«∗ Ramana Nanda Matthew Rhodes-Kropf Harvard Business School Harvard Business School Boston MA Boston MA January, 2012 Abstract We ﬁnd that ...»
Investment Cycles and Startup Innovation∗
Ramana Nanda Matthew Rhodes-Kropf
Harvard Business School Harvard Business School
Boston MA Boston MA
We ﬁnd that VC-backed ﬁrms receiving their initial investment in hot markets are less likely to IPO, but conditional on going public are valued higher
on the day of their IPO, have more patents and have more citations to their
patents. Our results suggest that VCs invest in riskier and more innovative startups in hot markets (rather than just worse ﬁrms). This is true even for the most experienced VCs. Furthermore, our results suggest that the ﬂood of capital in hot markets also plays a causal role in shifting investments to more novel startups - by lowering the cost of experimentation for early stage investors and allowing them to make riskier, more novel, investments.
JEL Classiﬁcation: G24, G32, O31 Key Words: Venture Capital, Innovation, Market Cycles, Financing Risk ∗ Soldiers Field Road, Boston, MA 02163, USA. Email: firstname.lastname@example.org and email@example.com. We are grateful to Bo Becker, Shai Bernstein, Michael Ewens, Bill Kerr, Paul Gompers, Robin Greenwood, Thomas Hellmann, Josh Lerner, David Scharfstein, Antoinette Schoar and Rick Townsend for fruitful discussion and comments, and to the seminar participants at MIT, UT Austin, Tuck School of Business, Harvard, Houston University, Northeastern University, University of Lausanne, Notre Dame, Hong Kong University. We thank Oliver Heimes and Sarah Wolverton for research assistance, and the Division of Faculty Research and Development at HBS and the Kauﬀman Foundation for ﬁnancial support. All errors are our own.
Investment Cycles and Startup Innovation Abstract We ﬁnd that VC-backed ﬁrms receiving their initial investment in hot markets are less likely to IPO, but conditional on going public are valued higher on the day of their IPO, have more patents and have more citations to their patents. Our results suggest that VCs invest in riskier and more innovative startups in hot markets (rather than just worse ﬁrms). This is true even for the most experienced VCs. Furthermore, our results suggest that the ﬂood of capital in hot markets also plays a causal role in shifting investments to more novel startups - by lowering the cost of experimentation for early stage investors and allowing them to make riskier, more novel, investments.
JEL Classiﬁcation: G24, G32, O31 Key Words: Venture Capital, Innovation, Market Cycles, Financing Risk “Our willingness to fail gives us the ability and opportunity to succeed where others may fear to tread.” - Vinod Khosla on his venture ﬁrms innovative success.
I. Introduction It is well known that the ﬁnancing available for startups that commercialize new technologies is extremely volatile. These “investment cycles” have been extensively studied in the literature on venture capital (Gompers and Lerner (2004), Kaplan and Schoar (2005), Gompers et al.
(2008)), but have also been documented in historical work linking ﬁnancial market activity to radical innovations in manufacturing, communications and transportation going back to the mid 1700s (Kindleberger (1978); Perez (2002)). Conventional wisdom and much of the popular literature tends to associate these cycles with negative attributes. Herding among investors is believed to lead to an excess supply of capital in the market (Scharfstein and Stein (1990)), lowering the discipline of external ﬁnance and leading to more “junk” and “me-too” ventures getting ﬁnanced in hot markets (Gupta (2000)).
However, an alternative view suggests that periods of heated activity in the ﬁnancing of startups may also be associated with better investment opportunities (Gompers et al. (2008), Pastor and Veronesi (2005)). In addition, Nanda and Rhodes-Kropf (2011) argue that the abundance of capital in such times may also allow investors to experiment more eﬀectively, thereby shifting the type of startups that investors ﬁnance towards those that are neither better nor worse but more risky and innovative.
According to this latter view, the abundance of capital associated with investment cycles may not just be a response to the arrival of new technologies, but may in fact play a critical role in driving the commercialization and diﬀusion of new technologies. It also suggests that looking only at the failure rates for ﬁrms funded in hot markets is not suﬃcient to infer that more “junk” is funded in such times. Greater failures can also result from more experimentation, so that simultaneously examining the degree of success for the ﬁrms that did not fail may be key to distinguishing between a purely negative view of investment cycles and one that suggests it also facilitates experimentation.
We study the ultimate outcome for venture capital-backed startups that were ﬁrst funded between 1980 and 2004. We ﬁnd that startups receiving their initial funding in quarters when many other startups were also funded were less likely to IPO (and more likely to go bankrupt) than those founded in quarters when fewer ﬁrms were funded. Conditional on being successful enough to go public, however, startups funded in more active periods were valued higher on the day of their IPO, had a higher number of patents and received more citations to their patents.
Our results suggest that more novel, rather than just “worse” ﬁrms, seem to be funded in boom times.1 We further examine whether more novel ﬁrms being funded in boom times is being driven by the entry of diﬀerent investors during these periods, or whether the same investors seem to change their investments across the cycle. When we include investor ﬁxed eﬀects our estimations suggest that the results are not being driven by uninformed investors entering during hot times, but rather by the current investors changing their investments. Furthermore, when we reduce the sample to those investors with greater than 25 investments from 1980-2004 (the most active 7%), we ﬁnd that even the most experienced investors back riskier, more innovative startups in boom times.
An obvious question about the observed correlation between hot markets and the funding of more novel startups is whether the hot markets are purely a response to diﬀerent investment opportunities where the type of startup is more novel, or whether the abundance of capital also changes the type of ﬁrm that investors are willing to ﬁnance in such times (independent The idea that worse projects are funded during hot times is likely true - we are suggesting that simultaneously riskier, more innovative projects are funded.
of the investment opportunities at diﬀerent points in the cycle).
In order to shed light on this question, we exploit the fact that the supply of capital into the VC industry is greatly inﬂuenced by the asset allocation of limited partners putting money into ‘private equity’ more broadly. We therefore use an instrumental variables estimation strategy, where the number of startup ﬁrms ﬁnanced in a given quarter is instrumented with a variable that measures the number of leveraged buyout funds that were raised in the 5-8 quarters before the ﬁrm was funded. The assumption is that the limited partners decisions to invest in buyout funds are uncorrelated with the opportunity set in early stage venture capital, since buyout funds focus on turnarounds of existing companies while early stage investors focus on new technologies and opportunities. However, the fact that limited partners allocate capital to the ‘private equity’ asset class as a whole leads fundraising by venture and buyout funds to be associated. Our instrumental variables approach should capture that part of the VC investments that are due to increases in capital unrelated to the investment opportunities available at the time for venture capital funds. Lagged buyout fundraising is used as an instrument to account for the fact that venture funds take 1-3 years to fully invest the capital in their funds and has the added advantage of further distancing the instrument from current VC opportunities. Our results are robust to this IV strategy, suggesting that after accounting for the level of investment due to diﬀerential opportunities in the cycle, increased capital in the industry seems to change the type of startup that VCs fund, towards ﬁrms that are more novel. This ﬁnding also holds when we include investor ﬁxed eﬀects, including for the most experienced investors. Thus, increased capital in the venture industry seems to alter how even the more experienced venture capitalists invest. These ﬁndings are consistent with a view that an abundance of capital causes investors to increase experimentation, making them more willing to fund risky and innovative startups in boom times (Nanda and Rhodes-Kropf (2011)).
Thus, our work is related to a growing body of work that considers the role of ﬁnancial intermediaries on innovation and new venture formation (see Kortum and Lerner (2000), Hellmann (2002), Lerner et al. (2011), Sorensen (2007), Tian and Wang (2011), Hochberg et al.
(2007), Hellmann and Puri (2002), Mollica and Zingales (2007), Samila and Sorenson (2011), Bengtsson and Sensoy (2011)). Our results suggest that rather than just reducing frictions in the availability of capital for new ventures, investment cycles may play a much more central role in the diﬀusion and commercialization of technologies in the economy. Financial market investment cycles may create innovation cycles.
Our ﬁndings are also complementary to recent work examining how R&D by publicly traded ﬁrms responds to relaxed ﬁnancing constraints (Brown et al. (2009), Li (2012)). While this work is focused on the intensive margin of R&D, our work examines how shifts in the supply of capital impacts the choice of ﬁrms that investors might choose to fund, thereby having a bearing on the extensive margin of innovation by young ﬁrms in the economy.
Our results are also related to a growing body of work examining the relationship between the ﬁnancing environment for ﬁrms and startup outcomes. Recent work has cited the fact that many Fortune 500 ﬁrms were founded in recessions as a means of showing how cold markets lead to the funding of great companies (Stangler (2009)). We note that our results are consistent with this ﬁnding. In fact, we document that ﬁrms founded in cold markets are signiﬁcantly more likely to go public. However, we propose that hot markets may not only lead to lower discipline among investors, but also seem to facilitate the experimentation that is needed for the commercialization and diﬀusion of radical new technologies. Hot markets allow investors to take on more risky investments, and may therefore be a critical aspect of the process through which new technologies are commercialized. Our results are therefore also relevant for policy makers who may be concerned about regulating the ﬂood of capital during such investment cycles.
The rest of the paper is structured as follows. In Section 2, we develop our hypothesis around the relationship between ﬁnancing environment and startup outcomes. In Section 3, we provide an overview of the Data that we use to test the hypothesis. We outline our empirical strategy and discuss our main results in Section 4. Section 5 concludes.
II. Financing Environment and Startup Outcomes Popular accounts of investment cycles have highlighted the large number of failures that stem from investments made in good times and noted that many successful ﬁrms are founded in recessions. A natural inference is that boom times lower the discipline of external ﬁnance and lead investors to make worse investments when money is chasing deals. The underlying assumption behind this inference is that as the threshold for new ﬁrms to be founded changes in boom times, so that the marginal ﬁrm that gets funded is weaker. Looking at the average pool of entrants is therefore suﬃcient to understand how the change in the ﬁnancing environment for new ﬁrms is associated with the type of ﬁrm that is funded.
However, understanding the extent to which a ﬁrm is weaker ex ante is often very diﬃcult for venture capital investors, who may be investing in new technologies, as-yet-non-existent markets and unproven teams. In fact, much of venture capitalist’s successes seem to stem from taking informed bets with startups and eﬀectively terminating investments when negative information is revealed about these ﬁrms (Metrick and Yasuda (2010)). For example, Sahlman (2010) notes that as many as 60% of venture-capitalist’s investments return less that their cost to the VC (either through bankruptcy or forced sales) and that about 10% of the investments – typically the IPOs – eﬀectively make all the returns for the funds. Sahlman points to the example of Sequoia Capital, that in early 1999 “placed a bet on an early stage startup called Google, that purported to have a better search algorithm” (page 2). Sequoia’s $12.5 million investment was worth $4 billion when they sold their stake in the ﬁrm in 2005, returning 320 times their initial cost.
Google was by no means a sure-shot investment for Seqoia Capital in 1999. The search algorithm space was already dominated by other players such as Yahoo! and Altavista, and Google may just have turned out to be a “me too” investment. In fact, Bessemer Ventures, another renowned venture capital ﬁrm had the opportunity to invest in Google because a friend of partner David Cowan had rented her garage to Google’s founders, Larry Page and Sergey Brin. On being asked to meet with the two founders, Cowan is said to have quipped, “Students?
A new search engine?... How can I get out of this house without going anywhere near your garage?” (http://www.bvp.com/portfolio/antiportfolio.aspx) In fact, Bessemer ventures had the opportunity to, but chose not to invest in several other such incredible successes, including Intel, Apple, Fedex, Ebay and Paypal.