instrumental value theory and the human capital of entrepreneurs 26.5.09

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Instrumental Value Theory and the Human Capital of Entrepreneurs

Eli Gimmon and Jonathan Levie

Eli Gimmon is a Lecturer at Tel-Hai Academic College, Israel and Jonathan Levie is a Reader in the Hunter Centre forEntrepreneurship, niversit! of "trathcl!de# The authors $ould li%e to than% the t$o anon!mous revie$ers and theeditor of the Journal of Economic Issues for their comments#

Abstract: Given the contribution of Schumpeterian entrepreneurship to technological

progress and well-being, the accuracy of investment decisions by venture capitalists is a

societal issue. Venture capitalists nd the human capital of entrepreneurs dicult to assess.

This paper employs instrumental value theory to assess the value of dierent human capital

factors to the performance of new ventures. ! meta-analysis of "# previous empirical studies

that e$amined the eect of founder%s human capital on new venture performance suggested

that instrumental value theory holds promise as a guide for research on entrepreneurs%

human capital and new venture performance. &t could also help venture capitalists to ma'e

better investment decisions, beneting society in general.

ey!ords: instrumental value theory, entrepreneurship, human capital

JEL Classi"cation Codes: ("), ()", *"+, , "

&n institutional economics, entrepreneurs are seen to play a critical role in the conversion of

technological progress into economic development and human well-being /c0aniel "112

"11)2 3lein #445. !lthough !lfred arshall and Thorstein Veblen recogni6ed this in the # th

century, 7oseph Schumpeter /#82 #85 was the rst to describe the role of innovative

entrepreneurs in the evolution of the economy in detail. Schumpeterian entrepreneurs

disrupt the status 9uo by introducing new and better ways of doing things. This typically

re9uires considerable investment of resources to succeed /see 7avary "118 for an e$ample5.

:or a new venture with little internal nancial reserves to draw on, this means e$ternal

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funding. !s Schumpeter himself pointed out, ;credit is primarily necessary to new

combinations< /Schumpeter #8, =15.

!t the e$treme end of Schumpeterian entrepreneurship are new ventures that are so

innovative and asset-poor that conventional debt nance is not appropriate. ! completely

dierent form of funding is re9uired, one that shares in the upside gain but also accepts the

downside ris'. This is venture capital. To illustrate how unusual this form of nancing is, only

around 4> of !merican start-up funding needs are met by venture capital /?eynolds "11=5.

@f the " million or so start-up attempts in the Anited States each year, only around 411 are

invested in by venture capitalists, yet venture-capital-bac'ed rms provide 4> of Bobs in A.S.

businesses /Shane "1145. !vailability of e$ternal capital, then, is a critical institutional factor

for Schumpeterian entrepreneurship.

The accuracy of venture capitalists in pic'ing which Schumpeterian entrepreneurs to

bac' is a societal issue, since poor Budgment will lead to a loss of the benets that society

can reap from technological progress. Cot only will society not gain from the innovations

these Schumpeterian entrepreneurs see' to introduce, but the venture capitalists will nd

their sources of capital drying up as their losses induce fund managers to invest their money

elsewhere. uch decision-ma'ing in venture capital is based on intuition and herd behavior

/Dider ##45. ! wide range of evidence suggests that the accuracy of venture capitalists%

predictions is not high, with a small number of spectacular successes boosting the return

rates of some funds and mas'ing a low overall ;hit< rate in the industry /Dachara'is and

eyer "1115. &ndeed, following poor returns, investment in seed and early-stage private

sector venture capital funding has been in relative decline recently, particularly in Europe

/7FFs'elFinen, aula and urray "11=5. &n summary, given the economic importance of

Schumpeterian entrepreneurship and its dependence on substantial e9uity funding,

investment choice by venture capitalists is worthy of attention, particularly given the interest

of institutional economists in value and Budgment.

Venture capitalists invest based on their Budgment of the human and social capital of the

entrepreneur/s5, the potential in the technology and the potential in the mar'et /Dachara'is

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and Shepherd "11)5. @ne of the most dicult issues for many venture capitalists is

assessing the human capital of the founder /*evie and Gimmon "1145. uman capital

/(ec'er #=)5 has more generally been recogni6ed as a 'ey success factor in new venture

performance /Stuart and !betti #4=2 art, Stevenson and 0ial ##)5. ! surprising feature of

the human capital literature is that there appears to be no e$-ante method of predicting

which of the dierent forms of human capital commonly employed in the entrepreneurship

literature, and by investors in new ventures, might be e$pected to have an eect on

performance. &n other words, no commonly accepted theory is routinely used to sort or

classify founder%s human capital factors e$-ante as relevant or irrelevant to venture

performance.

He propose the use of instrumental value theory as interpreted by 7. :agg :oster /Tool

##a2 ?anson "1145 as a tool for e&-ante prediction of the eect of dierent forms of

human capital on new venture performance. &n this article, we test its ability to predict

performance through a meta-analysis of published empirical studies of founder%s human

capital and performance. He argue that the use of instrumental value theory is valid in this

case because accurate choice of Schumpeterian entrepreneurs by venture capitalists is in

the interests of society generally, not Bust venture capitalists.

!s (aldwin ?anson /"1145 has remar'ed with specic reference to instrumental value

theory, applicability is the nal test of the correctness of theories. !lthough applying

instrumental value theory as an aid to e&-anteprediction might appear to violate 0eweyan

principles that conte$t is 'ey /0ewey ##2 Gordon ##15 and that instrumental value is

dynamic /3lein #445, we argue that by applying it in the narrow case of new venture

performance, and remaining sensitive to alternative interpretations, some degree of useful

generali6ation is possible. He nd the instrumental criterion helpful as a way of ordering, as

a rst appro$imation, the value of dierent forms of human capital to Schumpeterian

entrepreneurship, while recogni6ing that this approach has its critics.

This study aims to ma'e a contribution to instrumental value theory through illustrating

its value in classifying human capital that is useful for predicting new venture performance.

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This is important because there are many forms of human capital, and a classication

enables a theory-driven focus on the human capital that really matters in a particular

conte$t. The paper also answers a call for further meta-analysis in economics /Iressman and

ontecinos ##+, 4=#5. ! third contribution is to suggest how the instrumental value

framewor' can guide further research in areas that have not been addressed before, for

e$ample by separating out the instrumental and ceremonial value of social capital factors

such as reputation.

Instrumental Value Theory and #e! Venture $erformance

Veblen%s recognition of the importance of technological innovation to social progress, and

how such progress can be hindered, is a central concern of institutionalism. @ne way in

which progress can be hindered is what Jlarence !yres /#+, 5 refers to as ceremonial

ade9uacy,< a 'ind of imitation of technological ade9uacy. e illustrated this with the

following e$ampleK ;The tribal medicine man purports to be altering the course of events in

imitation of the tool activities by which technicians really do alter the course of events.

?ecogni6ing it ma'es possible a clear dierentiation of technological reality from ceremonial

fantasy, and so the real values from fancies, or pseudo values.

instrumental value theory and the human capital of entrepreneurs 26.5.09

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