Balancing startup success and failure: how VC investors can tip the scales

Recently, I’ve come across an interesting paper, “Tolerance for Failure and Corporate Innovation,” published in 2011 by Xuan Tian of Indiana University and Tracy Yue Wang of University of Minnesota. Tian and Wang studied the relationship between venture capital (VC) investors’ attitude towards failure and the performance of startups backed by these VCs.

Tian and Wang have developed an original approach to measuring VCs’ tolerance for failure: they examined VCs’ willingness to continue investing in ventures that missed their target milestones. The idea here is that VCs have two options when dealing with an underperforming venture: either to write it off immediately or to give the entrepreneur a second chance by continuing to infuse capital into the venture. Other things equal, the longer a VC firm waits before terminating funding of underperforming ventures, the more tolerant it is for early failures in investments.

The most remarkable result of Tian and Wang’s study was that startups backed by more failure-tolerant VCs were more innovative (as judged by the number and significance of patents they filed). The authors also found that the effect of VC failure tolerance on startup innovation was much stronger when the failure risk was higher (e.g., in drug discovery) and thus failure tolerance was more needed and valued.

These findings are important given the role VC funds play in supporting the startup economy and entrepreneurship. They may also provide a clue to the growing popularity of corporate venture capital (CVC) funds, a specific subset of venture capital by which corporations invest in external startups.

In recent years, CVCs have been rapidly gaining traction. According to CB Insights, a tech market intelligence platform, the number of CVC groups making their first investment in startups in 2014 grew 28% over 2013 (and 208% over 2010); the number of existing CVC funds was expected to double in 2015. In fact, one-fifth of all venture deals in Q3 2015 included CVC participation.

Moreover, it was shown that CVC investment is particularly beneficial to startups: startups that had gone public, over the period of 1980-2004, after being funded by at least one CVC investor outperformed those funded exclusively by traditional VCs (as measured by average annual revenue growth, increase in ROA and stock price performance).

Why is that? The first reason might be that most CVCs actively work with their portfolio companies providing them with domain expertise and access to proprietary networks. One could thus argue that the industry-specific expertise delivered by the corporate teams is much more valuable to startups that the knowledge provided by the “generalists” employed by traditional VC firms.

The second reason could be rooted in the goals corporate and traditional VCs pursue when investing in startups. While traditional VCs invest capital with the sole objective of financial returns, CVCs often invest for strategic reasons, with financial return being only a secondary consideration. (In a CB Insight survey, four out of five CVCs named strategic value of working with startups as a key decision driver.) Besides, managers of CVC funds are typically compensated by a fixed salary and corporate bonuses. This may make them more tolerant to financial losses associated with investing in startups and thus more tolerant to startups’ failures.

Supporting this assertion—and pointing to the results of Tian and Wang mentioned above–is a study conducted by researchers from the Wharton’s Mack Institute for Innovation Management. They tracked the performance of biotech startups—ventures with a particularly high risk of failure–funded by both types of VCs and found that startups backed by CVCs demonstrated higher innovation output (in terms of the number of granted patents and published scientific articles) than those backed by traditional VCs.

Taken together, both the Wharton and Tian and Wang’s studies strongly suggest that the positive effect of CVC financing on startup performance, including innovation output, is due to a higher tolerance to startup failure displayed by corporate VC investors as compared to traditional VCs.

A lesson that aspiring entrepreneurs can draw from this story is this: if your venture carries elevated risk of failure, choosing a corporate investor to support it might increase your chances to succeed.

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About Eugene Ivanov

Eugene Ivanov is a PMI-certified Innovation Management Consultant who helps organizations increase the efficiency of their internal and external innovation programs.
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