Cost of Experimentation and the Evolution of Venture Capital


The emergence of the "cloud" has had a major impact on the founding and growth of entrepreneurial firms.  This new technology began with the introduction of Amazon's Web Services in 2006.  It allowed software and internet companies to rent rather than buy powerful computing resources, thus lowering the cost of entry and growth.    The ability to easily rent hardware in small increments that could scale was not possible before 2006.  Changes to the cost of starting high-technology investments will affect both the entrepreneurs who found them and the investors that finance them.   The latter include predominantly include venture capitalists who play an important role as gate-keepers to early-stage firms that often grow to become large, innovative firms in the economy. In this research, we explore whether and how venture capitalists investment activity and portfolio formation changed in response. 

Consider the initial startup costs of a new software company.  The company has to learn about both the viability of its technology and the demand for its software.  Prior to 2006, simply getting a company started a product rolled out to customers could cost millions of dollars.   Such a large fixed cost could limit the ability for a large set of entrepreneurs and ideas from being founded.  Thus, the introduction of AWS had a first-order impact on the cost of initial experimentation.  This impact was particularly strong for startups in information technology.  Venture capitalists could respond by simply investing less capital in startups or spreading their capital across more startups.  Using a large sample of first-time venture capital financings from 2002 to 2010, we first find that the initial funding size provided by VCs fell by 20% in the industries benefiting most from cloud technology.  Yet the total capital raised by firms in those sectors that survived three or more years was unchanged.   A change in investment size could have additional consequences for VC investment selection and portfolios. 

Supplying less capital to first time financings coincided with VC forming larger portfolios in the industries affected by the cloud.  More investments in portfolios does not come without a cost to the VC, who typically faces their own capital and time constraints.  Indeed, we find that VCs were significantly less likely to follow-on their initial investments, leading to higher failure rates.  VCs were also less likely to take on active governance roles in startups through board seats.  These patterns are consistent with the notion of "spray and pray," where investors invest less capital in more startups.   The collection of evidence demonstrates that a technological shock had an important impact on the way financial intermediaries behave.  The move away from a governance model in the early stages to one of passive "learning" represents a meaningful shift in the role of venture capitalists.  

Although VC investors have changed their investment strategy, it is possible that the lowered startup costs simply allowed lower quality ideas and founders to start firms.  The paper instead finds that although the shift to a "spray and pray" led VCs to invest in startups with younger, less experienced founders whose firms failed at higher rates, those firms that do survive have relatively large valuations and exits.  This evidence suggests that the lowered startup costs allow VC investors to pursue relatively riskier ideas or "long shot bets."   Such a shift suggests that, in the long run, VC investors may shift their capital to technologies where initial learning is relatively cheap and away from more complex technologies.    

Finally, the evolution of the early-stage VC market documented in the paper help frame other changes observed in startups.  There has been a rapid emergence of new players in early stage finance, such as micro-VCs, angel investors, incubators, accelerators, and crowdfunding platforms.  Many of these financing platforms provide small amounts of seed financing that would have provide too little capital for new firms prior to 2006. These entrants have enabled even more long-shot bets to succeed, as even entrepreneurs with seemingly bad ideas can get incremental funding that allows them to pivot and scale.  
 

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