Professor Rhodes-Kropf’s work in entrepreneurship and finance seeks to understand how capital markets shape the creation of new firms, their financing, and their ultimate success or failure. For example, his research has considered how the contract between venture capitalists and their limited partners impacts the pricing of firms they fund.

His latest work is on innovation waves. The standard view of the innovation cycle is one of Schumpeterian creative destruction, in which an idea fails because it is replaced by a better idea. However, most new ideas do not fail because they are unable to compete effectively; rather, new ideas fail because they do not receive funding. By examining the interaction between innovation and the financial markets, it is possible to understand and predict not only why waves of innovative activity occur, but the type of activity that occurs at different points in the cycle.

The great bubbles of innovation are often associated with investment in startup firms.  The inherent uncertainty in these firms leads investors to stage investments, which causes investors to face a unstudied type of risk. Professor Rhodes-Kropf has introduced the importance of financing risk and show how it can both cause and amplify bubbles of innovation in the real economy. Financing risk occurs when investors with limited resources must rely on future investors to fund a project at later stages. The project NPV then depends not only on the fundamentals of the project, but also on a given investor's belief about other investors' willingness to fund the project at later stages. When the risk that future investors will not fund the project becomes high, then like in a bank run, current investors flip to an equilibrium in which no one invests. Financing risk is particularly costly for innovative projects with substantial real option value, where the financing constraint is not easily overcome by a large investment ex ante. Therefore, the most innovative projects in the economy are particularly vulnerable to waves of investment activity.

Professor Rhodes-Kropf is pursuing new work on how venture capitalists use the financial guillotine. Preliminary evidence suggests that venture capitalists “fall in love” with their companies and throw good money after bad, leading to mispriced insider-led financing rounds.

Professor Rhodes-Kropf’s research in M&A examines why firms appear to merge in waves, demonstrating the rationality of merger waves and their link to misvaluation. He has shown that merger waves and waves of cash and stock purchases can be rationally driven by periods of over- and undervaluation of the stock market. To test his theory, Professor Rhodes-Kropf developed a novel decomposition that breaks the market-to-book ratio into three components: the firm-specific pricing deviation from short-run industry pricing; sector-wide, short-run deviations from firms’ long-run pricing; and long-run pricing to book. He has used this decomposition to find strong support for his theories of misvaluation and mergers.

Professor Rhodes-Kropf has also shown the role of matching in merger activity. The most-repeated fact in M&A is “high buys low” – that is, high market-to-book firms tend to purchase firms with lower market-to-book ratios. This maxim fits well with the classical view that higher-quality firms are purchasing poorly run firms in order to redeploy their assets to a better use. However, Professor Rhodes-Kropf has shown that, while the difference in acquirer-target market-to-book ratio is slightly positive on average, the difference is actually quite small. Thus, a better verbal description of M&A activity is not “high buys low,” but “like buys like.” He hypothesizes that this matching is actually the natural outcome of a search process where acquirers and targets try to find one another and negotiate mergers.
Professor Rhodes-Kropf’s latest work in M&A focuses on firms that “merge into the fast lane.” His preliminary work shows that firms move from industries that were valued more highly in the past into industries where firms will be valued more highly in the future. This finding suggests that M&A activity is about a management team looking for a new activity and leads to questions about the definition of a firm.