Financing Risk and Bubbles of Innovation
Abstract (via Nanda & Kropf @ SSRN)
Investors in risky startups who stage their investments face financing risk – that is, the risk that later stage investors will not fund the startup, even if the fundamentals of the firm are still sound. We show that financing risk is part of a rational equilibrium where investors can flip from investing to not investing in certain sectors of the economy. We further demonstrate that financing risk has the greatest impact on firms with the most real option value. Hence, the mix of projects funded and type of investors who are active varies with the level of financing risk in the economy. We also highlight that some extremely novel technologies may in fact need ‘hot’ financial markets to get through the initial period of diffusion. Our work underscores that financial markets may play a much larger and under-studied role in creating and magnifying bubbles of innovation in the real economy.