Abstract
Venture capitalists (VCs) ideally like to invest in innovations at a nascent stage but this is inherently incorporated with huge risks (Ruhnka and Young 1991, Gompers 1995). Because it is difficult to value novel technologies at an early development stage, VCs may be herding into financing advanced-stage projects for which an archive of scientific knowledge and commercial performance are available that enables a correct valuation (Lerner 2009). A response to this market failure in investor-investee matches might be an institutional change that can steer investors towards supporting new innovations at an early stage, providing more information necessary to value young projects. Using the setting of the Orphan Drug Act (ODA) in the European Union (EU) enacted in 1999, we test these ideas in the fields of biotechnology using a difference in difference methodology and find that VCs are indeed more likely to invest in early-stage technologies in sub-fields disproportionately affected by ODA. In addition, we document that exit performances of VC-backed startups do not get worse as a result of VCs investing into early-stage innovations. Our results suggest that VCs are enabled to make fully-informed decisions as ODA provides some additional information on early-stage technologies. We conclude discussing the role of public policy in correcting market failure between investor-investee matches in the market for entrepreneurial finance.
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