Battistini and Haemmig: does failure tolerance matter?

Over the past two decades, a large number of authoritative empirical studies have documented that innovation in entrepreneurial ventures is one of the most important drivers of economic growth and corporate innovation. While the importance of high-potential, disruptive start-ups for large, incumbent corporations across industrial sectors is indisputable, more systematic analysis is required to understand fully what factors facilitate innovation in startups.

See accompanying graphs for this article here and here.

A recent study in Review of Financial Studies investigates the relationship between the tolerance for failure and innovation. Specifically, based on a sample of venture capital-backed initial public offerings (IPOs), the study examines whether and how investors’ attitudes towards failure affect innovation in their portfolio startups.

The authors of the study – Prof Xuan Tian of Indiana University and Prof Tracy YueWang of the Minnesota University – developed a measure of venture capital investors’ failure tolerance by examining their willingness to continue investing in underperforming startups – those not meeting milestones. In so doing, they test empirically the argument that tolerance for failure is critical in motivating and nurturing innovation.

They show that IPO firms backed by more failure-tolerant venture investors are significantly more innovative, and failure tolerance is particularly important for startups subject to high failure risk due to the disruptive nature of their technology or business model. More specifically, IPO firms backed by more failure-tolerant venture capital investors are consistently associated with innovative performance.

Their innovativeness is measured by multiple indicators – for example, such startups do not only produce a higher number of patents, but also produce patents with greater impact. As observed in the analysis, “the results are robust to alternative measures of venture capital failure tolerance and alternative empirical and econometric specifics. Moreover, these results are not driven by endogenous matching between failure-tolerant venture capital firms and start-ups with high ex ante innovative potential”.

Interestingly, the study also discovers that both capital constraints and career concerns can negatively distort a venture capital firm’s failure tolerance. Specifically, younger and less experienced venture capitalists tend to be more exposed to these distortions, making them less failure-tolerant than more established venture investors. In fact, young and less experienced investors appear to become more failure-tolerant after a relaxation of capital constraints and after a decrease in career-related concerns.

Reference

Tian, X, and Wang, TY (2014) ‘Tolerance for failure and corporate innovation’. Review of Financial Studies, 27(1): 211–55

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