Cornell University - College of Business - Finance Department
Indiana University - Kelley School of Business - Department of Finance
Indiana University - Kelley School of Business - Department of Finance; China Academy of Financial Research (CAFR)
November 4, 2014
Kelley School of Business Research Paper No. 2014-43
Using a sample of venture capital (VC)-backed initial public offering (IPO) firms, we study the effect of financial intermediaries’ tight leash on entrepreneurs’ innovation productivity. We find that financial intermediaries’ tight leash impedes innovation: IPO firms are significantly less innovative when VCs interfere with their development more frequently through staging — as measured by a larger number of VC financing rounds. To establish causality, we exploit plausibly exogenous variation in the frequency of direct flights between VC domiciles and IPO firm headquarters that are due to airline restructuring. Our identification tests suggest a negative, causal effect of VC staging on firm innovation. Furthermore, staging is more detrimental to innovation when innovation is more difficult to achieve and when VCs are less experienced with the industry in which their entrepreneurial firms operate. By documenting a previously under-recognized adverse consequence of VC stage financing, our evidence suggests that contract mechanisms are at play so that short-termist incentives can be cultivated even in a private equity market populated with long-term, sophisticated investors.
Number of Pages in PDF File: 54
Keywords: Innovation, Stage financing, Venture capital, Short-termism
JEL Classification: G24, O31, G34
Date posted: October 6, 2013 ; Last revised: November 13, 2014
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