
8.1. Summary of the Results.............................................................................................................................................92
8.2. Concluding remarks: Implication of the differences and their impact on sustainable innovation ....94
8.2. Limitation and critique...............................................................................................................................................94
8.3. Further Research..........................................................................................................................................................96
9. Bibliography...........................................................................................................................................................................97
10. Appendix........................................................................................................................................................................... 106

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Executive Summary
The literature on venture capital and the finance of innovation is vast. Much of it focuses upon the existence and
extent of non-financial value added to new ventures, through active ownership also known from the private equity
industry.
This thesis develops a framework to identify cross-country differences within the investment strategies and value-
adding activities, and see if some of these differences could cause a better functioning venture capital industry.
Similar frameworks have often been used to investigate which activities add most value to ventures and also in
determining differences between different venture capitalists like private and public sector venture capitalists. The
framework developed in this thesis is founded in venture capital and innovation theory, which provides the insights
necessary to investigate how the venture capital approach can or cannot spur innovation, and hereby identify
perception perceptions of the value added from their venture capitalist and their network. The purpose of the
investigation is to uncover cross-country difference of how venture capitalists invest in Denmark, Israel, United
Kingdom and in the Unites States, and see if some of these differences can be traced back to whether some
countries have a better innovative eco-system than other countries.
The empirical data is mainly collected through a survey sent out to 60 venture firms, in Israel and Denmark, as well
as previous data points of 67 VCs in the United States and 15 in the United Kingdom. In addition, the hypothesis
development tested in this paper has been developed through 11 interviews of different venture capitalists,
entrepreneurs and business angels in Europe and the US.
Overall the research shows that the differences found between the four venture capital markets have limited
influence on the overall value adding services, and therefore there is no sufficient evidence that the U.S ventures are
capable of adding more value and should be copied into the European ventures' way of doing business. There are
however, significant differences in the way VCs invest in the four markets, and especially the DK market, which
seems more risk averse than the US, IL and UK venture markets and with a lower average amount of investment
throughout the lifecycle. Even though the above results are not conclusive, the research has clearly identified
differences between the four countries that could limit the innovative ideas and the development of healthy
ventures, and therefore create a less attractive ecosystem for startups.

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1. Introduction
Venture Capital refers to a specialized form of industrial finance that can be used to prove a business concept, help
set up a business or allow it to expand (Cumming D. , 2010). In the last century, venture capital has developed as an
important intermediary in financial markets, providing capital to firms that might otherwise have difficulties
locating capital towards expansion of their venture, such as biotechnology, IT, software, etc. In addition, venture
capital is often appealing for young companies with inadequate operating history that are too small to raise capital
in public markets and have yet to reach the point where they are able to obtain a bank loan or complete a debt
offering. The high risk that venture capitalists take on, by investing in smaller and less mature companies, venture
capitalists in exchange usually get significant control over company decisions, in addition to a significant portion of
the company's ownership (and consequently future value). (Privco, 2011)
The origins of the term "venture capital" are unknown, and there is no standard definition of it. It is, however,
generally agreed that the traditional venture capital era began in 1946, when General Georges Doriot, Ralph
Flanders, Karl Compton, Merrill Griswold, and others organized American Research & Development (AR&D), the
first (and, after it went public, for many years the only) public corporation specializing in investing in illiquid
securities of early stage issuers (Ante, 2008). In the 1960’s the US venture capital industry for technology firms got
consecrated when Silicon Valley laid the fundament for an inspiring environment for the information technology
industry to grow, whereas we today see London and Berlin as the new technology hubs of Europe, (Malik, 2011)
and (Johnson, 2012)
During the 1980’s and 1990’s, there was a tremendous boom in the American Venture Capital industry. The pool
of US venture funds – partnerships specializing in early stage equity or equity-linked investments in young or
growing firms – has grown from just over USD 1 billion in 1980 to about USD 29.4 billion in 2011. (NVCA, 2012)
Much of this growth seems to have bypassed Europe. European VC’s have long been overshadowed by the funds
specializing in buy-outs and other later-stage transactions: not only has the level of such activities been far lower
than elsewhere, but so have the returns. While there was a brief surge of European venture capital activity in the
late 1990s, it proved short lived and many of the new entrants collapsed early in the next decade. Many of the
policy initiatives of that era, such as the creation of the pan-European EAASDAW market for young growth
companies, and the First North market in the Nordic countries, have been written off as failures.
The European Venture Capital emerged about 20 years after the US emerged in the 1960’s in Boston,
Massachusetts investing in young technology firms. In the early 1980’s, the European Venture Capital invested
around 1/8 of the equivalent of their US counterparts. (Roure, Keeley, & van der Heyden, 1990) Furthermore, this
gap seems to be widening, especially within the information technology sector, proven with data from Jeng, Wright,
Mason, Sapienza, Friend and Manigart, that suggests that the rate of success of venture capital-backed startups in
Europe is far less than that of the U.S. (Jeng, 2000), (Wright, Robbie, Albrighton, Mason, & Harrison, 1998)
(Sapienza et al.; Burton), (Friend and Manigart) The scope and sophistication of the venture capital industry in the
US is one reason for the exceptional ability of the US to continually nurture new global and trailblazing information

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technology gazelles, as well as other industries, such as Cleantech and Biotech. According to Jeng and Well, in
comparison to European venture capitalists, the propensity and frequency at which high growth information
technology start-ups which are developed by US venture capitalist are much higher.
Venture capitalists are today regarded as key actors in well-integrated innovation systems. (Cooke et al., 1997;
Florida and Kenney, 1988; Kenney, 2011; Powell et al., 2002; Samila and Sorenson, 2010) Persuaded by the belief
that venture capital firms are the ideal partners for financing corporate research and development, many OECD
governments have sought to promote innovation by channeling public funds to venture capital firms, securing
favorable fiscal and regulatory frameworks and directly mobilizing venture capital firms in support of small,
innovative firms. (EVCA, 2012; OECD, 1997)
To maximize the effectiveness of these policies it is important to understand exactly where in the product
development process venture capital firms (VCs) are most likely to enter (research or development) and how this
affects invention and contributes to create sustainable businesses that will grow with the economy. Theoretically
public agencies might find themselves in one of the following three scenarios:
- First, VCs might target their funding and managerial efforts both to research and development
- Second, VCs might focus only on ventures in the developed stage
- Third, VCs might focus exclusively on the commercialization of preexisting inventions, leaving both
research and development out of their boundaries
Denmark has frequently been seen as one of the biggest knowledge hubs, with a high educational level and an
entrepreneurial mindset, compared with similar Nordic and European countries (European Commision, 2012).
However, the Danish knowledge society has for many years been less superior when it comes to innovative
ventures and their success rate. Historic numbers show that the number of ventures who have succeeded has long
been overtaken by other Nordic and European counterparts, and so has the perceived number of discontinued
ventures (Zephyr, 2012). More so, there have been fewer successful tech firms in Denmark compared with other
European countries, and in many cases it has proven that “Danish” ventures in foreign countries have been more
successful. (TV2, 2012) Especially the US venture capital industry has carried out many successful startups, such as
Google, Instagram, Facebook, Etsy, Zoosk, Xirrus, etc. which and hereby helped innovative initiative to grow
within the US, and also creating economic value in the end, especially through job creation.
This research study deals specifically with the differences in the financing of start-ups within the technology
ecosystem in US, UK, Israel and Denmark. The study will map the difference between these countries and the end
discuss will focus on what could be done in the Danish Venture Capital Industry to make a better ecosystem for
innovative ideas in the future.

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The thesis is structured as follows: The first three sections present the theoretical review on both innovation and
venture capital theory, which ends up in a theoretical discussion on the venture capital impact on innovation and
economic growth. In section four a short macroeconomic analysis is made on the four countries in the peer group,
which will be include in the hypotheses development. The fifth section gives an introduction on the research
framework and the hypotheses developments followed by a sixth section that analysis the above findings. A
discussion based on the previous section will be made based on what can be done within the Danish venture
Capital environment to enhance the spur of innovation within the tech industry. The paper will summarize with a
selection with a conclusion, limitation and further research based on the findings within this paper
1.2 Research Objective
Differences in Venture Capital markets are well documented and argued for in various articles and papers, as well
as new stories on electronic platforms such as Techcrunch and Gigaom. (PWC, 2012), (Nesta, 2010) and
(Lindström, 2006) Differences on different continents, countries, regions and even cities have been enlighten the
last couple of decades (European Venture Capital, Financial Systems, Corporate Investment in innovation, and
Venture Capital), where the majority of the research projects have had the objective to show the differences from
an European and US perspective. This research acknowledges that there are differences on multiple levels within
venture capital and also internal differences within a country itself, such as, Boston to New York, London to
Birmingham and even Copenhagen to Aarhus. These differences, with some of them of notable significance, have
been neglected within this research paper and each country (UK, US, DK, IL) is seen as homogeneous clusters.
Therefore, the assumption of this empirical research study is:
 There is a U.S. way of venture capital financing of startups, which is homogenous and there are
therefore no regional differences
 There is a UK way of venture capital financing of startups, which is homogenous and there are
therefore no regional differences
 There is a DK way of venture capital financing of startups, which is homogenous and there are
therefore no regional differences
 There is a IL way of venture capital financing of startups, which is homogenous and there are
therefore no regional differences
With the above definition of the homogenous clusters per country in place, we therefore have a comparison of four
different countries. The study is both a descriptive, and a comparative analysis of each country and the goal is to
identify differences between the four countries, and hereby analyze the differences with an innovative perspective,
and identify some of the reasons why the US venture capital market has been and still is superior to the European
markets.
The differences are to be analyzed for the from the due-diligence phase until the exit phase within the venture
capital investment cycle: due diligence phase, investment stage, deal structuring and negotiation phase, management

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phase – value adding services, and exit phase. The thesis will therefore not look into the differences in the contact
and investment criteria phase, but these phases will also be mentioned in short in the introduction to the venture
capital industry. In regard to the venture capital investment process, this empirical research aspire to answer the
following research question, propositions’ and phenomena:
What are the differences in the way US start-ups are financed with venture capital compared with the UK,
IL and DK way, and to what extent can these countries learn from the differences to help spur more
innovation within these countries?
More accurately, the thesis attempts to compare, highlight and answer the following questions:
 Is the average size of investment in start-ups in the seed, start-up and growth stage in the US Post
Exchange rate adjustments larger than in UK, IL, and DK?
 Is the risk strategy of the venture capital firms in the US more aggressive, and less risk averse than
in the UK, IL, and DK?
 Is the percentage of due diligence (market, product, financial and team) analysis that is done
informal in the US bigger than in the UK, IL, and DK?
 Do US venture capital firms add more value to their portfolio companies than their UK, IL and
DK counterparts?
 Are the exit-channels different in the US compared with the UK, IL and DK counterparts?
This paper should be seen as an outline of the differences of the venture scenes in the United States, United
Kingdom, Israel and Denmark, with the purpose to show the main differences that spur innovation from a Venture
Capital perspective. In addition, the paper will manly take part in the microeconomic perspective, and only in short
discuss the macroeconomic take on the differences.
1.3 Research Method
This thesis aims to answer the stated research question by employing three complementary research methods:
 Literature review
 Qualitative study
 Quantitative study
First, the most relevant academic literature about venture capital, innovation and economic growth is reviewed. The
main focus is upon papers studying the differences in the venture capital financing in different countries, as well as
how venture capital spurs innovation. The purpose of the literature study is to give an overall picture of the
academic research in the domain of the research question and to obtain a theoretical framework on which the
empirical part of the thesis can be built. The literature review is also utilized to identify the best and most recent

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methods for the quantitative part of this thesis. In addition, the empirical review of the literature within the topic of
Venture Capital to spur innovation looks to show that a better Venture Capital industry within an economy will
spur the national innovation and therefore create economic growth. The reviewed materials include articles in
scientific journals, textbooks, publications from venture capital industry associations, and other academic materials.
The empirical part of this thesis starts with an interview study based on 11 interviews with business angels,
entrepreneurs, venture fund managers, and other industry experts, from the UK, IL and DK. The objective of
these interviews where to obtain a better understanding of how venture capital companies are managed, what kind
of criteria they use in their investment decisions, and how they interact with their portfolio companies. This also
offers us an idea of what entrepreneurs and business angels see as the biggest challenges and differences between
the different countries. By interviewing experts in the field of venture capital, it is possible to ensure that all relevant
theories and hypotheses for the determinants of venture capital returns have been identified in the literature review
part of this thesis. Otherwise, there would be a risk that the academic literature on the subject has not identified all
relevant performance determinants. This might be true since, there are currently surprisingly few academic papers
concentrating purely on venture capital and its connection with innovation. The literature reviews, as well as the
qualitative study, have helped to develop the hypotheses in the thesis, which is to be analyzed from the quantitative
date study.
The most important part of this thesis is the quantitative study, which aims to analyze the differences in the
approach of the venture capital funds in different regions of the world. The findings and insights from the previous
research methods are used as inputs in the form of hypotheses development and therefore the groundwork for the
analysis. The objective of the analysis is to explain, at least partially, the observed differences between the four
different countries and their way of investing within young ventures, by finding statistically significant explanatory
variables. The research study employs secondary data collected from previous research for data on the US and UK
venture capitalist, as well new data collected from a question guide similar to the one used in the afore-mentioned
data research for the DK and IL venture capitalist. The quantitative study is done through 69 data points from the
US, 17 in the UK, 19 in the IL and 11 in DK. The collected data is in some cases analyzed statistically using
econometric methods, and some is compared by a simple average mean.
After the main differences have been identified, the study aims to give some practical suggestions on further
research in order to improve the Danish venture capital scene, given the findings in the US, UK and IL venture
capital markets.

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1.4 Research Design
Research Method & Design
Introduction to Venture Capital
Does Venture Capital spur
innovation?
Introduction, framework
and paper thesis outline
Literature review and
knowledge development
Analysis and discussion of
relevant findings and
differences
Research Framework Model and
Hypotheses development
Analysis and Comparison
Discussion of the findings in
relation to the innovative
environment
Conclusion and future research
Innovation and Economic
Growth
Innovation Introduction

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2. Introduction: Venture Capital Financing of Start-Ups in Business
Administration Theory
2.1 Definition of Venture Capital
Though Venture Capital has been a term used extensively, “venture capital” has yet to be defined in business
literature, thus several researchers in the field have come up with their own definition: Venture capital is a segment
of the private equity industry, which focuses on investing in nascent young firms with high growth rates, and large
market potential (Haeming, 2003). Private equity includes all equity invested in corporations that are not listed on
stock exchanges, whereas venture capital is a private or institutional investment limited to relatively early-stage
companies (Arundale, 2007).
Many people have given their own definition of what venture capital is; common between them all is that they see
private capital invested in young risky assets, often very early in the business cycle of a start-up. In the next section
some basic terms within venture capital will be introduced, which are important for understanding the purpose and
the background of the main problem in this paper.
2.2 Equity Financing: Venture Capital Financing
A start-up or innovation requires capital during the formation of the idea. One of the main problems many start-
ups have realized today in the process of starting a new venture/innovation is raising capital. Within the idea
generation (innovation process) start-ups need capital to finance cash flow needs long before demand and revenue
materialize. (Sherman, 2005) Typical characteristics of the financial needs of start-ups can be described as following:
 Start-ups often have little history and thus possess no fundamental customer base and financial data, which
would make it difficult to create a reliable financial valuation
 Start-ups are often considered by a high level of uncertainty and risk both internally and externally -
management team risk, product development risk, market risk, and exit risk
 Start-ups are more likely to seize up in the market compared with established businesses are
 They often do business in dynamic and perpetually evolving markets with extensive growth rates, such as
IT, BIO, Pharma, Cleantech, etc.
 They often have a negative cash flow the first couple of years and are not expected to make any profits in
the forthcoming years
 Business decisions are predominantly made by founders with industry knowledge but lack of management
and established business administration
 The start-up is provided equity funding by early stage investors, such as venture capitalist and business
angels, who in return obtain equity share, voting and control rights
 Start-ups often have a strong technology orientation

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With no or limited operating history, missing hard-knock financial data and no collaterals, start-ups cannot raise
funds by taking loans or issuing debt securities – at least not at any favorable interest rates. Therefore, start-ups
often rely mainly on equity capital in financing entrepreneurial venture or through crowd funding.
As a result, venture capitalist and other early stage investors, make the decision whether to fund a project often
based on the perceived strength of an idea, capabilities, scalability, originality, skills and quality of the management
team. Venture capital have often been the preferred financing path for many start-ups due to the reason that start-
ups have no or limited access to debt financing.
Figure 1: Investment options for start-ups
As illustrated in figure 1 equity financing takes three main forms: Institutional, non-institutional and crowd funding.
Generally we see two groups of non-institutional investors: Founders, Fools, Family and Friends on the one hand
and Angel Investors (Business Angels) on the other hand. Institutional investors consist of three main sub-groups:
independent venture capital, corporate venture capital and public venture capital. Crowd funding is a new
phenomenon, which especially has been used within non-profit, art, social development, etc. However, the term is
growing and crowd funding could be a new way of getting your start-up funded, as big crowd-funding sites such as
Kickstarter, FundersClub and Seedrs are starting with equity crowd sourcing.
2.2.1 Crowd Funding
The value of the crowd has long been acknowledged within the venture scene. The proof of having a crowd
following your investment, Twitter, Facebook or Angelist, gives your firm value and recognition. However, crowd
funding also now makes it “easier” to realize the first round of funding (RockThePost, 2012).
Kickstarter, who has been the pioneer within venture crowd funding has been successful the last couple of years
helping start-ups realize their dreams through the public crowds (Mashable, 2012). Individuals invest small amounts
($50-$100), and if the investment reaches its target amount of funding, the money is withdrawn from the
individuals (Kanberg, 2012). This is a powerful resource, which has been previously seen within art and other
creative industries. (Velazco, 2011)

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Today there are several crowd funding sites as Kickstarter, GrowVC, Fundrs, RockThe Post, Seedups, RocketHub,
FoundersClub etc. Crowd funding platforms have already revolutionized the funding of new ventures. However,
the management of all the new shareholders is a new issue raised by many experts. People who have either donated
or invested in your firm all have the right to be informed in decision making as other shareholders, which can bear
costs on the firm such as limiting the innovativeness of the ventures. Research on this field is still to be carried out,
and the results are going to be interesting. In addition, the value adding aspect of expert and knowledge of the
market will often not be part of the equity financing, within crowd funding.
Even so, crowd funding could be a new aspect of Venture Capital, and engage more start-ups and maybe even spur
innovation even more. However, this paper is not focused on crowd funding, and its importance for the future of
venture capital, even though it might have some important aspects. In addition, the aspect of comparing different
nations’ innovative process is limited as the crowd sourcing is global and therefore all start-ups are given the same
opportunity to become successful.
2.2.2 Institutional Venture Capital
“Institutional Venture Capital” used as a term can be traced back to the year 1946. General Georges Doriot, Ralph
Flanders, Karl Compton, Merrill Griswold, and other angel investors with interest in investing in start-ups or other
early stage actives, established the first institutional venture capital firm “American Research & Development” in
Boston. (Bygrave & Timmons, 1986) In recent years, Haeming defines institutional venture capital as equity or
equity-linked investment in young companies, where the investor is a financial intermediary, who typically acts as an
active director or advisor in the young company. (Haeming, 2003)
National Venture Capital Association (NVCA) defines institutional venture capital as private, corporate or public
funds that focus on investments in early stage technology companies. (NVCA, 2012) Institutional venture capital
firms are financial intermediaries, who specialize in raising funds from private, corporate or public sources and
investing it in young innovative technology companies with high risk and growth potential. (Bygrave & Timmons,
1986)
Institutional investors often invest when the start-up has established some kind of “proof-of-concept”, and thereby
lower the risk of the investment significantly. As a result, institutional venture capitalists invest in start-ups after
they have been funded with non-institutional venture capital or crowd funding scenarios. In contrast to the latter,
institutional venture capitalists are very formal, highly professional and do not invest their own funds. They are
fund-managers who are employed to invest and manage custodial money, i.e. funds from third parties such as
wealthy individuals, banks, insurance, university endowments, and pension funds. As depicted in fig 2.2, there are
three main types of institutional venture capital: corporate venture capital public venture capital and independent
venture capital. The source of funds, investment objectives, organizational structure, investment behavior, range of

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non-financial value – added services and legal forms vary across all three types of institutional venture capital firms.
(Landström, 2007)
The most common way of financing start-ups around the world is still venture capital financing. Even though
crowd funding seems to be very popular, especially in the US, crowd funding is only a small amount of the total
invested capital in start-ups (CrunchBase). This thesis will therefore continue to look at independent venture
capital, which is often referred to as “traditional capital” and also seen as the majority of capital for start-ups in the
countries of DK, UK, IS and US (Lumme, Mason, & Suomi, 1998)
2.2.3 Independent Venture Capital (IVC)
2.2.3.1 Definition and Characteristics of IVC Financing
IVCs are neither a subsidiary of a corporation nor do they exist to fulfill government economic policy tasks, but act
as stand-alone venture capital firms. They are normally representative of a small team of administration and
industry experts and therefore also flexible, which allows them to make quick decisions. Furthermore, IVCs are
often set up as limited partnerships in which the venture capital manager is the general partner who invests money
contributed by limited partners. Consequently, IVCs have large investment capacities and monitor start-ups
through formal control. (Nesta, 2010)
IVCs do not invest the whole amount that they raise into start-ups. Often there is a management fee of 1-3% of the
capital raised, to cover up the overhead costs of running a venture capital firm over the life of the fund. For
example, if the IVC raises 800 MDKK of a fund over 10 years, with a 2% management fee, the IVC charges 2% of
the 800 MDKK every year, which amounts to 160 MDKK (20% of 800 MDKK) over the life of the fund.
Therefore the total amount invested would only be 80% of the total amount raised. (Sbietiati, 2012) (VCIC DK,
2012)
Some cases of IVC have a management fee for the total amount raised and thereafter the management fee changes
for the percentage of the total amount invested. Often you see more deals in the end of a fund, since this will affect
the wage of the management in the IVC in active period of the fund. (Sbietiati, 2012) (VCIC DK, 2012)
In addition, if an IVC at the end of the life of a venture capital fund returns more money to limited partners than it
raised, the IVC receives a percentage of the profit. This part of the profit allocated to an IVC is called carried
interest (carry). Carried interest ranges from 20-30% of capital gain in the VC industry. (Sbietiati, 2012) (VCIC DK,
2012)
IVC have some certain criteria they look at before investing: (VCIC DK, 2012)
- High Return (Potential Revenue): IVCs are focused purely on financial gains and making big exits

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- Market Size: To realize a high return the potential market has to follow the business ideas well augmented
revenue stream, otherwise VCs would not see any reason for investment
- Team: IVCs place enormous emphasis on the management team, much more than the business idea itself
– placing a bet on the jockey, not the horse
- Innovative ideas: IVCs look at the frontier of today’s technology for ideas and scientific advances that
will create tomorrow’s technologies. From there they try to identify start-ups that fit into that framework
Below is outlined the differences in the institutional venture capital industry, excluding crowd funding, explained in
the previous sections.
Independent VC Corporate VC Public VC
Source of Funds Pension Funds
Wealthy Individuals
Insurances
Public Administration
Corporate Funds Public Administration
Legal Form Limited Partnership Subsidiary of a big
Corporation
Fully owned by the
government
Motive for investment Equity Growth Synergy and to a lesser
degree equity growth
Job Creation
Regional Economic
Growth
Platform innovation
Monitoring Formal Control Corporate Control Limited Formal Control
Table 1: Different types of venture capital and the differences in between (Garbade, 2009)
This study is fully focused on independent venture capital financing. From this point forward in the study, the term
venture capital always refers to independent venture capital firms.
2.3. Stages in the Financing Life Cycle of a Start-up
A-, B-, C- and D-Rounds are terms used to express the different levels, also known as rounds, of financing start-
ups. A-round is seen as the first institutional venture capital round into a start-up, and so follows B, C and D-
rounds when each investment round has gone. In recent terms Just-Eat, the take-away portal, just finished their C-
Round and received $64 million on the 30th of April 2012. (CrunchBase)
The product life cycle model, known from marketing, is also a common toll to identify the different stages of
financing in early-stage ventures. The product life cycle model is a practical tool used to identify and analyze the
distinct stages affecting the sales and maturity of a product from the introduction stage, growth and maturity until
its decline. (Klepper, 1996)

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Previous literature dictates that the ideal stages in development of a start-up are classified into three main life-
cycles: early stage, growth stage and late(r) stage. (Nathusious, 1987) (William & Jeffrey, 1984) (Rhunka & Young,
1987) (Stanley, 1986) However, in recent years a new term, seed stage, has gone into venture investing. This stage is
often financed through the non-institutional investors; however some VCs also invest at this point.
Figure 2: Illustration of Entrepreneurial Capital Flow (Own illustration)
2.3.1 Venture Characteristics in the Different Stages
In the forthcoming paragraphs we will discuss the differences when investing in the different stages of the firm life-
cycle. The stages in the life cycle will be examined in terms of venture characteristics, source of investment,
investment size, major management challenge, major risks, progression of investment and business risk, and
difficulty in raising venture capital. This dissertation is extensively focused on early and growth stages of a start-up;
the seed stage, which is primarily nursed by business angels, and the later stage will not be examined.
(SQWconsulting, 2009)
2.3.1.1 Early Stages (Seed Stage):
This stage involves a relatively small amount of capital provided to an investor or entrepreneur to prove a concept
and to qualify for later stage start-up capital. If the initial steps are successful, this may involve product
development, market research, building a management team, and developing a full business plan. Venture capitalist
often stay-out of this investment round, because of the high risk, and let the 4F’s (Founders, Family, Friends,
Fools) take on this risk. (SQWconsulting, 2009)
2.3.1.2 Start-up Stage (Consolidate Market):
Financing in the start-up stage is generally for companies completing development and may include initial
marketing efforts. Companies may be in the process of organizing or they may already be in business for a couple
of year or less, but is still waiting to sell their products commercially. In VC terms these companies would have
been in Beta-mode and is ready for commercialization. Usually such firms will have made market studies,

19. 19 | Page
assembled the key management, and developed a business plan – and are now ready to conduct business.
(SQWconsulting, 2009)
Furthermore, financing in the later phase of the start-up stage could also increase the valuation, total size and the
share price for companies whose products are either in development or are commercially available. Due to the stage
of the venture and the outlook to commercialize the products in the near future, this round of financing, would
often be the first sign of engagement of a venture capital fund. Seed and early start-up financing tend to involve
angel investors more than institutional investors. The networking capabilities of the venture capitalists are used
more here than in the more advanced stages. (SQWconsulting, 2009)
2.3.1.3 Growth Stage (Expansion Stages)
This stage is mainly focused on applying working capital to the initial expansion of a company. The company is
now producing, shipping, and have growing accounts receivables and inventories. It may or may not be showing a
profit. Some of the usage of capital may include further plant expansion, marketing, or development of an
improved product. Other institutional investor is likely to be included along with initial investors from previous
rounds. The venture capital’s role in this stage involves a switch from a supporting role to a more strategic role.
(Metrick, 2006) and (SQWconsulting, 2009)
Throughout these stages several management challenges and risks are essential to overcome, before any success can
be achieved.
2.3.2 Structure of Independent Venture Capital Firms
VCs are becoming more and more specialized, both within industry focus and investment stage. Thomas Knudsen
from NorthCap Partners states that VCs typically specialize by focusing on a particular stage of the business
lifecycle. (Knudsen, 2012) Looking further into the business cycle VCs can be assessed within two main criterion:
 Stage of investment
 Investment horizon
Based on Figure 2 of the capital flow of investment, VCs often invest in the Start-up and Growth Stage of the
development of the firm. There are however also venture capital firms that specialize in investing and managing
start-ups in the seed. These are VCs whose funds are not very big, but who invest a lot of time and huge personal
management resources in the start-ups they invest in.
Many venture capital firms fall into the class of growth venture capital. This is normally the ideal stage, where
venture capital firms can add maximum value, namely assisting a start-up strategically and operationally to expand
in their home markets and expand into new (international) markets. Even so, there are VCs who invest in all of the
above stages, because of their internal portfolio companies and external network, to help and improve the chance
of success of the start-up.

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Depending on the prospect of the investment, VCs tend to have a long horizon to build up a strong business case
and make the start-up profitable. Of course, the horizon depends on the time of investment (what stage), which has
been clarified above. Many VCs plan to exit within 5-7 years, as the firm should have proven to take a certain
market share in that time. One thing to keep in mind is that the start-ups that VCs invest in should be highly
growth orientated and therefore also expand rapidly into new markets.
2.3.3 Role of Independent Venture Capital Firms in Start-ups
The role of VCs in start-ups is focused upon the specific added-value that VCs add in each stage of the lifecycle.
This paper discusses this by looking at how VCs support and create success for the different start-ups, and thereby
create more value and improve the rate of success in each stage. The thesis will only look at the early stage up until
the growth stage, and the later stage is therefore completely excluded in this research.
“Venture capital is more than money – venture capitalists bring valued added” – this phrase is what many sees as
the big difference, compared to bank loans and other debt orientated loans. (Kølendorf P. , 2012) Today many
recognize this term as smart-money. Whereas, dumb money is simply money where capital is the only value added.
Haeming portends that it is important to draw upfront a distinction between founders and entrepreneurs; a founder
has a lot of analytical skills but little or no idea about the market, whereas an entrepreneur is a person with
knowledge in all aspects of technology, market, finance, and people skills. (Haeming, 2003) VCs are often well
suited to fulfill these gaps of start-up founders. They have money and expertise in commercializing business
models. VCs have good access to capital, are endowed with managerial experience and often have comprehensive
knowledge of the targeted industry, and count on a well-developed network of suppliers, customers and key
personnel. Seppa and Hsu even displayed in empirical research that entrepreneurs are willing to accept lower
valuations and face higher dilution, only due to the expectation that VCs will contribute more to the future value of
their venture. (Seppa, 2002) (Hsu, 2004)
All the professional assistance that VCs deliver to start-ups can be categorized into social capital and human capital.
Human capital refers to managerial and entrepreneurial experience, whereby social capital relates to professional
contact networks that VCs provide, through their long experience within the market. This paper's research did not
uncover a specific list of what value added services VCs provide, however through interviews and readings on the
topic we have listed the following as the most important features of a VC in terms of added value:
 Monitor – VCs monitor start-ups through their voting and control rights. They act as strategic generators
of sound board members for strategic initiatives
 Advisor – VCs role as an advisor/consultant is probably one of the most value-adding services to new
entrepreneurs/founders. The VCs have had an enormous experience within the industry and knows what
to do in certain cases; this will often mean that the VC will succeed instead of fail. Services could be:

21. 21 | Page
Proactively consulting in important decisions, helping executing strategies, operational issued internal
disputes, financial management, marketing, public relations, etc.
 Interim Manager – In certain situations (often in the seed-stage), VCs take the role of interim managers
carrying out day-to-day operational activities. VCs helps on executing ideas and tasks, which the current
management will or could not achieve
 Contact Networker – On the same page as the advisor role, the VC network is one of the most valuable.
Young entrepreneurs often lack a strong business network, due to their limited time in the “market”.
(Kølendorf P. , 2012) VCs fill this void by making strategic introduction of start-ups to the extensive
networks they have cultivated over a long period of time: customer introduction, portfolio company
introduction, strategic alliances within the VC industry, etc.
 Motivator – VCs automatically take the role of mentor and motivator of the entrepreneurial teams they
invest in. They teach young founders and inspire them to work harder and goal-orientated in making the
start-up a success
 Proof-of-Concept (Reputation) – Often start-ups get a “boost-of-confidence” and recognition within
the industry, when they get backed by a VC. This proves that the start-up has gotten through the “keyhole”
and that your idea has a high potential (Watzenig, 2012)
 Portfolio alliances – Portfolio alliances is also seen within Private Equity. VC has many portfolio firms,
and the potential of becoming customers and partners in-between are high. Therefore, start-ups can realize
a set of new customers from which they can learn from in both the alpha and beta stages.
In the growth stage the role of the VC is more on acting as monitors, operate as directors on the board, and having
an outside-in overview of the whole development of a start-up and advising on important legal agreements and
contracts. (Broomfield, 2005) In this phase VCs help in reshaping the start-up in building a professional
organizational structure as it grows. Within this stage, changing the management team could be necessary, since the
one who founded and made the company grow, is probably not the right individual to ensure that the start-up is a
success in the next phase. VCs therefore also helps hiring people with experience within the industry and stage of
the start-up.
Start-ups that are backed by top-tier VCs can cherry pick their local alliance partners because of the name
association with coveted VC firms. In the role of a mentor in the growth phase, VCs are the entrepreneur’s
confidants with whom founders share their personal entrepreneurial problems and thoughts.
2.4 Theoretical Foundation for Explanation of the Behavior of Venture Capital
Firms
Start-ups and VCs tie their specific knowledge, capabilities and resources together to build a start-up that, with
these combined aspects, will have an increased chance of success. In this relationship, the VC signs contracts with
the start-up and hereafter delegates the mandate to manage the employees and the daily operation to the founders.

22. 22 | Page
Typically in such a deal, the start-up brings the business idea, product and the people to the negotiation table,
whereas the VC often brings capital and value-adding-services, explained earlier in this section.
VCs attain a large influence in the start-up, when buying the equity of the founders and the founders are in fear of
losing control over the firm. Hence, problematic issues and conflicts can arise, when the founders of the start-up
and the VC have diverging interests and goals. The relationship between the founders of the start-up and the VC
are complex. On the one hand they have engaged in a marriage often up to a decade long, and on the other hand
the VC needs to govern the founders, and make sure that the start-up is developing as expected. The founders
could become free-riders coasting on the investment of the VC, and seek other opportunities. Agency risk is a
significant hurdle to overcome for VCs and relies on good due diligence work and people skills.
2.4.1 Agency Theory Model: Asymmetric Information, Moral Hazard and Adverse
Selection
An agency relationship is a relationship in which one party (principal) delegates work to another party (the agent) to
perform a job as defined in a contract. (Eisenhardt, 1989) Looking at the VC/founders conflict with an agency
theory perspective of Eisenhardt, the VCs take the role as the principal and founders takes the role as the agent.
Because the contract of the VCs and the founders is not contractually well defined, the founders of the funded
start-up could act/behave reluctantly towards the VCs. The two most important appearances of agency risk within
early venture financing are information asymmetries and goal incongruences. Cable and Shane define information
asymmetry as all the hidden (private) information that a founder or VC holds which is not necessarily readily
available to the other transaction partner. Research has in addition shown that there is a perception from founders
that the relationship with BAs (Business Angels) is better than the one they meet within VCs. (Fairchild, 2011)
Through interviews and talks with both BAs and VCs they more or less all identified three main information
asymmetry aspects: Capabilities, Intention, and Actions:
 Capabilities is often an aspect which VCs try to limit through thorough research in the due diligence
session. However, it is difficult to see if the founders have the characteristics and capabilities’ to make this
venture a success
 Intention is also difficult to measure. VCs will not know the founders real intention with their venture
before they have worked together in a couple of months/years. Furthermore, this information asymmetric
goes both ways. VCs will also see their knowledge and intention hidden for the founders of the firm.
 Actions (moral hazard) of the founders can lead to huge successes or dramatic losses from one day to
another. VCs will have a hard time governing and controlling founders on a daily basis, Founders of the
start-up will therefore have the space and opportunity to act against the strategy which the VCs have set
for the venture.

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Both the VCs and founders need to limit the asymmetry of information to engage in a healthy relationship and
make the best of their future work. If the goals of the VC and the founders are aligned, all actions by the founders
will lead to a concomitant maximization of the utility of the principal and agent. Both parties therefore have some
basic tools to limit this asymmetry, which will be discussed in the next section of agency risk.
2.4.2 Mitigation of Agency Risk
The more the interest of the VC and the founders are aligned, the higher the likelihood of cooperation in-between
the VC and the founders on a long-term, which will without a doubt increase the chances of a successful venture.
In mitigating agency risk, the following specific mechanisms and contractual provisions, which align the interests of
both transaction partners, can be deployed. (Kaplan, 2003)
1) Screening of founders and investment opportunity is the most important factor of limiting or mitigating
agency risk within a given investment opportunity. The ability to attract and screen the right people and
business plans is a difficult task, and the ability of recognizing untruthful founders is generated through
experience rather than haven a certain checklist etc. (Rasmussen, 2012)
2) “Hand-on-the-hob” is also a great way to make sure that both parties need to perform and create value.
Witteloostuijin argues that having a substantial stake of ownership in a firm, team members may have a
greater incentive and commitment to leverage their human capital to enhance organizational performance.
(Witteloostuijin & Wijbenga, 2006) This view is often also seen within a private equity perspective, where a
lot of knowledge within the top-management has to perform to create future value within the target firm
(Splid, 2007)
3) A suitable contract requires a venture capital contract designed to align the interests of both the VC and
founders – a contract which maximizes the value of both parties. This requires that the contract should
contain both legal and financial consequences in case of severe violation. (Cable & Shane)
4) Comparable with the private equity market performance-based allocation of stock options, or other
financial incentives, to founders has historically proven to be a effectual method of increasing the efforts of
the founders (Splid, 2007)
5) Milestone Financing of a start-up in stages induces founders to fulfill and behave honestly of the given
terms, because a VC can withdraw from an investment at the next milestone if not fulfilled (Wright &
Robbie, 1998)
6) Monitoring through board positions: Through board representations, which entails voting rights,
information and approval rights, VC can gain a strong control leverage of the founders of the start-up.
7) Post-investment involvement from the VCs with the founders will make a stronger commitment, and the
possibility of the founders to feel more connected with the VC, will increase. Also, the founders might find
it more difficult to “go-their-own-ways” if the VCs are actively present and involved in strategic decisions
(Cable & Shane)

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There are several ways in which VCs and founders can mitigate the asymmetry information. If you go on top of the
seven options, you can extract two main characteristics you should take action upon when deciding to fund a
certain start-up. Contractual design and active involvement, will limit the asymmetry information significantly,
however, it will be impossible to eliminate all asymmetry. (Lerner & Schoar, 2004)
2.5 Typical Venture Capital Investment Process: VC Investment Cycle
The investment process can vary from one VC firm to another; however it typically involves five aspects. The
process starts with the sourcing and screening of ideas, followed by due diligence, negotiating the terms of the
forward work, post-investment monitoring/involvement, and generating return (exit phase). Generally, as stated
previously, the most important, and also the most common deal breaker, is the lack of faith in the current
management team and their abilities to execute the business case. The next section will briefly discuss every step of
the venture capital investment cycle.
2.5.1 Contact Phase
Time is limited and is one of the most valuable resources for both VCs and Business Angels. Often cold calls, e-
mails and letters are therefore seen as “spam”, and even though many proclaim that they try to answer all inquiries,
time is limited and often the answers are given without even looking at the business plan. (Kølendorf P. , 2012)
(Buch, 2012) The only qualified deal flow routes are through strategic referrals or direct contact with a VC at an
industry event, but the strategic referral is the primarily preferred source of deal flow. Angel.co is a platform
actually based on this approach, trying to connect start-ups through network of referrals and sponsors, where
getting the right sponsor/referral could mean the difference between finding capital or not. VC’s prefer to rely on
their intimate network for new investment opportunities.
“I have invested in five different businesses now, but they all have one thing in common: I trust and know the people who have
either referred me to the cases or they are involved within the case. In my experience this is the same for many VC’s I have
encountered with my work at Just Eat” (Buch, 2012)
Even though Angel.co and crowd sourcing platforms have changed the way start-ups can promote themselves and
get social proofing, the financing part is still done through referrals either virtually or in person, and the basic
investment are therefore often linked to the personal connection. Effective networking with sponsors and referrals
of a VC is therefore paramount to receive funding. Sponsors can be angels, attorneys, accountants, consultants, or
venture capital networks. The best sponsors would however always be the ones who are within the VCs’ inner
circle; an investor or some management from previous investments who have performed. (Cardis, 2001)
Generally there are four possible deal “flow-routes” to approach a VC with the investment opportunity.
1) Strategic referral or sponsorship contact
2) Direct contact with a VC at an industry event
3) IT platforms: (Angel.co, Angellist), crowd sourcing platforms (Kickstarter, Seedrs, Fundrs), etc.

25. 25 | Page
4) Cold contact through, mail, telephone, or letter
If it is not possible to find a suitable sponsor and investor, the next step should be to attend industry events where
the target venture capital firm would likely show up – Web 2.0, Nexxt, Barcamp, Open coffee club, Web 2.0 Expo,
Techcrunch 50, Techcrunch Europa, Comed, Idealab, Web 2.0 Summit.
VCs has three purposes to visit these industry events:
 To socialize with other VCs
 To socialize with entrepreneurs
 To experience the latest trends within a field
The main components of a business proposal are analyzed in a short meeting and industry experts are asked of
their opinion. The VC then sends out a prompt “no” or calls to ask specific questions and requests a business plan.
This is however more common and seen as a normal procedure in the US, compared to what is seen in the EU.
(Titus, 2011) If the business plan survives the rigid initial review, the VC invites the entrepreneur for a face-to-face
presentation of the business case.
2.5.2 Screening Investment Ideas
It is important to elaborate that the choice of getting VC capital is an important choice for both the VC, but also
essential for the start-up. The right chemistry between the management team and the Limited Partners (LP) and/or
General partners (GP) within the VC is essential. It is thus important to have a certain analysis from both the VC
and the start-up, when starting their initial search and screening of candidates on either funding or receiving
funding. The VCs wants to take a glimpse at the members of the future management team of their investment, and
build a strong connection with them. Presentations to VCs should be like a sales pitch – a moment of personal
selling in which you sell yourself, your team and company.
Sherman and Arundale argue that the key questions any VC needs to have answered after the presentation and the
following Q&A are: (Garbade, 2009)
 Is the product or service technically sound and commercially viable?
 Is the business model understandable and does it make sense?
 Is the management team experienced and do they have the ability to exploit the business potential, control
the company through the growth phase and make the business happen?
 Which companies are the main competitors?
 How proprietary or unique are the company’s products or services?

26. 26 | Page
 How valid are the financial and strategic assumptions that support the basis for future success of the start-
up?
 How big is the size of the market?
 Is there an effective strategy for getting to market and building a potentially sizable and market-leading
business quickly?
 Who are the early customers? How are buying decisions made? Why do they want the product?
 What investment amount is needed to finance the business to the next stage?
2.5.3 Due Diligence
VCs often have different approaches towards the due diligence phase, as it also depends on the internal resources
and the maturity of the overall venture capital market. However, VCs often construct a detailed review and analysis
of an investment opportunity before an investment is made. In empirical research, it is found that the most VCs
prefer an investment opportunity which offers a good management team and acceptable product and market
characteristics. (Muyzka & Birley, 1996) This is also confirmed by both T. Knudsen and J. Buch from Miinto, who
have invested in several businesses in the last couple of years.
“I know it is starting to be a cliché, but it does not make it less true. I would rather invest in a A-management team and a B-
idea or business case, than investing in a A-business case and a B-management team. Basically I think the team means
everything for a case to succeed – you have to look into the eyes of the entrepreneur and you should see fire – if I don’t I will
not invest. The management team is the one who is going to carry the business case through its tough times, and you only do
this with passion and commitment” (Buch, 2012)
As stated above the management team seems to be recognized as the simple most important fact for a VC to
invest. However, this is also highly dependent on the investment stage of the VC. Investing in the growth and later
stages requires different capabilities, of both the VCs and the investment team. The idea has probably proven that it
has potential, and now the requirements to succeed are different, which implies that the management teams’
importance might be diluted with the development of the business/start-up.
Other parameters on which the VC make their decision whether to invest or not are: perceived strength of the idea,
capabilities, skills and past record of the founders. VCs have to cover three main types of risk within their due
diligence: management risk, which influences execution risk and agency risk, and market risk; competition risk,
new entrant risk, market growth risk and market size risk and product risk; product development risk, proprietary
risk and technology obsolescence risk. Due diligence can be defined as a rigorous assessment and evaluation of the
embedded factors that affect the likelihood of failure or success of a start-up.
There are many different approach of conducting a due diligence within the industry. Some VCs basically talk with
industry experts within their network, while others buy strategy and market reports from external consultants.

27. 27 | Page
There are three parts of a due diligence, also known from the Private Equity market; Business, Financial and Legal.
This report will not take on the Legal perspective of the due diligence, even though this perspective is often also
very interesting within start-ups. In the next couple of sections the report will go through some of the most
important areas of the due diligence phase within the VC environment. Some of the most important investment
criteria’s and how VC tends to eliminate risk within the different areas will be described. Of course the way a VC
do their due diligence differs, however, this thesis will take some of the most normal and basic characteristics of the
due diligence and enlighten these. The next section will be structured as follows:
 Management Team Due Diligence
 Business Model (Product Due Diligence)
 Market Analysis (Market Due Diligence)
 Valuation (Financial due diligence)
2.5.3.1 Management Team
In a correlation analysis, Tyebjee and Bruno find a negative correlation between the independent variable
“management capabilities” and subordinate variable “risk”, which fully validates the shift in weight of the key
investment decision criteria. VCs examine the business proposal and determine what skills and characteristics are
needed by the management team to make the start-up succeed. (Tyebjee & Bruno, 1984)
They evaluate every single member of the team and in addition the chemistry in-between the members of the team,
checking for passion, focus, vision, integrity, and profound dedication needed to run a successful start-up. The
basement of each founding member falls into two categories:
a) Individual characteristics – a founder/entrepreneur has to have a good business understanding, have a
good approach towards risk and good verbal ability.
b) Experience – VCs seek a track record of the founders, both success and failures, as you learn from every
single step within the entrepreneurial environment. Founders who have successfully managed business
before, including intrapreneurs. An experienced management team knows how to react when markets
change; therefore VCs often fancy founders with extensive experience in the relevant industry. Many VCs
even find it hard to invest in entrepreneurs who haven’t experienced failure of any kind. (Gladstone &
Gladstone, 2002)
2.5.3.2 Business Model: Product Due Diligence
In the product due diligence phase, VCs primarily focus on five main areas (Tyebjee & Bruno, 1984):
 Unique selling proposition of the product: describes a uniqueness yet not seen in the market, either
within the product, the go-to-market strategy or a new cost structure.

28. 28 | Page
 Stage of product development: It is important that the product is not to fare from market entry – as
penetration and scaling the products into new markets are initial to create the value for the shareholders
 Proprietary product: VC’s are afraid of competition and the easiness of copying the investment.
Therefore it is essential that the product is difficult to copy and the barriers to entry and copy the product
is high
 Technology obsolescence: The importance of having a product which technology is not going to
obsolescence for several years is important due to the long investment period of the VCs. Therefore a
thorough analysis of comparable technologies and their emergence have to be analyzed
 Scalability: Is one of the most important factors for VCs. To get the desirable return, it is important that
the product can be launched in multiple markets without to many barriers.
2.5.3.3 Market Analysis
VCs often carries out detailed and extensive market analysis to check the numbers given by the entrepreneurs, as
large markets are essential for achieving high exit value. The analysis are often done both through informal contacts
and external consultants, however this varies. Market due diligence covers three main fields:
a) Market size, growth rates and overall outlook is often seen as the number one reason for rejection if not
met. Generally many VCs will not consider investing in a small market as their future return would be
limited and not acceptable due to the high risk of the investment (Kølendorf P. , 2012)
b) Competitive environment is also an essential aspect of the overall market due diligence. A market with
fierce competition and low entry barriers would not be a perfect fit for a venture capital investment, as the
commercialization of a product often takes time (Rasmussen, 2012)
c) Clear targeted customer user is essential for any business. This includes a clear understanding of what type
of customer to target, and likelihood of the customer to purchase the product offering.
2.5.3.4 Financial Due Diligence (Valuation)
Financial due diligence of start-ups, which is seen as the valuation of a start-up and the price of which the shares is
worth, is a difficult and almost impossible task for the external advisor/investor. There is no valuable or credible
forecast tools, such as financial models or excel sheets that creates an overview of what the venture have
historically performed and what they have forecasted in the future as seen within other M&A transactions.
Therefore the financial due diligence is often a close collaboration with the before mentioned due diligence
sesseion. Moreover, VCs do have other valuation methods than looking at the market, customer etc. such as virtual
valuation, comparable companies method, comparable transactions method and in the later stages, the discounted
cash flow method. (Weston, Mitchell, & Harold, 2004)
In the forthcoming sections the paper will in short outline the some of the valuation tools VCs use to value start-
ups: Virtual valuation, comparable companies’ method, and comparable transactions. These sections should not be

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seen as a complete list of the valuation types used within venture capital. In addition, it is important to have in
mind that these tools are often only used in the later-stages of venture capital financing, and a more informal
valuation approach is often used in the previous valuation rounds.
2.5.3.2.1 Virtual Valuation
Virtual valuation is often used within the seed stage of financing. It is therefore primarily used by founders,
business angels, 4Fs and private investors, in the early stage of the ventures life, where there is nothing other than a
business plan or prototype of the product or service. (Kølendorf P. , 2012) In virtual valuation, the valuation is not
based on the potential future value of the start-up, but basically just on the amount of funds the investor pledges to
the investment. The equity stake that an investor receives is freely negotiated between the founders and investors
without prior placement of a new valuation method. For example an angel investor might offer a start-up the
amount of $25.000 needed to get the product on market and finance the first six months for an equity stake of
10%. (Garbade, 2009) In addition, convertible debt method could be used instead of an equity stake.
2.5.3.2.2 Multiples: Comparable Companies and Comparable Transaction Method
Within M&A a normal sanity check of a valuation is basically to look at transactions within the industry and
compare the multiples and value they have been sold for. It is often difficult to identify the exact same business,
however, it is used to identify a range of values (multiples) in which you would be able to identify a pattern. It is
therefore also essential that the peer group is homogeneous without too much variation.
The biggest problem is as stated to identify a good peer group – which is difficult within “normal” M&A, and
therefore almost impossible within the venture industry. The criteria that are used in selecting peer group members
are a) Market segment b) Target customers c) Size of start-up/firm d) Growth rate of a start-up e) Geographic
location and f) Capital structure. (Landström, 2007)
The most suitable multiple is the transaction multiple, which identifies the real value in the market of a series of
firms within the same peer group. Such an analysis can be made by using databases such as Thomson Reuters,
Orbis, Venture One, and Zephyr. However, a new database with knowledge from the Venture industry, which
should be used in the future are Angel.co and ChrunchBase. Both are US start-ups that facilitate information on
venture transactions and development of start-ups around the world. Angel.co is in essence an online founding
system used with the integration of the social aspect of your near associates. Whereas ChrunchBase is a more data
minded service, with a lot of data available to analyze and identify trends within the venture industry.
The comparable companies and comparable transaction methods are the dominant valuing methods in the early
stage of start-up. However, as mentioned previously, VCs need to check their valuation and interest through deeper
analysis and especially the execution of the business case is important. In some cases the DCF method would also
be suitable – however, this is often used at a later stage, since the credibility is even worse when evaluating a start-
up.

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2.5.4 Management Phase (Value Adding Services)
Value adding services are one of the most important aspects of the venture capital approach of investing. Often
start-ups decide to agree on a cheaper valuation because of the outlook of a VCs high reputation of not just
investing dumb-money, but acting in a very active way throughout their ownership, and therefore also increase the
potential exit-value. In the next two sections, the different value adding services in the different investment stages is
discussed, followed by the ways venture capitalists create value through active ownership. We had a brief
introduction to the “Role of a VC in a start-up” in section 2.3.3, which we will discuss more in-depth in the
following sections.
2.5.4.1 Value Adding and Investment Stage.
In early stage ventures, the weight attached to operational value added is expected to be higher than in the stage of
expansion. This is in line with results produced by Bygrave & Timmons, Landström, Elango, Fried, Sapienza,
Manigart, & Vermeir. They all argue that the importance of ‘hands-on management’, which in this context is a
synonym for operational value added, vanishes with the ongoing development of the venture. (Bygrave &
Timmons, 1986), (Landström, 2007), (Elango, Fried, Hisrich, & Polonchek, 1995), and (Sapienza, Manigart, &
Vermeir, 1996) Furthermore, it is rational behavior for entrepreneurs to ask for and accept help at an early stage of
the company’s development, since it is in this crucial stage that the foundation for success or failure is set. Many
entrepreneurs do not have the right experience in starting a company, and the knowledge and experience of a VC-
team is therefore seen to be highly adding value in the early stages of the life cycle.
In the expansion stage, the role of operational value added diminishes with the maturity of the venture. This result
is confirmed by a study from EVCA, which found that investors care less (in terms of time per venture) for
portfolio companies in their expansion stage than for those in their early stage. (EVCA, 2002) Nevertheless there is
value adding activities by investors during the later stages. In a period of expansion the value added is often
dependent on internationalization, exit related topics and general management tasks. In addition, value adding is
more focused on expansion on the sales force, with tasks such as contacts to key accounts, sales channels, and
cooperation partners.
As this thesis’ focus is on the early and growth stage of the venture funding, we will focus more on the active value
adding services that could help ventures create value and succeed.
2.5.4.2 Active Value Adding Services
There are two types of value adding services mentioned in venture capital theory:
Table 2: Value adding services

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Below we will in short discuss the active value adding services, as the passive is not seen as a management tool, but
more as a cause-and-effect action of the investment. The above is a cluster of the total list, which has proven to be
the most important to create a successful start-up:
 Monitoring/Controlling. Venture capital investors supervise their investments through regular
controlling and monitoring. Entrepreneurs know and expect this and adapt accordingly – or are forced to
do so by their investors. Regular monitoring and periodic controlling may cause entrepreneurs a lot of
work, but on the other hand they also lead to more professional work. This is so, since entrepreneurial
management needs the information obtained from proper controlling in order to back up its decisions. The
implementation of a reporting system at a comparably early stage of a company’s development results a
great improvement in the quality of management and an increase in efficiency, thereby creating ‘value
added’.
 Advice. The classical way to add value is for a venture capital investor to advise entrepreneurs or provide
them or their employees with guidance. Almost all studies in the field of ‘value added’ from venture capital
companies view advising entrepreneurs as key to the creation of ‘value added’. This is due to the special
role of management in the development of a company. (Gorman & Salman 1989, Brüderl et al. 1992) The
advice can cover all functional areas or departments of a venture and is especially important for young or
inexperienced entrepreneurs. More mature entrepreneurs may also profit from the wide experience of
investors who may have been associated with and shaped several venture establishments before.
 Information. Providing advisory services to entrepreneurs goes hand in hand with giving them support in
the form of information. The difference between the two is that advice is aimed at solving a potential or
concrete problem in the venture, while the provision of information is merely the starting point for
management decisions. Information of relevance will usually concern the development of markets, industry
sectors, or technology.
 Networking/Contacts. Some of the terms most often mentioned in the context of ‘value added’ are
those of ‘network’ and ‘contacts’, which in the present context mean that the entrepreneur expects to
obtain access to the investor’s established network(s) of useful business contacts. These networks and
contacts differ from investor to investor and may be more or less extensive, and more or less useful, to the
entrepreneur. The ones most often mentioned during the course of this study were: potential customers
and suppliers, further or alternative venture capital investors, portfolio companies, holders of technological
knowledge, sales channels, key personnel (especially technology/R&D and management), press/media and
general contacts to consultants, etc. Where the investor is a corporate venture capital company, the most
important contacts it could facilitate were those to different departments of the corporate parent, such as
marketing/sales, technology/R&D and especially the corporate parent as a potential key account. ‘Value
added’ gained through networks and contacts can therefore add value in all functional departments of a
venture.

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 Coaching/Motivation/Sparring. During research interviews these terms were used synonymously to
describe value-adding activities that were focused on the entrepreneur as an individual. ‘Sparring’ is derived
from the sport of boxing. Transferred to the business world, ‘sparring’ means – besides ‘coaching’ – the
supervision, training and education of a manager or, as in our case, an entrepreneur. The aim of sparring is
to allow the entrepreneur to become skilled at solving motivational, leadership and organizational
problems, as well as personal difficulties and crises. This vehicle is perhaps the closest to a pure value
added activity of all. However, since the recipient of coaching is the entrepreneur and not the venture
itself, we have placed it among the vehicles by which value is added to the enterprise.
2.5.5. Exit Phase
While it is important to locate the best start-ups, it is just as important to be able to exit your investments. Often a
Venture Capitalist's reputation is made on both being part of the right investments, but also on success stories of
great exit cases. (Siang, 2009) In essence, it all comes down to: “Do the VC see a potential and successful exit of the
current investment opportunity?”
When we talk of exit routes, we have identified five potential routes, when a VC decides to exit an investment:
 Initial public offering
 Strategic acquisition
 Secondary purchase
 Management buy-out
 Write-off
The most common and preferred exit routes are IPO or trade sale, which often are preferred, however, there is no
real order and the exit often depends on the founders and the current investment team (different VC, Angels, etc.)
(Giot, 2004) and (Nesta, 2010)
- Initial public offering is an increasing trend within the start-up world, where in recent years, Google,
LinkedIn, Facebook etc. all have gone through venture financing to an IPO. One of the main reasons is
the previous mention shift in investment focus of many VCs which creates more money to develop and
mature the companies, which is required due to high huge registration requirements. In addition, the
management team within the venture must prepare a prospect for the stock market, with assistance of the
management of the VC. The amount and quality of information that is required within a prospectus can be
can be burdensome, and it is therefore often suitable to have VCs with experience in the forthcoming task.
An internal investor relations division must be created, the internal reporting systems must be prepared for
the stock market, and organizational structure of the firm reshaped to resemble that of a listed company.
(Grompers & Lerner, 2004)

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The advantage of an IPO is that it could provide the venture with enough funds for future expansion,
enchanted “status” and public awareness. In addition, an IPO could ease the recruiting of senior employees
due to a conjured job security perception, and the before mentioned reputation. The disadvantage of an
IPO the increase cost due to reporting is the prospect drafting, underwriting, legal and accounting costs,
quarterly reporting pressure, constant need to propel earnings on a shorter basis without respite.
(Cumming D. J., 2002) and (Chemmanur & He, 2011)All of the above disadvantage gives an good
identification on the size a firm needs to be before they can maintain all of the above information and cost
related to an IPO.
Furthermore, in Canada a venture stock exchange has been created with less fees and requirements, which
creates an opportunity to have a more smooth transaction from private to public. (Carpentier & Suret,
2010)
- Strategic acquisition is the acquisition made by a larger player in a related industry. This is seen as the
dominant exit channel in venture capital financing. Strategic investors accentuate synergy and strategic fit
of a start-up into their existing business as the main impetus of an acquisition. In addition, they are often
willing to pay above the market price, due to the value of synergies. Strategic investors most often purchase
a whole firm instead of a minority interest, and in comparison with the IPO, a strategic acquisition is a
private transaction, associated with less stress and difficulty, fewer limitations, and faster capitalization of
your stock. (Hellmann T. , 2001)
- Secondary purchase or secondary sale is also a well-known phenomenon in the VC industry. Often one
VC agrees to sell their part of the company on to a new VC/PE fund. This is often seen as lifecycle of
investment, and if the first VC is specialized in the market the seed stage and the next VC is more evolved
in the later stages – it could be viewed as a transaction from one VC to another.
- In a management buy-out, the founders of the business decide to buy back their shares of the firm –
often at an agreed price in the current contract. The founders often found this investment through a bank
loan or other private resources.
- Write-off VCs are not always able to exit and cash out their investment. The prospect of a write-off hangs
over all start-ups, since about only 10 % of all start-ups invested in bye VCs survive after the first three
years. (Knudsen, 2012) The VC may consider it better to cut losses on the sport and put the start-up into
an orderly shutdown, rather than go through a messy traumatic process of forced receivership.
In the previous sections we have given a brief introduction to the venture capital industry, which should be used as
a fundament of understanding the remaining part of the thesis. In the following paragraph it will be discussed and

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illustrated how venture capital contributes to innovation and economic growth, through examining the literature on
the subject.
3. Empirical Study on Explaining the Venture Capital Impact on Innovation
and Economic Growth
In the previous section, an introduction into the venture capital way of doing business, as well as the different
investment stages they go through when they engage and act both prior and post investment, was outlined. In the
following sections of the paper it will be discussed what impact venture capital can have on innovation and how it
can help create economic growth.
The first section will define innovation and economic growth, and discuss which factors that will be used as
innovative indicators. The next section will discuss theories and literature on the best way to manage innovation,
with focus on establishing a connection between the venture capital industry and the success of innovation, and to
see what matters to create successful ventures. In the last section the paper will discuss the current literature on the
topic and highlight the influence a well-structured venture capital industry can have on innovation.
3.1 Empirical Study and Definition of Innovation
3.1.1 What is Innovation?
In 2000, the Lisbon European Council recognized that Europe’s future economic development would depend
crucially on its ability to create and develop high-quality, innovative and research-based sectors. (OECD, 2012)
The ability to develop new ideas and innovation has become a priority for many organizations and nations. Intense
global competition and technological development have made innovation to be a source of competitive advantage,
both on macro- and microeconomic levels. (OECD, 2012)
The shared method which most theorists study the development and implementation of new ideas is known as
Diffusion Theory (In some cases also known as Innovation Theory). In its fundamental outline, diffusion is defined
as the progression by which an innovation is adopted and gain acceptance by individuals or members of a certain
group (society). The diffusion theory has been present for many years and theorist have developed many sub-
theories that all support the collectively study of the processes of adoption. Perhaps the first famous account of
diffusion research was done in 1903 by French sociologist Gabriel Tarde, who outlined five ”stages” of successful
innovation:
1) First knowledge
2) Forming an attitude
3) A decision to adopt or reject
4) Implementation and use
5) Confirmation of the decision

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Through these stages, Tarde recognize that innovation is full implementation and confirmation of the product, and
not just developing a new product. Similarly economist Joseph Schumpeter, who has added significantly to the
research on innovation, claimed that industries must revolutionize the economic organization from within, that is
to innovate with more effective processes and products, such as seen from the shift from the craft shop to the
industrialized factory. (Schumpeter, 1943) In addition, entrepreneurs continuously look for better ways to satisfy
their consumer/customer base with improved quality, durability, service, and price which often culminates in
innovative ideas within advanced technologies and organizational strategies. (Heyne, 2010)
This thesis focuses on sustainable innovation, which is created and managed so that it generates economic value to
the nation and its owners. This thesis looks at the venture capital industry’s influence on the innovation process -
throughout the life of the innovation, thus not limited to the creation of the innovative idea/product/service/etc.
Therefore focus will to see if venture capital has influence on innovation, within the five stages, introduced by
Gabriel Trade, since these show a formation, introduction and confirmation of the given innovative idea. (Robbins
& Beach, 2012) The influence of venture capital might however be limited to certain parts of the five stages,
however these thoughts will be analyzed in the following section on innovative input and output indicators as well
the section on how venture capital can spur innovation.
3.1.2 How to Measure Innovation
For further analysis on how venture capital effects the innovative environment and show if venture capitalist has a
positive impact on innovations, we have to first discuss which parameters are used to measure innovation.
In the above section it is argued that an innovation has to, from an economist's point of view, create better or more
efficient products/services. In addition, the S-shaped diffusion curve from Tarde, argues that the innovation
process is not just a simple go-to-market, but defined by five parameters stated in the previous section.
Below different measurements of innovations is presented, on both input and output on a macro- and
microeconomic level that has been used in common innovation theory analysis. It is important to state that even
though theories have argued of both input and output indicators, there seems to be some areas in which you can
argue that the indicator could be a measure of both output and input on innovation.
3.1.2.1 Input Indicators
Input indicators include science and engineering graduates, the population with tertiary education, broadband
penetration rates, public and private R&D, innovation expenditures, ICT expenditures, early-stage venture capital,
and small and medium-sized enterprises’ (SMEs) innovating in-house and co-operating on innovation.
Science and technology indicators need to measure a wider range of actors, such as universities, research institutes,
transfer platforms, start-ups, small innovative firms, multinationals and venture capital firms. Understanding what
drives their behavior is an important component in understanding the performance of the aggregate system. Hence,