How Knowledge Spillovers between Venture Capitalists and Entrepreneurs Affect the Specialization and Diversification of Venture Capital Funds -- and Why it Matters

We have a limited understanding of why different venture capital (VC) funds follow substantially different portfolio strategies and how these choices affect VC performance. We investigate this question by combining and extending the real options and knowledge spillover views of strategic entrepreneurship. In this approach, specialization by a VC fund implies a call option with liquidation value as the exercise price, while VC diversification strategy creates the compound of call and flexibility options. Depending on the extent of knowledge spillovers and uncertainty, the choice between diversification and specialization influences strategy and performance of VC funds. The model has five implications. First, the performance of specialization increases relative to diversification as the marginal effect of post-investment VC activity increases. Second, when the effort of a VC fund is crucial for an entrepreneur, diversified VC funds innovative projects more. Third, cross-sectional and serial knowledge spillovers have complementary impacts on the performance of specialized, relative to diversified, VC. Fourth, specialized VCs participate in the early-stage financing while diversified VCs emphasize late-stage ventures. Fifth, post-investment effort of a VC for an entrepreneurial firm is a hump-shaped function of economic shocks to the firm; moreover, the hump shape becomes stronger as VC diversification increases.