By: Jeremy Colless
In a paper released in October 2015 “Cost of Experimentation and the Evolution of Venture Capital” Michael Ewens (California Institute of Technology), Ramana Nanda (Harvard University) and Matthew Rhodes-Kropf (Harvard Business School) attempt to explain the changes in the investment strategy of VCs in recent years.
The research paper posits that venture capitalists have had to innovate and disrupt their own business model in reaction to the dynamics driving the revolution in technology. The paper provides a model of venture capital investment that can highlight how falling costs to start new businesses can alter the composition of investments and the portfolio management strategy of VC investors.
In particular the paper provides 3 main insights:
- The falling cost of starting new businesses allows a set of entrepreneurs who would not have been financed in the past to receive early stage financing. In particular, these are entrepreneurs whose projects have low expected value, but where one can learn a lot about the ultimate outcome of the project from an initial investment in the startup.
- The only profitable way to finance these projects is for investors to back a large number of such startups in order to learn about their potential, but without committing to tolerate ‘failure’ if intermediate information is negative.
- Because a fall in the cost of experimentation makes a “failure tolerant” investment strategy relatively more costly, this tends to skew investments towards startups with more discriminating early experiments, and away from those with a slower, or more costly, revelation of final project value. This change alters the trajectory of aggregate innovation.
The paper discusses how the lower cost of starting up (and failure) has created a shift away from value-added ‘governance’ in early stages of ventures to more passive ‘learning’ about startup potential.
The cost of starting up and therefore the cost of experimentation (and failure) are now dramatically lower. Innovative VCs now understand that they must make hundreds of small bets in order to mitigate the asymmetrical risk of the asset class and that there is enormous underpriced optionality for both abandonment and follow on rights.
This thesis mirrors Artesian’s view of an alpha/beta approach to venture capital investing and the idea that unlike any other asset class, early stage venture capital involves both a financial and strategic return of similar or equivalent importance.
A pre-screened and highly diversified portfolio of early stage ventures acts as a pipeline for follow on investments (with a pro-rata option that prevents you from missing out in follow on rounds in successful, and therefore highly sought, ventures) as well as being a source of distributed R&D for corporations looking to gain insights into innovative & disruptive threats and opportunities.