Innovation and VC investors

Academic research provides abundant empirical evidence suggesting that corporate and socio-economic policies tolerating failure, both at individual and firm levels, foster innovation. For example, labor laws limiting firms’ ability to discharge employees at will were shown to stimulate corporate innovation. Corporate innovation is encouraged not only by protecting individual employees but the firms themselves, as evidenced by the finding that debtor-friendly (i.e., firm-friendly) bankruptcy laws have a positive effect on innovation output.

Yet another piece of evidence that the tolerance for failure positively affects corporate innovation comes from the work by Xuan Tian and Tracy Yue Wang published in 2011.

Tian and Wang studied the subject of innovation failures using an original empirical approach: by analyzing venture capital (VC) investors’ attitude towards failure in VC-backed startup firms. Startup firms are known to have high innovation potential, but also a substantial failure risk; thus, innovation failure tolerance is very important to them. On the other hand, VC investors’ tolerance for failure is crucial for the innovation productivity of VC-backed startups. If VC investors can’t tolerate early failures, they can prematurely liquidate a startup upon initial unsatisfactory progress and prevent it from realizing the startup’s true innovation potential.

Tian and Wang developed a practical measure of VC investor’s failure tolerance: they examined investors’ willingness to continue funding underperforming ventures (i.e., ventures not meeting pre-determined milestones). The rationale behind this approach is that when a project does not show progress towards its goals, a VC investor has a choice: to give the entrepreneur a second chance by continued funding or to write off the project immediately. What a choice the VC made would to some extent reflect their attitude towards failure. Other things equal, the longer the VC firm waits before terminating funding of underperforming projects, the more tolerant the VC is for early failures in investments.

Tian and Wang showed that IPO firms backed by more tolerant VC investors are significantly more innovative in terms of the quantity and quality of patents issued to them. (More specifically, if a VC firm on average invests for two years before terminating a project, but is willing to invest for additional two years in an IPO firm, then this IPO firm tends to have 40% more patents per year later.)

Tian and Wang also found that the effect of VC failure tolerance on startup innovation was much stronger when the failure risk is higher and thus failure tolerance is more needed and valued. For example, being financed by a failure-tolerant VC is much more important for ventures born in recessions, ventures at early development stages, and ventures in industries in which innovation is especially difficult (e.g., drug development). VCs’ tolerance for failure allows these startups to overcome early difficulties and realize their true innovation potential.

In my previous post, I described a Stanford study that shows that firms going for IPO may jeopardize their innovation output. In fact, going public can result in a 40% decline in the quality of patents issued to the IPO firm in the five years immediately following listing. Of course, this fact by itself shouldn’t prevent startups from considering IPO. However, they ought to be mindful of the consequences this development may have on their post-IPO ability to innovate—and they must adjust their corporate innovation policies accordingly. Choosing a “correct” (i.e., failure-tolerant) VC investor would be a smart move.

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The image credit: https://www.thoughtco.com/prayers-of-protection-701301

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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