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The Impact of Financing Risk on Innovative Startups

Staged financing of new firms poses dangers to early investors. But in a hot market, it can set loose a frenzy of funding.

(originally published by Booz & Company)

Title: Financing Risk and Bubbles of Innovation (Subscription or fee required.)

Authors: Ramana Nanda (Harvard University) and Matthew Rhodes-Kropf (Harvard University)

Publisher: Harvard Business School, Working Paper No. 11-013

Date Published: October 2010

Startup firms are typically at the heart of technological revolutions — from the birth of the auto industry to the spread of the Internet. They are also high-risk ventures, and investors, in order to hedge their bets, often dole out capital in careful stages. But this reliance on staged funding introduces a new risk to the investment/innovation equation, a risk that has not been taken into account by finance theory, say the authors of this research paper. The danger revolves around the need of investors with limited capital to estimate the odds that subsequent investors won’t come forward when more money is needed, even if the fundamentals of the startup remain sound. If early investors conclude that later funding won’t be there, they too may head for the exits.

This financing risk, as the authors call it, has broad implications for the innovation sectors of the economy. The authors say that the risk is part of a rational equilibrium in which investors can switch from investing to not investing, depending on the condition of the financial markets. Moreover, the risk has the greatest impact on firms that have the most potential value but that are still unproven and need time and resources to make good. Hence, the mix of projects that are funded and the type of investors who are willing to act vary with the level of financing risk in the economy.

During a period of “cold” financial markets, worthy startup firms may not be able to attract the later-stage funding they need — investors may just be too jittery to take the plunge. Conversely, during periods of “hot” financial markets, investors may scramble to put their money into what they think might be the next new thing. Some extremely novel technologies may in fact require a hothouse financial environment to make it to the next level.

Indeed, the authors say, sectors with high innovation possibilities attract more spikes in investing activity than other sectors. This could explain the historical link, seen in industries as diverse as telephones and the building of canals, between the rapid introduction of novel technologies and on-fire financial markets. In short, the markets may play a much larger role than previously understood in creating and magnifying bubbles of innovation in the real economy.

Employing standard investing rules, the authors developed a mathematical model to examine the impact of the financing risk on the fortunes of a typical startup firm. In the researchers’ model, the young company had to surmount several hurdles — representing technological uncertainty, customer skepticism, or production difficulties, for instance — in order to reach its expected payoff, the IPO. (Think of a biotech startup that must first determine how well a new compound works in mice and then, depending on the result, decide whether to extend the project to primate trials, order further mice experiments, or cancel the project altogether.) In a series of scenarios using their mathematical model, the authors illustrate how the most innovative firms present the riskiest propositions to investors — and thus must endure the greatest threat of inconsistent funding.

Bottom Line:
Investors in risky startups face the possibility that later-stage investors may not be available in a slow market, regardless of the firm’s potential. Some firms with the most potential may need a hot market to get to the next level.

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