How much does a country's legal system affect the behaviour of entrepreneurs and investors? How much does the law simply reflect culture, rather than shape it? To what extent will tax reforms encourage the development of growth businesses? These are vital questions for European policy-makers, but the answers are far from clear. For instance, some say that the USA's sympathetic bankruptcy laws have helped to create an entrepreneurial culture; others say the USA has developed sympathetic bankruptcy laws because it has an entrepreneurial culture. Some even argue that the two things are completely unrelated, and that one has had no impact on the other.
Important new research may help to supply some answers. A study published at the end of November looks at the correlation between venture capital activity and background legal and tax rules. In Europe and North America it finds clear empirical evidence for the proposition that laws do matter, and in a more fundamental sense than had been previously established.
The study used the European Private Equity and Venture Capital Association's index of legal, tax and regulatory variables that were included in its benchmarking report published earlier this year. The variables include capital gains tax rates, competition law, availability of suitable fund vehicles, corporate tax rates for smaller companies and the taxation of stock options, among others. By comparing those variables with the demand for and supply of private equity finance across the countries studied, whilst controlling for a range of economic factors, clear evidence emerged of a strong correlation between the two.
Until now, the general view was that the depth and liquidity of capital markets played a major role in stimulating a country's venture capital industry, but there was little empirical support for the proposition that legal and tax rules could make an important difference. To some extent, this study establishes that link and shows law to be at least as important as stock markets. That finding will no doubt prove valuable to those lobbying for change, including EVCA itself.
But the EVCA index only provides a snapshot of the European environment - the first one was produced this year, although there is an intention to update it annually. For that reason, it was not possible to establish any clear causal link - did the evolution of legal rules stimulate venture capital, or did the emergence of a venture capital industry influence the evolution of law?
To answer that question the researchers looked at bankruptcy laws. Again, a clear correlation was found, this time between the 'severity' of personal bankruptcy rules (measured by the number of years until debts are discharged) and the demand for venture capital. More temperate laws are associated with increased venture capital activity. In that case, though, it was also possible to show how changes in demand followed changes in the law - improving the legal position does, it seems, change behaviour.
There was a further significant finding. It seems clear from the evidence that government attempts to 'jump start' venture capital programmes by subsidising seed or venture funds may in fact crowd out an equivalent amount of private finding, and so do not stimulate venture capital investment in an economy. That, and the other findings of the study, provides much food for thought for law-makers, and for interest groups which are lobbying for changes.
5 December 2003
The paper referred to in this bulletin is The Legal Road to Replicating Silicon Valley and can be downloaded from The Encyclopedia of Private Equity and Venture Capital. It is authored by John Armour (Faculty of Law and Centre for Business Research, University of Cambridge, UK) and Douglas Cumming (University of Alberta School of Business, Canada)