Individualism and Venture Capital: A Cross-Country Study.

Author:Gantenbein, Pascal

1 Introduction

The success of the US Silicon Valley is often reported to stem from the American spirit of entrepreneurship, people's risk appetite, and their capitalistic mentality. These factors are usually recognized to provide an ideal breeding ground for the launch of start-ups and the provision of venture capital (see The Economist 2009). According to several authors (see, e.g., Gompers and Lerner 2001; Jeng and Wells 2000; Kortum and Lerner 2000; Popov and Roosenboom 2013; Samila and Sorenson 2011), start-ups are fundamental for innovation and productivity, the renewal of economies, the creation of jobs, and economic growth. In line with this view, the G20 leaders concluded in their 2014 Summit that the 'promotion of competition, entrepreneurship and innovation' would help increasing economic growth. Given the importance of venture capital for economic development, researchers have put considerable efforts in explaining different drivers of venture-capital investments. In particular, scholars were able to show that different formal institutions matter for the development of venture-capital markets. (1)

In spite of these findings, the academic community still struggles in explaining the large differences in venture-capital investments across countries (see, e.g., Wright et al. 2005). In particular, although cultural aspects are recognized to affect economic outcomes in a variety of situations and dimensions (see, e.g., Franke et al. 1991; Li et al. 2011) and Fukuyama (1995, p. 103) has argued that "[...] non-rational factors like culture, religion, tradition, and other pre-modern sources, will be key to the success of modern societies in a global economy", no study has so far studied the direct influence of individualism--a cultural trait that emphasizes individual freedom, personal responsibility, self-reward, self-orientation, as well as personal achievement and fulfillment--on venture-capital investments. This research gap is surprising, as Gorodnichenko and Roland (2012) and Heine (2008) convincingly argue that individualism is the most important aspect in cross-cultural psychology and represents the main cultural divide in today's world.

In this paper, we address this research gap by studying the influence of individualism on venture-capital investments across countries and considering both moderating and mediating variables of this relationship. On the theoretical side, we argue that individualism encompasses entrepreneurial characteristics and thus fosters venture-capital investments. Furthermore, individualism is also positively related with the quality of formal institutions (e.g., rule of law) and informal institutions (e.g., generalized trust) that both support venture-capital activity. In this respect, the paper builds on the insights from new institutional theorists, such as North (1990). Figure 1 summarizes the structure of our analysis by depicting these relationships and highlighting the positioning of the paper.

On the empirical side, we perform an extensive empirical analysis on a sample of 1496 country-year observations based on ca. 300,000 venture-capital transactions across 88 countries over the period 1998-2014. We show that individualism accounts for 30% of cross-country variation in venture-capital investments, which makes it the single most important variable in terms of cross-country explanatory power. Furthermore, we show that even after accounting for a large set of controls, moderating variables, suitable mediating variables, and endogeneity issues, the direct effect of individualism on venture-capital investments persists both statistically and economically. Finally, based on an extensive analysis of moderating and mediating effects, we offer evidence that the influence of individualism on venture-capital investments is moderated by economic conditions (GDP per capita) and partially mediated by the quality of formal institutions (rule of law) and entrepreneurial attitudes (uncertainty avoidance).

Our study contributes in several ways to different strains of literature. First, we contribute to the growing literature that links culture to economic outcomes and decisions (see, e.g., Chen et al. 2015; Guiso et al. 2003, 2006, 2009; Li et al. 2011). Second, we add to the current debate on the relative importance of individualism within the broader spectrum of culture [see, e.g., Gorodnichenko and Roland 2012; Heine 2008; Hofstede et al. 2010 (HHM)]. Third, and most importantly, our study contributes to the ongoing discussion on the determinants of venture-capital markets (see, e.g., Armour and Cumming 2006; Jeng and Wells 2000; Lerner and Tag 2013; Li et al. 2014) by establishing, for the first time, a direct relationship between individualism and venture-capital investments across countries. In contrast to Li and Zahra (2012)--who suggest that culture moderates the effect of formal institutions on venture-capital investments--we show that individualism is the single most important cultural element in explaining venture-capital investments. Fourth, as institutional theorists argue that institutions (formal and informal) affect economic outcomes both directly and indirectly (North 1990, 1994; Scott 1995; Williamson 2000), we contribute to the understanding of these issues by providing an extensive analysis of the moderating and mediating effects in the relationship between individualism and venture-capital investments.

The sample of 88 countries employed in this paper is larger than the samples used in existing studies on the determinants of cross-country venture-capital investments (e.g., Anokhin and Schulze 2009: 64 countries; Da Rin et al. 2006: 14 countries; Jeng and Wells 2000: 21 countries; Li and Zahra 2012: 68 countries). As our sample includes both developed countries and emerging markets, we are able to capture a larger variety of manifestations of individualism as well as economic and institutional conditions.

In the paper, we specifically address the recommendations of Kirkman et al. (2006), as elaborated in Beugelsdijk et al. (2017) on HHM-inspired work. First, we make sure to establish a clear distinction between country and culture by controlling for a large set of country-specific characteristics beside culture, such as economic conditions (e.g., GDP growth, GDP per capita, and exports), geographic conditions (e.g., latitude and malaria infections), and the formal institutional environment (e.g., the legal system). The relationship is robust to the inclusion of all the above controls and holds for different subsamples (e.g., different income groups and time subperiods).

Second, we consider and explore cultural values beyond those proposed in HHM by including cultural characteristics, such as religion, language, and World Value Survey's trust in the regressions.

Third, throughout the paper, we stress not only the statistical significance of the influence of individualism on venture-capital investments but also its economics significance in terms of magnitude and explanatory power.

Finally, we address endogeneity concerns by using an instrumental variable (IV) approach that confirms the main findings. Our instrument (polity score) measures the characteristics of a country's political system between the Congress of Vienna (1815) and just before the outbreak of World War I (1914), i.e., within the period 1816-1913. As this period was relatively stable, it likely laid ground to the values and norms that define individualism in modern societies. We provide evidence that the polity score is a valid instrument as it is related with individualism but is uncorrelated with venture-capital investments.

2 Theoretical Framework

2.1 Venture Capital

The prosperity of economies depends on the commercialization of ideas. The transformation from innovative ideas into new products often originates from start-ups (see Kortum and Lerner 2000) that require financial resources in the form of venture capital (see, e.g., Jeng and Wells 2000). In this respect, the definition of venture capital used in this paper is broad and includes all types of equity financing provided to young companies by a variety of investors, such as family members, friends, and 'fools' (3F-Hypothesis), business angels, foundations, pension funds, or venture-capital funds. On the contrary, start-ups cannot typically rely on either internal financing or external debt, because they lack both (stable) cash flows and tangible assets to be pledged as collateral.

Unfortunately, venture-capital financing tends to be scarce for several reasons. First, it is intrinsically risky due to the large number of potential pitfalls that can jeopardize a steady growth path of start-ups and which ultimately results in very high failure rates (Cochrane 1981; Stinchcombe 1965). Second, venture-capital investments are characterized by a material asymmetric distribution of information (also due to a relatively low level of transparency) and serious conflict of interests between investors and start-up founders (see Amit et al. 1998; Jensen and Meckling 1976; Sahlman 1990). In particular, venture-capital investors often have to overcome an information disadvantage with respect to the technology, the founders' skills, and their commitment. Further, the entrepreneurs are often emotionally bounded to the firm, whereas the venture capitalists mainly focus on the return on investment.

The entrepreneurs' creativity and innovations are key drivers of economic development. While lasting peace or open economies are basic conditions for economic-growth and good laws can act as a transmitter, Cooter and Schafer (2012) point out that the economic development of a country affects the provision of (non-relational) venture capital. Several studies show that the countries' (formal) institutional environment, e.g., their political and legal framework (see Armour and Cumming 2006), financial-markets development (see Black and Gilson 1998), tax...

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