MIT Sloan Management Review

A new working paper tackles an interesting topic: the relationship between tolerance for failure and innovation. In particular, authors Xuan Tian and Tracy Y. Wang looked at venture capitalists’ tolerance for failure  — and its effect on the innovativeness of the young companies they invested in.

One of Tian and Wang’s interesting findings: Venture-backed companies that eventually conducted IPOs (initial public offerings) and were backed by more failure-tolerant venture capitalists were significantly more innovative than other venture-backed IPO companies. 

What’s more, the researchers’ analysis suggests that what particularly matters is investment at an early stage by a failure-tolerant investor.   Venture capitalists, Tian and Wang conclude, appear to influence the culture of the early-stage start-ups they invest in — and failure-tolerant early investors result in IPO companies that are more innovative. 

Tian and Wang measured VCs’ failure tolerance by looking at how long the VCs continued to invest in prior companies that they eventually wrote off.  The authors’ measured innovativeness by looking at a company’s patents and the impact of those patents.

In the U.S., venture capital (VC) firms are disproportionately concentrated in a few geographic areas. Ever wonder why? Well, a new study explores the relationship between venture capitalists’ location and their investments  – and finds some intriguing results.

Henry Chen, Paul Gompers, Anna Kovner and Josh Lerner examined the location of U.S. venture capital firms’ headquarters, branch offices, and investments — as well as their investment success rates. Here are highlights of a few of their findings:

• First, no surprsies: U.S. venture capital is heavily clustered in just three areas of the country – San Francisco/San Jose, New York, and Boston. More than half of all venture capital offices in the U.S. are located in those three metropolitan areas. Just under half of all companies financed by venture capital are located in those areas, too.
• And, it turns out, there are reasons for that. Venture capital firms are disproportionately concentrated in regions where VC investments have been successful in the past — and those regions are in states with higher than average levels of economic output per person. VC-intensive regions are also areas with high numbers of patents per capita. What’s more, venture capital firms headquartered in the three regions that the researchers call “venture capital centers” have a higher average success rate than VC firms based elsewhere.
• Now, here’s a surprising finding. Even though VC firms headquartered in venture capital centers like San Francisco and Boston perform better overall — and even though VC firms disproportionately invest in local start-ups – the VC firms, on average, get better results from their investments in locations outside their headquarters region.

Why would that be? The researchers suggest one possible explanation: Because venture capitalists prefer to invest close to their offices – so they can more easily monitor performance — they may only invest farther afield when start-ups are particularly promising. Conversely, the investors may have slightly lower standards for start-ups that are closer to home, since such start-ups are less costly to keep tabs on.

In other words, start-ups outside the hubs of venture capital may have to overcome higher hurdles to gain VC investors – and then are more likely to perform well.

These days, March is apparently the season for young innovators to apply for start-up financing for the summer. Y Combinator, TechStars and DreamIt Ventures all have deadlines within the next ten days for their summer programs for very early-stage high-tech start-ups.

The idea behind all three organizations? To match would-be entrepreneurial teams who have an idea with expertise and a very modest amount of financing  —  in hopes of getting some of the start-ups to the next stage, where they may interest more traditional venture capital or angel investors. For example,  Y Combinator’s website says the organization typically invests $5000 per participating founder, plus an additional $5000 (so a team of three, for instance, gets $20,000 for the summer) and takes a median equity stake of 6%. Y Combinator invests “mostly in software and web services.”

Not all such really-early-stage investors operate on a summer cycle, however; for example, Founders Co-op in Seattle has a somewhat similar target market — combining  very early-stage start-ups in software and web services with expertise and a small amount of capital, ranging from $10,000 to $250,000 — but no fixed summer schedule. And Y Combinator also funds a group of start-ups in a program that starts in January.

Innovations that span more than one industry discipline or technology domain often face commercialization challenges – in part because of a dearth of venture capitalists with the background to evaluate them. So argues Silicon Valley strategist (and MIT alumna) Sramana Mitra in a recent Forbes.com column about obstacles to cross-disciplinary innovation. Mitra calls such cross-disiplinary business models “cusp businesses.”

One example Mitra cites: designing semiconductor chips for greater ease of manufacturing. She writes:

Yes, you do find some technologists who grasp the cusp. But then you also need business people and investors to play their parts for an innovation to successfully make it to the market.

But many more entrepreneurs and venture capitalists get excited about Web 2.0 than about the cusp of design and manufacturing of semiconductors. Why? Because these two fields are extremely complex, requiring a level of technical depth, intellectual horsepower, business savvy and appetite for risk that is rare in today’s technology industry.

On the plus side, Mitra quotes a cross-disciplinary entrepreneur who points out one benefit of his business: His model is hard for big companies to imitate.