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Failure-tolerant venture capitalists spawn more innovative companies, U of M researcher finds

Just like having a wise, old, rich uncle who can impart life lessons along with a loan, it’s important for entrepreneurs to choose their venture capital backers carefully.

Just like having a wise, old, rich uncle who can impart life lessons along with a loan, it’s important for entrepreneurs to choose their venture capital (VC) backers carefully. Their tolerance for failure makes a big difference down the road in terms of how innovative a company is, according to research recently reported by a University of Minnesota finance professor and a colleague at the University of Indiana.

Initial public offering firms backed by more failure-tolerant VCs not only produce a larger number of patents but also ones with larger impact, as reported in a paper titled “Tolerance For Failure And Corporate Innovation,” co-authored by Tracy Yue Wang, assistant professor of finance and insurance at the U of M’s Carlson School, and collaborator Dr. Xuan Tian, assistant professor of finance at the Kelley School of Business at Indiana University.

It’s not just preventing premature liquidation of companies that ultimately succeeded that accounts for the findings, either. The researchers believe that “VC investors’ attitudes influence the shared beliefs and attitudes about failure” and can encourage or discourage formation of a failure-tolerant culture that will influence innovation in a new company from the very beginning stages.

Because startup ventures inherently contain a high degree of risk, one might conclude that entrepreneurs are more influential in educating their VC backers on failure tolerance. Not so, Dr. Wang said in an email exchange.

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“In general, entrepreneurs don’t want to easily give up their projects … (and) VCs have substantial power over the termination decision.” The entrepreneur needs to convince the VC that a project is worth investing in, not that the VC needs to accept failure.”Thus it is the VC’s failure tolerance, not the entrepreneurs’ failure tolerance,” that is critical, she said.

“Innovation is vital for the long-run comparative advantage of firms. However, motivating and nurturing innovation remains a challenge for most firms,” the researchers said in arguing that the cultural impact of early-stage VC backers can be crucial.

Failure-tolerant VCs are more likely to invest in the biotech, medical device, pharmaceutical and consumer related industries where there is high risk of failure “but also high potential payoff for successful innovation. In such industries the value from ‘wait-and-see’ is high, and thus the optimal level of failure tolerance is high,” they reported.  

As a VC firm becomes more experienced and more specialized over time, it also becomes more failure tolerant. The researchers did not find any significant connection between failure tolerance and the percentage of companies in a VC portfolio that ultimately went public. They also found that VC’s failure tolerance is not important in predicting future innovation when investing in late-stage ventures that have lower potential and lower risk of failure.

The researchers ranked 2,857 VC firms on their “failure tolerance” by looking at their investment history across thousands of startups between 1980 and 2006. VC firms that ranked in the bottom 25 percent kept funding an ultimately failed project for 1.3 years on average, while the VC firms ranking in the top 25 percent kept firms alive nearly a year longer before deciding to pull the plug. The researchers then looked at the portfolio firms that ultimately survived and went public, finding that companies with failure-tolerant VC backing produced 20 percent more patents on average and that the patents were comparably cited more often, signifying greater overall importance of the patents.

While more than 18,500 firms in the initial sample ultimately failed (i.e., lost funding), on average, 53 percent of the firms ultimately survived, while only 16 percent went public.

The study period coincided with regulatory changes in the United States that allowed pension funds to invest in venture capital partnerships, leading to a large influx of capital and a significant increase in venture capital activities beginning in 1980.