Does informal risk capital relax the financial constraints of high-tech entrepreneurial ventures?

Abstract

This work analyses the effect of informal risk capital financing on a firm’s investment/cash flow sensitivity (ICFS) in a sample of 498 Italian privately held high-tech entrepreneurial ventures (HTEVs) observed from 1996 to 2008. To detect financial constraints, we resort to an error correction model (ECM). We find that the receipt of informal risk capital in the seed stage results in reduced ICFS, indicating a persistent relaxation of financial constraints.

Keywords:

• informal risk capital
• financial constraints
• error correction model
• high-tech entrepreneurial ventures

JEL classifications:

• G31
• G24
• D92

Notes

¹ For Italy, the country covered in this study, the Italian Business Angel Network (IBAN) states that business angel deals as in 2011 accounted for greater than 70% of the total number of early stage deals (http://www.iban.it/wp-content/uploads/2012/11/Comunicato-Stampa-IBAN+VeM_-latest.pdf). Because business angels affiliated to IBAN represent only a portion of informal risk capital investors, the total size of the Italian informal risk capital market is likely to be quite large.

² We also include area dummies, time dummies and industry dummies interacted with time dummies.

³ All continuous variables have been winsorized with a 2% cut-off for each tail.

⁴ The use of a large number of instruments may result in significant finite-sample bias. To address this problem, we limit the instrument set with moment conditions in the interval between t−2 and t−3 (see Bond, 2002).

⁵ As to the endogeneity of IRC_i, one may wonder whether external factors may affect both the availability of informal risk capital and the financial constraints of high-tech entrepreneurial ventures (HTEVs). Accordingly, we considered the average interest rate on bank loan in the NUTS3 region in which HTEV operates in order to control for the affordability of bank financing that makes informal risk capital less attractive and reduces financial constraints. Following a similar reasoning, we also considered population wealth proxied by value added per inhabitant. However, we did not detect any significant difference between firms that receive informal risk capital and those that did not. Furthermore, a reverse causality problem may affect our results as more financially constrained firms are allegedly more inclined to look for informal risk capital. However, this would generate an upward bias in the estimates of the relationship between informal risk capital and investment/cash flow sensitivity (ICFS), thereby making our results even stronger.

⁶ We also estimated Equation 1 by excluding HTEVs from the year of receipt of the first round of venture capital or the first public subsidy (see Section IV).

⁷ We also estimate the error correction model (ECM) specification on a sample of HTEVs that did not receive informal risk capital. Results (not reported here) confirm that HTEVs are financially constrained.

⁸ In line with this view, the estimates not reported in this work show that the likelihood of receiving venture capital is significantly higher for HTEVs that received informal risk capital at foundation.

⁹ The TEPA law, introduced in 2007, allows French residents to deduct from the solidarity tax the wealth capital invested in small firms, up to 50 000€. The Enterprise Investment Scheme provides an attractive tax relief to individual investors who provide funding to unlisted small firms. In Italy, public intervention in this area is limited to the introduction in 2008 of a tax relief scheme for business angel investments (European Commission, 2012).