20 Oct 2010Working Paper Summaries

Financing Risk and Bubbles of Innovation

by Ramana Nanda and Matthew Rhodes-Kropf

While start-up firms are key to any technological revolution, they also run a high risk of failure. To that end, investors often provide limited capital in several careful stages, gaining confidence in a firm before doling out another round of funding. However, these investors still face the possibility that other investors won't provide follow-on funding, even when the firm's prospects remain sound. That's a big risk for individual investors who can't afford to fund a new firm all by themselves, and whose investment will flounder if others don't invest, too. Research by HBS professors Ramana Nanda and Matthew Rhodes-Kropf explores why future investors may not fund the project at its next stage even if the fundamentals of the project have not changed. Key concepts include:

The paper introduces the concept of financing risk--the risk that a project cannot garner the additional funding it needs to proceed, even if its fundamentals remain sound.
When investors become worried, future investors will not support the project. Withdrawing support today leads to a self-fulfilling jump to a poor financing environment.
Investors face a trade-off: either providing more capital to novel ideas to protect against financing risk, or providing less funding to maximize knowledge before providing more capital.
The most innovative firms face the most acute trade-off situations, and thus, funding to these firms is the most unstable.
The additional capital that enters the market during "hot" times goes not only to weaker projects, but also to more innovative projects that are a good investment only when financing risk is low. Thus, the most innovative projects may need a hot funding environment to get funding at all.

Author Abstract

Investors in risky start-ups who stage their investments face financing risk-that is, the risk that later-stage investors will not fund the startup, even if the fundamentals of the firm are still sound. We show that financing risk is part of a rational equilibrium where investors can flip from investing to not investing in certain sectors of the economy. We further demonstrate that financing risk has the greatest impact on firms with the most real option value. Hence, the mix of projects funded and type of investors who are active varies with the level of financing risk in the economy. We also highlight that some extremely novel technologies may in fact need "hot" financial markets to get through the initial period of diffusion. Our work underscores that financial markets may play a much larger and under-studied role in creating and magnifying bubbles of innovation in the real economy.