The Interaction between Venture Capital and Innovation in Europe

Venture Capital (VC) has been a significant source of finance for technology based investments. Thus VC has played a key role in fostering innovative entrepreneurship and technological progress in new economies. Accordingly, it is generally argued that there is a positive causal relationship from venture capital to innovation, which called "venture capital-first hypothesis". However, some studies in literature indicates an opposite causality that innovation stimulates venture capital, which called "innovation-first hypothesis". The aim of this paper is to test these hypothesis to determine direction of causality between Venture Capital and Innovation in European countries. We use dynamic panel data analysis in order to investigate the direction of causality between innovation and venture capital based on annual data set related to European patent applications and venture capital investment. Empirical results of our study provide a strong evidence in favour of "innovation-first hypothesis" that innovation induces venture capital investment in Europe. This result presents significant implications for innovative entrepreneurship capacity of Europe. It seems that, although policy makers aim to make more financial resources available for innovation, the absence of innovative ideas is the big issue rather than the lack of available fund for innovative entrepreneurships in Europe.