Working Paper | HBS Working Paper Series | 2013

Financing Risk and Innovation

by Ramana Nanda and Matthew Rhodes-Kropf

Abstract

We provide a model of investment into new ventures that demonstrates why some places, times, and industries should be associated with a greater degree of experimentation by investors. Investors respond to financing risk―a forecast of limited future funding―by modifying their focus to finance less innovative firms. Potential shocks to the supply of capital create the need for increased upfront financing, but this protection lowers the real option value of the new venture. In equilibrium, financing risk disproportionately impacts innovative ventures with the greatest real option value. We propose that extremely novel technologies may need "hot" financial markets to get through the initial period of discovery or diffusion.

Keywords: Business Startups; Venture Capital; Financial Markets; Financing and Loans; Investment; Price Bubble; Innovation and Invention; Technological Innovation; Risk and Uncertainty;

Citation:

Nanda, Ramana, and Matthew Rhodes-Kropf. "Financing Risk and Innovation." Harvard Business School Working Paper, No. 11-013, August 2010. (Revised March 2014.)