Heaven help the poor VC if the return was only 12%, the historical return on the 500 companies listed in the Standard and Poors’ 500 Index. This is one of the public policy issues related to the U. S. tax code that favors the financial interests of venture capitalists over the financial interests of common wealth. The tax code has a perverse economic effect by assisting in the assisted suicide of valuable innovation.

Searching for regional innovation investments opportunities means watching for VC investments made with convertibles and waiting for the subsequent high death rates, and having capital ready to step in before the VC applies the coup de gras.

The Radical Innovation IPO Economic Solution for Regional Economic Growth

The third part of the VC legal roadmap is the process used by the VC to make the exit. Generally, the use of convertible preferred equity is pointing at an acquisition, not an IPO, exit. The most desirable economic growth, however, comes from IPOs made in radical, risky innovative ventures.

Cumming explains this difference in Table 3b of his two main findings. "First, the use of common equity is more often related to IPO exits, and less often to acquisitions. Second, the use of specific control rights and veto rights (which are related to convertibles; see Table 3a) are more often associated with acquisition exits, not IPOs," he writes.

Cumming notes that VCs take a majority ownership percentage when they are preplanning an acquisition exit at the top of the investment pipeline. He notes that his research is "consistent with Black and Gilson (1998). Black and Gilson argue that entrepreneurs prefer IPO exits insofar as the entrepreneurial team regains control over the firm upon an IPO exit (acquisitions transfer control to the acquiror)."

Part of the roadmap of VC legal contracts points to an intended exit via M&A, which has the least desirable economic effects for the entrepreneurs. The main economic development strategy for regions is to rescue the firm before the VCs apply the Dr. Kervorkian effect and re-target the exit to an IPO that benefits the financial interests of both the entrepreneur and the regional economy.

His research is also supported by recent evidence provided by Armin Schwienbacher (Innovation and Venture Capital Exits, 2007, Accepted for Publication at Economic Journal). Schwienbacker makes an economic link between exits and markets, a very valuable insight for innovation economic development, since most of the future economic benefits of innovation flow from future, as-yet created markets.

He makes the distinction between sustaining innovation and radical innovation this way: "Most innovative ventures backed by venture capital provide quality enhanced products to markets, and not so much products that are similar to those that already exist (but potentially at lower production cost). This considered product market structure is well in line with empirical evidence provided by Bhidé (2000). Among the Inc. 500 company founders he surveyed, only 6% entered entirely new markets. In most cases, entrepreneurs entered markets that had some form of substitute products that may have differed along several dimensions."

In other words, the most beneficial economic effects that result from radical innovation only occur around 6% of the time. Following Cumming, it would be most likely that those radical innovations were headed down the M&A route, not the IPO route, due to the type of legal contract used to make the initial investment.

Schwienbacher also confirms the use of convertible preferreds in the U. S. venture capital market. "While venture capital firms predominantly use preferred equity (combined with convertibility and participating features) in the US, Bienz and Walz (2006) provide evidence for the widespread use of debt-equity mixes in Europe."

The M&A route preferred by venture capitalists is generally for the best types of risky innovation, but headed for the worst types of exits, economically. On the other hand, Schwienbacher’s results show that more innovative and profitable ventures are more likely to go public than ventures with more imitative or derivative projects, aka sustaining innovation.

It turns out that what is financially good for the entrepreneur is an IPO exit, which also tends to produce the greatest economic benefit because the IPO is generally for a radical innovative firm that is going public, not being acquired. The VC legal roadmap leads to innovation investments that have greater economic benefits through the IPO route than the M&A route.

Follow The VC Yellow Brick Road to Regional Innovation Investments

In her research, Should Venture Capitalists Put all Their Eggs in One Basket? Diversification versus Pure-Play Strategies in Venture Capital, April Knill, (2008), cite the benefits of industrial sector and regional geographic diversification for venture capitalist investments. She notes, "Historically, fifty percent of VC profits come from only 7% of investments. Up to 33% of venture capital investments result in losses, with as many as 15% going broke; that is, a - 100% return (National Venture Capital Association, 2004).

Of all the variables she investigated, regional geographical diversification in the VC portfolio provided the greatest marginal boost to VC profits.

Each metro region has a historically diverse industrial value chain capable of producing innovation. Within each region, existing VCs are at work seeking investments in innovation, only 7% of which provide the majority of profits.

The main idea is following the VC legal roadmap is to gain insights into what the VCs are doing by watching what kind of legal contract they are using for what type of innovation. The most valuable innovation is radical innovation which ends up in an IPO, not being acquired.

The VC legal roadmap will lead you to the right types of innovation investment opportunities, but not necessarily to the right exit stategy to promote regional economic development. That desirable outcome depends on much stronger regional capital markets within each metro region, and a change in the U.S. tax code.

As the Tin Man said to Dorothy, "That is a horse of a different color."