Working Paper: NBER ID: w19379
Authors: Ramana Nanda; Matthew Rhodes-Kropf
Abstract: Our paper demonstrates that while failure tolerance by investors may encourage potential entrepreneurs to innovate, financiers with investment strategies that tolerate early failure endogenously choose to fund less radical innovations. Failure tolerance as an equilibrium price that increases in the level of experimentation. More experimental projects that don't generate enough to pay the price cannot be started. In equilibrium all competing financiers may choose to offer failure tolerant contracts to attract entrepreneurs, leaving no capital to fund the most radical, experimental projects. The tradeoff between failure tolerance and a sharp guillotine helps explain when and where radical innovation occurs.
Keywords: Innovation; Failure Tolerance; Venture Capital
JEL Codes: G24; G39; O31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| failure tolerance (L15) | increased innovation (O35) |
| failure tolerance (L15) | less radical innovations (O39) |
| failure tolerance (L15) | funding for radical innovations (O36) |
| investor strategies (G11) | type of innovation (O35) |
| failure tolerance (L15) | lower expected returns (G19) |
| failure tolerance among financiers (G32) | no capital for radical innovations (O39) |
| entrepreneurs' preference for failure tolerance (L26) | equilibrium of failure-tolerant contracts (D86) |