Innovation when the market cools

Until recently, venture capital was booming in the UK. In 2011, VCs invested £1.6bn in startups and scale-ups. By 2019, the value grew almost tenfold to £12bn. Over the same time period, the number of equity deals made trebled.  Yet, COVID-19 has brought the good times to an end. Equity investment fell sharply in Q1 and Q2 is expected to be even worse. It raises the question, what happens to innovation and entrepreneurship when the market cools.

The conventional wisdom about ‘hot markets’ is that they draw in dumb money and investor discipline falls. As a result, startups that have almost no chance of succeeding end up getting funded. On this view, we’re more likely to get a Juicero when money is easy. When times get tough, VCs will still invest in the startups they believe in, but will pull funding from the startups least likely to succeed.  

This is the glass half-full take. If true, then we should be somewhat relaxed about a collapse in VC funding. The startups with the best prospects should still get funded. Someone on this side of the debate might note that over half of the companies on the Fortune 500 were founded during a recession. 

But I’m sceptical. A key feature of VC investing is that VCs don’t know which startups will succeed and which will fail. A US study found that 60% of VC investments return less than their cost to the VC and the vast majority of VC returns are generated by just 10% of investments. If VCs could easily spot which were which, then they wouldn’t invest in the 60% in the first place. They might, however, change their risk profile and go for safer bets when the market cools, accepting they might miss out on the next Facebook. 

A study by two Harvard economists, Ramana Nanda and Mathew Rhodes-Kropf, puts the conventional wisdom around ‘hot markets’ to the test. Are startups funded in booms more likely to flop?  

The answer is yes, but the ones that do succeed IPO at higher values, patent more, and patent better (i.e. their patents are cited more by other businesses). The study, which controls for the fact that boom markets might be driven by better investment opportunities, finds that when a market is hot, VCs take a riskier approach 

The result isn’t driven by ‘dumb money’ entering the market either. When they control for individual investors, they find they still adopt a riskier portfolio. 

So why are risky innovative businesses more likely to get funded during a boom? Nanda and Rhodes-Kropf are strong believers in the value of experimentation. Hot markets enable more experimentation because they reduce the risk that a start-up won’t be able to find further funding in the future.

As a result, VCs don’t have to make large up-front investments and can instead make smaller but more frequent bets. It is the investing equivalent of the Silicon Valley slogan: ‘strong ideas, weakly held’. 

In this downmarket, many viable firms will still be funded. But we might see fewer riskier bets – fewer experiments. Innovative startups working with risky, untested technologies will find it much harder. Many will fail, even more than usual. 

This should worry us as innovators rarely capture the full value of their innovations. Entrepreneurs are often standing on the shoulders of giants, building on past innovations.  It shows why interventions such as the Future Fund are needed. Otherwise innovation risks being another victim of COVID-19.