Editor’s note: Vivek Wadhwa is a fellow with the Labor and Worklife Program at Harvard Law School and executive in residence/adjunct professor at the Pratt School of Engineering at Duke University. He is a serial entrepreneur, including the founding of Cary-based Relativity Technologies. This article is reprinted with permission of BusinessWeek Online.

DURHAM, N.C. – Policymakers often believe that venture capital is a prerequisite for regional growth and innovation. And entrepreneurs tend to think that VCs know it all. They spend huge amounts of time and energy preparing business plans for innovative startups, then pitch them to VCs who often don’t seem to be interested. Yes, VCs are experts in knowing how to commercialize proven technologies and make lots of money from them. But VCs aren’t the gurus of innovation. In fact, new research shows that venture capital may actually slow it down.

In August 2008, Masako Ueda, a professor at the School of Business of University of Wisconsin-Madison, and Masayuki Hirukawa, a professor in the economics department at Northern Illinois University released an updated version of Venture Capital and Innovation: Which Is First?, a research paper that examines the correlation between venture capital investments and productivity growth. Ueda says it was inspired by research she had completed during the 1990s on unsuccessful attempts by European and Japanese policymakers to spur entrepreneurship by copying the U.S. model of investing in venture capital funds. She believed policymakers were naive to think that once venture capital was available, new firms would flourish.

To research the sequence of events in the innovation process, Ueda and Hirukawa analyzed total factor productivity (TFP) in U.S. manufacturing industries, including drugs, office and computing machines, communications, electronics, and professional and scientific instruments. (TFP is used by some economists to measure innovation).

A Drag on Innovation

What they found was surprising. VC investment lagged behind TFP growth by two years. And follow-on rounds of investment caused a decline in TFP in the first year. In other words, venture capital slowed down the innovation process. Additionally, they found that delayed TFP growth is correlated with first round VC investment. That essentially means that the money goes where the innovation is, not the other way around.

Bob Litan, vice-president for research at the Kauffman Foundation, says these findings are no surprise to him. "After all it’s the innovators who come knocking on the VCs’ doors asking for money, not the other way around", he says.

(Click this link for the full text of Vivek’s article{/a}}.)