The “chicken or egg” problem between venture capital and start-up growth

The amount of venture capital invested in a country is typically viewed as the financial input needed for innovation-enabled economic growth. However, given how VCs function, it may also be viewed as a proxy for their expectations for this growth. So, if venture capital investment is low, it may be wiser to interpret this as a signal that something else in the economy needs to be corrected rather than the problem itself. The dearth of venture capital investments is impeding start-ups and economic growth, and it has led to a debate on whether or not it is right for governments to intervene to bridge the equity gap in the start-up and VC ecosystem. Specifically, one side of the discussion believes that governments, with their involvement, would be able to generate a signalling effect, which will attract private investors (i.e., VCs), as well as an elimination of barriers to entry, tax breaks for research and development expenditures, and more favourable capital gain taxation. On the other hand, there is a faction arguing that subsidies given by the government are just a way of throwing money at the problem and generate a crowding out effect of private investors, since public loans are less expensive and do not pretend to be engaged in decision-making, unlike private ones. For the above reasons, this study aims to fulfil this research gap, by providing guidance to governments on what factors to act upon to establish a thriving ecosystem for start-ups and VCs, enabling them to generate a crowding in effect. After a systematic literature review on academic contributions on this topic, the factors that make up The Index of Economic Freedom by The Heritage Foundation have been identified to comprehensively explain the level of venture capital investments as % share of GDP in 36 OECD economies through linear regressions and correlations. Finally, an econometric model has been run in order to further provide evidence of how governments can intervene on each single factor and generate a forecasted change in the level of venture capital investments. The study's findings demonstrate that The Heritage Foundation's Index of Economic Freedom explains the amount of VC investment throughout the time period examined, however, it is crucial to note that changes in these factors may not be immediately translated into changes in venture capital investments since it takes time for investors to become aware of and confident in the evolving regulatory position of a country.