It’s not good news for venture capitalists if a startup they’ve invested in doesn’t succeed. But, according to a new working paper, venture capitalists who have a higher tolerance for failure foster innovation — that is, the successful companies in their portfolios tend to be more innovative. In their working paper “Tolerance for Failure and Corporate Innovation” (June 2009), Xuan Tian, an assistant professor of finance at Indiana University’s Kelley School of Business, and Tracy Y. Wang, an assistant professor of finance at the University of Minnesota’s Carlson School of Management, looked at venture capitalists’ tolerance for failure — and its effect on the innovativeness of their portfolio companies.
One of Tian and Wang’s interesting findings: Venture-backed companies that ultimately conducted initial public offerings and were backed by more failure-tolerant venture capitalists were significantly more innovative than other venture-backed IPO companies. Wang and Tian note that previous authors have theorized that a tolerance for failure is necessary to motivate people to undertake the risk of innovation, so their findings fit with that literature. What’s more, Wang and Tian found that if a company receives investment from a failure-tolerant venture capitalist at an earlier stage of the company’s development cycle, the positive effect of that investor’s tolerance for failure on the organization’s subsequent innovation is “much, much stronger,” Tian says, than if the investment comes at a later stage. Furthermore, the positive effect of a venture capitalist’s tolerance for failure on innovation continues to be significant for a number of years after a company’s IPO — even after venture capitalists have typically cashed out of a portfolio company. Venture capitalists, Tian and Wang conclude, appear to influence the culture of the early-stage startups they invest in.
Tian and Wang measured venture capitalists’ failure tolerance by looking at how long the venture capitalists continued to make investments in earlier portfolio companies that they eventually wrote off. The authors measured innovativeness by looking at a company’s patents and the impact of those patents. For more information about the research,