Startup Investment: Hot Markets Lead to Hot Dogs, and Much More

It's assumed that innovation comes first and investment dollars follow. It turns out "money can change innovation and innovation outcomes"
Startup Investment: Hot Markets Lead to Hot Dogs, and Much More

The essentials

Startup firms funded in active investment markets are more likely to fail completely and to be extremely successful and innovative than firms financed in cold markets. Once public, these firms are valued higher on the day of their initial public offering (IPO), are acquired for higher values, and have more patents and patent citations, signs of high innovation. Financial market investment cycles may create innovation cycles, says researcher Matthew Rhodes-Kropf, associate professor of business administration at Harvard Business School. Rhodes-Kropf presented his findings at a Queen's School of Business conference.

Hot markets, when venture capital abounds, are generally known as periods when dubious startups get funded and quickly flame out. But new research suggests there’s a lot more going on than meets the eye: in active investment markets, more innovative firms are also born and venture capital often acts as a driver rather than follower of innovation.

Finance observers have often noted that when there is plenty of venture capital to go around, investors seem to herd or lose discipline, allowing shakier startups to be funded compared with periods of less active investment. Others have suggested that, on the contrary, during hot markets there are better investment opportunities, so that projects funded during these times are better than those funded in less active times.

Both sides may be right, says Matthew Rhodes-Kropf, associate professor of business administration at Harvard Business School. Rhodes-Kropf was at the School of Business in June 2012 to present his findings at the Economics of Entrepreneurship and Innovation Conference.

Working with Harvard colleague Ramana Nanda, Rhodes-Kropf conducted a detailed analysis of data from the Dow Jones Venture Source. They wanted to learn more about both the financial and innovation outcomes of firms that received early-stage venture capital financing between 1985 and 2004. 

Focus on outcomes

“Most people think that when money flies into an industry, the junk gets funded,” said Rhodes-Kropf during a break from the conference. “Pets.com comes to mind. While there are lots of failures, it could be because worse things are funded but it could also be because more innovative ideas get funded. So we can’t just look at more failure. We have to look at the other end of distribution, the big outcomes.” 

The outcomes were intriguing. The researchers found that venture capital-backed firms receiving their initial investment in hot markets were significantly more likely to go bankrupt than those created in periods when fewer start-up firms were funded. But once public, the firms were valued higher on the day of their initial public offering (IPO), were acquired for higher values, and had more patents and patent citations, signs of high innovation.

The study also suggests that in hot investment markets, even experienced investors change their approach. They may say they invest in solid prospects in hot times and cold but in fact even the best of them adopt a different strategy: they are more willing to consider riskier and more innovative startups that may have higher probability of failure but also bigger successes. In effect, said Rhodes-Kropf, financial market investment cycles may create innovation cycles.

“Lots of people view innovation as coming first and money follows,” he said. “I’m turning around and saying money can change innovation and innovation outcomes. The willingness to experiment changes through the cycle and it changes with the amount of capital in the cycle.”

Alan Morantz

Smith School of Business

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Kingston, Ontario
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