Cost Of Experimentation And The Evolution Of Venture Capital

Cost Of Experimentation And The Evolution Of Venture Capital

Michael Ewens

California Institute of Technology – Division of the Humanities and Social Sciences

Ramana Nanda

Harvard University – Entrepreneurial Management Unit

Matthew Rhodes-Kropf

Harvard Business School – Entrepreneurial Management Unit; National Bureau of Economic Research (NBER)

October 30, 2015

Harvard Business School Entrepreneurial Management Working Paper No. 15-070


We study adaptation by financial intermediaries as a response to technological change in the context venture-capital finance. Using a theoretical model and rich data, we are able to both document and provide a framework to understand the changes in the investment strategy of VCs in recent years – an increased prevalence of investors who “spray and pray” – providing a little funding and limited governance to an increased number of startups that they are more likely to abandon, but where early experiments significantly inform beliefs about the future potential of the venture. We also highlight how this adaptation by financial intermediaries has altered the trajectory of aggregate innovation away from complex technologies where initial experiments cost more towards those where information on future prospects is revealed quickly and cheaply.

Cost Of Experimentation And The Evolution Of Venture Capital – Introduction

While technological change is increasingly seen as the primary driver of of productivity growth (Aghion and Howitt (1992)), adaptation by financial intermediaries may be equally important to realizing the benefits of these new technologies (King and Levine (1993); Laeven, Levine, and Michalopoulos (2015)). For example, Chandler (1965) documents how specialized investment banks evolved as a response to the “vast sums of capital” required to finance railroads and govern industrial corporations needing arms-length capital from distant investors.

The need for financial innovation is particularly salient in the context of early stage finance, where investors are not just passive, but play an active role as gatekeepers, deciding whether to make an initial investment to learn about the viability of a radical new idea, how to interpret intermediate results, and whether to continue or abandon their invest- ment. This process of experimentation by investors is a central aspect of entrepreneurial finance (Hellmann and Puri (2000); Sorensen (2007)). Indeed, the modern venture capital model arose from the founding of the American Research and Development Corporation (ARD) in the mid-20th century in order to channel capital to the myriad new technologies emerging outside of the corporate R&D model and today plays a central role in the commercialization of new technologies in the US and around the world (Nicholas (2015)).

In this paper, we posit that technological shocks to the cost of starting new businesses have led the venture capital model to adapt in fundamental ways over the prior decade, potentially resulting in significant consequences for the trajectory of innovation in the economy. A number of technological developments have made the early experiments by startups significantly cheaper in recent years, opening up a whole new range of investment opportunities that were not viable before. While anecdotal accounts of this phenomenon and the changes in the market for early stage finance have been documented in the press and the managerial implications popularized in frameworks such as the “lean startup model,” we are not aware of any systematic work examining how the changing cost of starting businesses impacts the early stage financing market.

From a theoretical perspective, the changing cost of experimentation requires adaptation by investors, shifting the way in which investors manage their portfolios and the types of companies they choose to finance. This is because investors backing startups engaged in the early stages of innovation face an important tradeoff. On the one hand, investors may want to tolerate early failure by entrepreneurs to encourage the entrepreneurs to engage in risky experimentation – thereby increasing the chances of radical innovation (Manso, 2011). On the other hand, failure tolerance requires investors to forgo abandonment options, and hence makes them less likely to fund the risky experimentation in the first place (Nanda and Rhodes-Kropf, 2013).2 Since the falling cost of experimentation makes abandonment options for investors much more valuable, this directly impacts the tradeoff between failure tolerance and the desire to exercise abandonment options and thus can have first order implications for the types of firms that are financed and the nature of innovation in the economy.

Venture Capital

Venture Capital

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