I study how relationship lending affect entrepreneurial innovation and venture capital activity. I develop a model in which an entrepreneur jointly chooses a project type (traditional or innovative) and a financier (bank lending or venture capital). Relationship lending allows banks to create continuation value when refinancing traditional projects, whereas venture capital creates value primarily for innovative projects but is costly to access. This difference in value creation shapes entrepreneurial choice. When the benefits of bank relationships are sufficiently large, entrepreneurs prefer traditional projects financed by banks over innovative projects financed by venture capital, even if the latter are more profitable absent financing frictions. The model predicts that stronger relationship lending can indirectly depress venture capital activity by reducing the number of entrepreneurs who choose innovative projects. This effect is amplified when venture capital is scarce or when its incremental contribution to firm value is limited. The paper thus identifies a new channel through which the structure of the banking sector can influence venture capital development.
Fabrizio Core (Fri,) studied this question.