The Financing Gap Public Venture Capital Is Meant to Fill
Government venture capital is meant to address a specific financing problem: innovative SMEs can be economically valuable while remaining difficult for ordinary lenders and private investors to evaluate. This chapter diagnoses that problem before considering any particular public instrument. The practical judgment is straightforward but demanding: a fund-of-funds or direct public investment can be justified only when it responds to a real constraint in capital, information, time horizon, geography, or investor capability—not simply because a larger pool of money sounds beneficial.
Why a promising company can be unbankable
Imagine a young company developing a new industrial sensor. Its main assets are engineers, experimental results, software, patents, and a process that may eventually lower costs for an entire industry. It has little equipment that a bank can seize, no long history of profitable sales, and a product whose market may not be clear until testing is complete. The company needs money now, but the evidence needed to predict repayment will arrive only after the money has been spent. This is a stylised example, not a claim about one company; it illustrates the mismatch that makes innovative finance different from ordinary working-capital lending.
A bank typically lends against expected repayment. Its return is mainly the interest and fees specified in the loan contract, while the borrower remains responsible for repayment even if the project performs poorly. Collateral, stable cash flow, and a track record help the lender estimate and contain that risk. A young technology firm may offer none of them. If it fails, the lender cannot recover much from intangible assets. If it succeeds only after several years of research, the lender still has to manage the earlier period of uncertainty and the borrower's fixed payment schedule.
Venture capital changes the risk-sharing arrangement. The investor supplies equity and receives a claim on the company's future value rather than a fixed promise of repayment. The investor can lose some or all of the investment if the venture fails, but can benefit if the company grows and reaches a successful exit. That return is not produced by the funding round alone. Venture investors may also supply managerial support, industry networks, strategic guidance, and access to later investors. Their economic bet depends on finding a small number of companies whose eventual gains can compensate for failures elsewhere in the portfolio.
This makes venture capital suitable for some businesses that debt markets underserve, but it also makes the asset class selective. An investor must decide whether a technology can be commercialised, whether the team can execute, whether the market will be large enough, and whether another investor will finance the next stage. Those judgments are difficult precisely when the firm has little history. The investor is not just pricing today's balance sheet; they are estimating a chain of uncertain future states.
The public case begins when that chain contains value that private finance does not fully capture. A company may create skilled employment, strengthen a regional cluster, reduce emissions, or develop a strategically important technology. Yet a private investor may still avoid it because the route to revenue is long, the market is small, the information is costly to obtain, or the likely exit is too remote. Public VC does not eliminate those risks. It can, however, absorb some of them or help make them legible to other investors.
That distinction matters. Saying that a firm is “underfunded” does not tell us why. The constraint may be a lack of money, but it may instead be a lack of information, a mismatch between the firm's development time and the investor's fund life, high transaction costs, or the absence of a local investment network. Each diagnosis points toward a different public response. A grant, a loan guarantee, a direct equity investment, a co-investment, and a fund-of-funds all move risk and decision rights in different ways.
The sequence is deliberately conditional. A public programme can enter after a bank or private investor has identified a mismatch, but its presence does not guarantee funding or success. The value of intervention depends on whether the programme changes the relevant constraint and whether the resulting risk is carried transparently by the public institution, private investors, or the company itself.
The market failures behind the funding gap
The OECD identifies several failures that can make VC allocation inefficient even when the industry is growing. The first is information asymmetry. Founders know more about the technology and their own effort than outside investors do, while investors may know more about markets, exits, and comparable companies than founders. Neither side can observe the full quality of the opportunity at the beginning. A private investor may respond by demanding a high expected return, investing only in familiar sectors, or waiting until more evidence is available. Those responses protect the investor but can leave socially valuable early work unfunded.
The second is the cost of evaluating small or unusual deals. Due diligence takes time, legal work, technical expertise, and repeated interaction with the team. A large fund can spread that cost across a portfolio; a small market or a remote region may not generate enough deals to make specialist coverage attractive. The result is a self-reinforcing pattern. Investors locate where they already have networks and deal flow, and companies in those locations become easier to evaluate. Companies elsewhere may be weaker not because their ideas are worse, but because they are farther from the information infrastructure that private VC relies on.
The third is a mismatch in time horizons. A private fund has a finite life and its managers ultimately have to return capital to investors. That creates pressure to support companies that can reach a financing milestone, acquisition, or public-market exit within a workable period. Deep-tech, climate, and other knowledge-intensive ventures may need long experiments, regulatory approvals, manufacturing development, and several rounds of learning before their commercial prospects become clear. A project can be worth pursuing for society while remaining inconvenient for a fund whose investors expect liquidity on a shorter schedule.
The fourth is concentration. Venture investors tend to favour sectors with large markets, visible comparables, and a history of successful exits. They also benefit from being close to founders, co-investors, specialised employees, and advisers. This concentration can improve selection inside a mature cluster, but it can deprive peripheral regions and less established fields of the very capital and networks needed to build a cluster. Demographic concentration adds another layer: founders who are less represented among investors or in high-VC sectors may have fewer opportunities to be screened, introduced, and backed.
These failures are related but should not be collapsed into a single “equity gap.” Consider two companies with equally uncertain technologies. One is in a major technology centre with several experienced investors and a pipeline of follow-on funds. The other is in a smaller region where the first investor would need to evaluate the science, recruit advisers, and help assemble the next round. The second company faces an information and network problem as well as a capital problem. A policy that only increases the amount available to established local funds may not change its prospects.
Public participation can be designed around these conditions in several ways. It may accept a longer time horizon, share risks that private investors are unwilling to carry alone, reduce information or transaction barriers, or widen access to regions and sectors that established networks overlook. These are possible responses to diagnosed failures, not evidence that public money always corrects the market. They work only if the programme is designed around the specific constraint and retains enough discipline to distinguish a temporary market gap from a persistently weak investment.
This is also why government VC has more than one objective. A programme may be asked to generate a financial return for the public balance sheet, create additional private investment, strengthen a regional ecosystem, or direct capital to a strategic technology. Those goals can coexist, but they can also conflict. A fund that maximises near-term exit probability may avoid the long-horizon firms that motivated intervention. A fund that prioritises access may accept a different risk and return profile. The diagnosis must therefore identify which loss the policy is willing to bear and which outcome it considers worth buying.
A moving target: boom, correction, and concentration
The financing gap does not stay fixed because the private VC market changes with liquidity and investor expectations. The OECD reports that global VC investment rose from USD 31 billion across about 3,500 start-ups in 2006 to USD 336 billion across 26,800 start-ups in 2020. In 2021, investment reached USD 669 billion across 30,500 start-ups. Historically low interest rates and broad participation by institutional investors increased the appetite for riskier assets, while the growing number of start-ups built on intangible assets increased demand for equity finance.
A larger market can make more financing available, but it can also obscure uneven access. The surge was driven heavily by start-up and late-stage rounds, while investors continued to prefer scalable businesses with large potential markets and relatively predictable routes to growth. A firm that needs a modest seed round may not benefit from a market headline measured in hundreds of billions if the investors around it are concentrating on later-stage companies. Aggregate volume is therefore not the same as availability at the stage, place, or sector where a particular firm needs capital.
The correction after 2021 made this distinction sharper. VC investment fell by 19% in 2022 and 34% in 2023, according to the OECD, as inflation and higher interest rates redirected capital toward fixed-return assets and reduced liquidity. Falling valuations weakened the exit environment and made it harder for existing portfolio companies to raise follow-on money. Investment improved late in 2024, but the recovery was heavily associated with artificial intelligence, and early 2025 brought renewed uncertainty around geopolitics and trade.
For a young company, the danger is not simply that the first cheque is smaller. Venture development is sequential. A firm may need seed money to prove a technology, a Series A round to build a product, growth capital to expand production, and later financing to enter new markets. If the private market becomes cautious between those stages, the value of earlier public or private investment can be stranded. A temporary funding interruption can force a promising company to cut research or sell under pressure before its business model has been tested.
This is why governments may be asked to play both a catalytic and a stabilising role. In an expansion, public capital can help widen the set of investors and firms that participate rather than simply follow the most popular deals. In a contraction, it can help preserve a financing network when private investors conserve cash. But countercyclical participation has a trade-off: public institutions may be tempted to fill every gap, including gaps created by weak projects rather than temporary market conditions. The ability to distinguish those cases is part of the investment function, not an administrative afterthought.
The same diagnosis rules out two tempting conclusions. First, the existence of a financing gap does not prove that every government investment is additional. A public fund may back a company that would have received private finance anyway, or it may crowd out private capital that was ready to participate. Second, a larger fund does not automatically correct allocation. If it uses the same networks, sector preferences, and time horizons as the private market, it can reproduce concentration at a larger scale.
The useful question is more precise: which part of the financing system is failing, at what stage, and for which firms? If private investors have capital but lack information about a new manager or market, a programme aimed at reducing that information barrier may help. If the problem is a technology that needs direct technical judgment and a long development horizon, a public institution may need to stay close to the company. If the problem is a missing follow-on market, the priority may be growth-stage coordination rather than more seed commitments.
The diagnosis before the remedy
A financing gap is therefore a relationship among risk, information, time, place, and incentives. Venture capital can finance firms that debt cannot, but private VC itself is selective and cyclical. Public VC is justified most clearly when it addresses a specified mismatch: it can provide patient capital, build investor capability, share evaluation costs, or extend access beyond the established market. It is justified least clearly when “more capital” is treated as the diagnosis and the programme has no account of who would otherwise invest, what risk the public sector is taking, or how additionality will be measured.
That diagnosis gives fund-of-funds a demanding starting point. An indirect structure may help when the missing capability is scale, diversification, private-manager expertise, or institutional confidence. It may be poorly matched when the missing capability is direct technical knowledge, local presence, or willingness to finance an opportunity that has no established manager base. The next step is to examine how a fund-of-funds is supposed to change the behaviour and capacity of the private VC system rather than merely add another investor.