How Novelty Aversion Affects Financing Options

Abstract

Entrepreneurs may undertake bad projects because they unwittingly rely on defective or incomplete information to estimate the returns. Investors' concerns about such misjudgements are relatively low when the entrepreneurs' knowledge about their projects has been well calibrated. But if the novelty of the project (or some other unusual circumstance) makes calibration impossible, investors may reject the entrepreneur's funding request. This `novelty aversion' effect helps explain why ventures that are initially self-financed can subsequently attract outside financing without any decrease in standard 'incentive' or moral hazard problems. It also provides new insights about the differences in the investment preference and procedures of individual 'angel' investors, venture capital partnerships and large public companies.

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Keywords: error control, governance, joint action, organizational structure, innovation