What are the economic foundations of modern knowledge-based firms? In an influential article, Zingales (2000) argues that while modern economies are dominated by human capital intensive knowledge-based firms, economics has only a rudimentary understanding of how these firms operate. One feature of the knowledge-based firm is that it deals with complex problem solving that requires the processing of what economists call “soft” information (see Garicano (2000) and Stein (2002)). A second distinguishing feature is that people are typically the firm’s most valuable asset, as the firm’s value is mainly generated through the application of its employees’ skills and knowledge. Unlike physical assets, individuals can exert discretion as to when and how they want to apply their skills and knowledge. Together, these two features imply that the provision of non-contractible actions is a defining trait of knowledge-based firms.
What determines the provision of non-contractible actions? Building on the seminal paper by Holmström (1979), a large theoretical literature links the provision of non contractible actions to the existence of a moral hazard problem. The main focus of this literature has been the design of optimal contracts (see Hart (2001) and Prendergast (1999) for recent surveys). A related strand of literature considers the role of organizational structure (see Gibbons (1998)). Following these literatures, empirical tests focus largely on how contractual design (e.g., Gaynor et al. (2004) and Lazear (2000)) and organizational structure (e.g., Baker and Hubbard (2003), Garicano and Hubbard (2004)) determine the provision of non-contractible services.
Fundamentally, human capital is an essential input in the production function of any knowledge-based firms. Rosen (1982) explains how human capital considerations affect hierarchical firm organization. Gibbons and Waldman (1999) emphasize the importance of task-specific human capital. We contribute to this literature by relating human capital inputs to the production of non-contractible services.
In this paper we submit that human capital is an important but often overlooked determinant of the provision of non-contractible actions. We examine the role of human capital in the context of financial intermediation. The recent work of Berger et al.(2004), Liberti (2003), and Stein (2002), emphasizes that processing of soft information plays a central role in financial intermediation. Moreover, apart from providing funding, investors can also provide a variety of valuable services, such as monitoring, corporate governance, advice and support. Our analysis focuses specifically on venture capital, which has become an important and growing part of the financial system, both in the US and globally. We study the role of human capital in the context of venture capital since prior research has already established the importance of non-contractible investor involvement. Theoretical models of venture capital place heavy emphasis on the non-contractible efforts provided by the investor. A growing body of empirical evidence documents that venture investors can help their portfolio companies in several ways, including giving advice and support, professionalizing the management team, creating strategic alliances, or exercising corporate governance.5 However, not all venture capital firms are alike. Using the industry’s language, some are “hands-on,” and provide more non-contractible services than “hands-off” investors. We set out to analyze this heterogeneity in investor behavior.
We base our analysis on a hand-collected dataset of European venture capital investments. The data covers the period 1998-2001, and consists of a sample of venture capital deals in the 15 member countries of the European Union (in the period under study), plus Norway and Switzerland. Our primary data source is a comprehensive survey of all the venture capital firms in these countries, which we augmented with numerous secondary sources. Our dataset consists of information on 124 venture capital firms, 513 partners, and 1,664 portfolio companies. The data collection required considerable time and effort, but resulted in a dataset that is significantly larger than other hand-collected datasets on venture capital, and much richer than the commercially available datasets.
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