VC investors and tech bubbles: New facts

Image courtesy of Flickr.com user greggoconnell

It's one of the great ironies of investing in start-ups. As far as entrepreneurs are concerned, there is never enough money to go around, and it takes way too much time and effort to get any funding at all. But every now and then venture capitalists and other early-stage investors will announce that the US is in a bubble -- there is too much money chasing too few deals. Which, of course, comes as a great surprise to your average entrepreneur.

Now, Ramana Nanda and Matthew Rhodes-Kropf, two researchers from Harvard Business School, think they may have figured it out. In a new paper, they claim that in hot markets, venture capitalists invest in riskier and more innovative startups--not just weaker companies. And they say that the more money that's sloshing around out there, the more likely this is to happen.

The researchers studied startups that got their first funding between 1980 and 2004. Here are two of their main findings:

1. Startups that got their first funding in quarters when lots of other startups also got funded were indeed less likely to have initial public offerings, and more likely to go bankrupt.

2. Those firms that were funded during a so-called bubble and did go public often managed outsized success. They were valued more highly on the day of their IPO, which could be a result of the same 'froth' that got them funded in the first place. But they also had more patents, and more citations to those patents. So there is evidence that more innovative firms--as well as weaker ones, most likely--get funded when investors have more money to put to work.

Similarity among investors

When the researchers culled their sample of investors to just the 250 most active, they found that those most active firms also funded riskier, more innovative startups during funding booms. So the ability to raise big funds, and the imperative to put that money to work, seems to change how even the most experienced investors choose companies. The researchers were also able to determine that changes in the types of companies that get funded are not generally a result of different investors entering or exiting the market at different times.

The researchers do not think that particularly risky or exciting startups and ideas draw more venture capital. Instead, they write:

The increase in financing activity also lowers financing risk, which allows investors to experiment more effectively and hence take on riskier, more innovative investments. According to this view, the flood of money associated with heated investment activity may actually cause VCs to change the types of investments they are willing to make - towards more risky, innovative startups in the market.

A healthy IPO market--back then

The research also reveals some interesting statistics about venture-backed companies. They found that 14,667 young companies get early stage financing between 1980 and 2004. The odds of any one of them going public was a relatively high 10%, although those chances varied widely by industry. Only seven percent of internet startups managed to go public (although they certainly got a lot of attention when they did) compared to 19% for biotech and healthcare startups.

The average venture-backed company, the researchers found, had 3.7 patents filed within the first three years after it first received funding. And they got an average of 16.5 citations to those patents by the time they went public, were sold, or failed.

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    Kimberly Weisul is the co-founder of One Thing New, the free email newsletter for smart, busy women. She was previously Senior Editor at BusinessWeek, responsible for all coverage of entrepreneurship and for launching BusinessWeek SmallBiz, a bimonthly magazine. She is also a freelance writer, editor and editorial consultant.

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