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October 1999
This paper argues that the truly unique role of venture capitalists is found in their information-mediating and governance functions, which can be understood only in the context of relationships between the "clustering" of entrepreneurial firms and (a club) of venture capitalists. The entrepreneurial firms in Silicon Valley compete in innovation and thus their activities are fundamentally substitutes. Therefore, their information processing activities need to be encapsulated from each other to excel competitors. A new product system may be then evolutionarily formed by combining modular products ex post that evolve from such decentralized efforts. In order for such evolutionary selection is possible, however, common standards for interfaces among modular products need to be provided to make individual product attributes compatible. Venture capitalists plays an important role in mediating information necessary for endogenously forming and governing competition among entrepreneurs under such framework. The first section assembles stylized facts about venture capital - entrepreneurial firm relationships as a basis for modeling. The second section presents a framework for comparing information systemic aspects of alternative R&D; organizations and tries to understand the unique innovation capability of the Silicon Valley model. The third section then proceeds to the analysis of the venture capital governance as an institution for supporting such information system. Repeated tournaments among initially funded firms for refinancing necessary for the completion of projects, and the threat of termination of financial support by the venture capitalist, are seen to provide greater incentives for the entrepreneurs than under traditional arms length financing. The fourth section discusses the incentives of the venture capitalist and other institutional characteristics of the Silicon Valley model.