Financing Risk and Bubbles of Innovation

Harvard Business School Entrepreneurial Management Working Paper No. 11-013

Authors:  Ramana Nanda and Matthew Rhodes-Kropf

Executive Summary:

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.