In our paper, Investment Cycles and Startup Innovation, which was recently made publicly available on SSRN, we examine how the environment in which a new venture was first funded relates to their ultimate outcome. New firms that surround the creation and commercialization of new technologies have the potential to have profound effects on the economy. The creation of these new firms and their funding is highly cyclical (Gompers et al. (2008)). Conventional wisdom associates the top of these cycles with negative attributes. In this view, an excess supply of capital is associated with money chasing deals, a lower discipline of external finance, and a belief that this leads to worse ventures receiving funding in hot markets.
However, the evidence in our paper suggests another, possibly simultaneous, phenomenon. We find that firms that are funded in “hot” times are more likely to fail but create more value if they succeed. This pattern could arise if in “hot” times more novel firms are funded. Our results provide a new but intuitive way to think about the differences in project choice across the cycle. Since the financial results we present cannot distinguish between more innovative versus simply riskier investments, we also present direct evidence on the quantity and quality of patents produced by firms funded at different times in the cycle. Our results suggest that firms funded at the top of the market produce more patents and receive more citations than firms funded in less heady times. This indicates that a more innovative firm is funded during “hot” markets.
Is this effect caused by new investors entering the market during “hot” times while older, more experienced investors “stick to their knitting?” Or, are experienced investors also changing their investments across the cycle? Our evidence supports the idea that even the most experienced investors invest in riskier and more innovative projects at the top of the cycle. These effects could occur because the type of investment available changes through the cycle. Potentially new inventions cause the arrival of more funding and create a “hot” environment. However, Nanda and Rhodes-Kropf (2011) demonstrate how excess funding in the venture capital market can actually rationally alter the type of investments investors are willing to fund toward a more experimental, innovative project. According to this view, the abundance of capital associated with investment cycles may not just be a response to the arrival of new technologies, but may in fact play a critical role in driving the creation of new technologies.
Using an instrumental variable approach we find evidence consistent with the idea that excess capital actually causes the type of investment to change. We argue that a hot IPO market two-three years in the past causes excess capital to flow into the venture industry that is unrelated to the current opportunity set. The increase in funding activity due to this excess capital should alter the type of investments made in a way that is unrelated to the current opportunities. We find strong results using this IV. Specifically, the results suggest that excess capital in the venture capital market causes investors, especially experienced investors, to shift their investments to riskier more innovative ideas.
To the extent that the top of the investment cycle leads to the funding of worse projects, then investment may be wasted. This leads many economists and regulators to believe that dampening the cycle would improve outcomes and therefore should be attempted. However, our work suggests caution. We show that the excess capital that arrives during “hot” markets may allow for investment to flow into the most novel projects. “Hot” markets allow investors to take on more risky investments, and may therefore be a critical aspect of the process through which new technologies are commercialized.
Our results demonstrate how the risk and innovation of venture investments are changing across the investment cycle. We find pronounced effects that suggest that in hot markets a more risky and more innovative type of investment is funded. Furthermore it seems that the abundance of capital also changes the type of firm that investors are willing to finance in such times. These findings are consistent with a view that an abundance of capital allows investors to experiment more effectively, making them more willing to fund risky and innovative startups in boom times (Nanda and Rhodes-Kropf (2011)). Financial market investment cycles may create innovation cycles.
The full paper is available for download here.