The Capital Logic of Innovation: Designing Capital to Tolerate Failure and Reward Success

Venture Capital and Innovation Venture capital firms differ from public-market investment firms in many ways. The most fundamental difference is VC's active involvement. VC firms participate closely in portfolio companies' management and operations, helping improve performance and corporate governance. Beyond helping companies grow, they also effectively promote economic development. VC can finance corporate innovation. Startups typically offer high growth, high risk, and high returns, matching the VC investment model. Compared with other traditional financial institutions, VC firms also have greater specialist expertise, enabling them to select high-quality investments. VC provides financial support for innovation and, in a sense, acts as an information intermediary between companies and investors, effectively addressing information asymmetry. VC funding is usually provided in stages rather than all at once. To receive continued support, a company must improve its R&D and operating capabilities to meet the VC firm's requirements at each stage. VC also enhances a company's reputation and arranges follow-on financing, greatly improving its access to capital and thereby addressing the funding needs of innovation. VC firms actively participate in management, cultivate companies' innovative capabilities, and provide value-added services such as access to relationship networks. Their ultimate goal is value creation, achieved through active involvement in management and operations. Hellmann and Puri (2000) found that VC provides not only financial capital for innovation but also valuable “knowledge capital” for management. After investing, VCs monitor and manage innovative projects, helping companies build management teams and establish their market positioning. In early-stage investments, VCs generally request board seats and use voting rights to strengthen oversight. VCs can also improve incentives for innovation, using aligned interests, bonuses, and equity incentives to strengthen employees' sense of ownership and encourage innovation. In addition, VCs can use their extensive relationship networks to provide value-added services, commercialize technology, and improve portfolio companies' innovation performance. These networks can connect companies with suitable investors, upstream and downstream suppliers, management talent, and even buyers. As Josh Lerner, Ann Leamon, and Felda Hardymon write in Venture Capital, Private Equity, and the Financing of Entrepreneurship: “Venture-backed companies may have the strongest governance. They have professional, active investors who select optimal strategies, organize resources, and work with management to achieve success. “There are virtually no gaps between shareholders, the board, and management.” VC plays a crucial role in companies' innovative R&D and day-to-day operations; its philosophy and behavior directly affect their ultimate fate. Innovation is a core competitive capability for a company's long-term operations, but encouraging and nurturing it is extremely challenging for most businesses. Unlike routine operations, technological innovation is long-term, risky, and uncertain. Traditional performance-based compensation contracts are insufficient to encourage it. Effective incentives for innovation require sufficient tolerance of failure. Tolerating failure encourages innovators to take paths others dare not take and to learn from their failures. In 2017, University of California, Berkeley professor Gustavo Manso published a paper in the Journal of Finance that modeled corporate innovation and found that tolerance of short-term failure effectively encourages innovation. The paper argues that optimal innovation incentive contracts must tolerate early failure and reward long-term success. Entrepreneurship and innovation depend on a supportive social environment. In Silicon Valley, the idea that “failure can create opportunities and better innovation” is widely accepted. Those who fail receive “mostly encouragement and little punishment.” As Sequoia Capital partner Doug Leone puts it: “Success and failure should be balanced. If you have not failed, you have not tried; but if you have only failed, you do not yet know how to do things correctly.” ----- VC tolerance of failure helps corporate innovation. If it encourages innovation, why do not all VCs choose to tolerate failure? What factors affect their tolerance? Capital Constraints Most VC funds have a fixed life. In the United States, a VC fund lasts 10 years, with two possible one-year extensions. VC firms therefore often face capital constraints and must periodically seek additional funding from limited partners. Existing research shows that capital constraints distort VC investment decisions and affect portfolio companies' decisions to go public. Capital constraints also affect tolerance of failure. Tolerating failure requires continued investment in underperforming startups, while capital-constrained VC firms generally lack the liquidity and capacity to provide it. Capital constraints therefore reduce tolerance of failure. When VC firms obtain substantial capital from limited partners through fundraising, their capital constraints ease. Researchers examine the effects of capital constraints by observing changes in failure tolerance after firms receive substantial funding. Tolerance rises sharply after such funding, supporting the researchers' hypothesis. Furthermore, Gompers and Lerner (1998) find that older, more experienced VC firms are less likely to face capital constraints. Their experience, accumulated relationships, and reputations make it easier to obtain capital from the market. The effect of capital constraints on failure tolerance is more pronounced among young, inexperienced VC firms. Researchers therefore compare subsamples by firm age and investment experience. After receiving funding, new and inexperienced VC firms show a larger increase in failure tolerance. In summary, capital constraints distort VC investment behavior and reduce tolerance of failure, with a more pronounced effect among newly established and inexperienced firms. Career Concerns Concern for their careers leads VCs to seek successful investment records, enhancing their reputations and future prospects. But do career concerns affect tolerance of failure? Existing research has not reached a consensus. On one hand, terminating a project is generally seen as evidence of weak monitoring and management, so career-conscious VCs may put on a brave face and refuse to end projects. On the other hand, VCs must allocate limited resources among investments. Goel, Nanda, and Narayanan (2004) find that career concerns lead managers to allocate resources fully, or even excessively, to demonstrate their investment ability. Thus, when projects perform poorly, career-conscious VCs terminate them more quickly and reallocate resources to promising projects. Although research has not reached a consensus on this issue, it has shown that career concerns distort VC tolerance of failure. Researchers first examine how firm age and experience affect failure tolerance. Compared with established, experienced VC firms, newly formed firms with little investment experience face more uncertain prospects and greater survival pressure. Their career concerns and motivation to establish a good reputation are therefore stronger. Firm age and experience are consequently used as two measures of VC career concerns. The findings show that newly established, inexperienced firms have lower tolerance of failure. Researchers next use successful investment experiences to examine the issue further. Although survival pressure cannot be observed directly, it eases somewhat after a VC investment succeeds, and career concerns diminish accordingly. If career concerns affect tolerance of failure, we should therefore observe greater tolerance after success, especially at newly established, inexperienced firms. Success can lay a foundation for a new firm: a reputation-making victory matters more than another win for a seasoned champion. Researchers test how successful investments affect tolerance of failure and examine subsamples by firm age and experience. They find that VC failure tolerance increases significantly after investment success, and that this effect appears only among newly established and inexperienced firms. #田軒的創新資本邏輯 (Xuan Tian's Finance and Innovation: A New Framework)