Tolerance for Failure and Corporate Innovation
Review of Financial Studies, Forthcoming
57 Pages Posted: 7 May 2009 Last revised: 7 Nov 2014
Date Written: September 8, 2011
We examine whether tolerance for failure spurs corporate innovation based on a sample of venture capital (VC) backed IPO firms. We develop a novel measure of VC investors’ failure tolerance by examining their tendency to continue investing in a venture conditional on the venture not meeting milestones. We find that IPO firms backed by more failure-tolerant VC investors are significantly more innovative. A rich set of empirical tests shows that this result is not driven by the endogenous matching between failure-tolerant VCs and startups with high ex-ante innovation potentials. Further, we find that the marginal impact of VC failure tolerance on startup innovation varies significantly in the cross section. Being financed by a failure-tolerant VC is much more important for ventures that are subject to high failure risk. Finally, we examine the determinants of the cross-sectional heterogeneity in VC failure tolerance. We find that both capital constraints and career concerns can negatively distort VC failure tolerance. We also show that younger and less experienced VCs are more exposed to these distortions, making them less failure tolerant than more established VCs.
Keywords: tolerance for failure, innovation, patents, venture capital, IPO
JEL Classification: O31, G24, G34
Suggested Citation: Suggested Citation