TOLERANCE FOR FAILURE AND CORPORATE INNOVATION Abstract We examine whether tolerance for failure spurs corporate innovation based on a sample of venture capital (VC) backed IPO firms. We develop a novel measure of VC investors failure tolerance by examining their tendency to continue investing in a venture conditional on the venture not meeting milestones. We find that IPO firms backed by more failure-tolerant VC investors are significantly more innovative. A rich set of empirical tests shows that this result is not driven by the endogenous matching between failure-tolerant VCs and startups with high exante innovation potentials. Further, we find that the marginal impact of VC failure tolerance on startup innovation varies significantly in the cross section. Being financed by a failure-tolerant VC is much more important for ventures that are subject to high failure risk. Finally, we examine the determinants of the cross-sectional heterogeneity in VC failure tolerance. We find that both capital constraints and career concerns can negatively distort VC failure tolerance. We also show that younger and less experienced VCs are more exposed to these distortions, making them less failure tolerant than more established VCs. 1. INTRODUCTION Innovation is vital for the long-run comparative advantage of firms. However, motivating and nurturing innovation remains a challenge for most firms. As Holmstrom (1989) points out, innovation activities involve a high probability of failure, and the innovation process is unpredictable and idiosyncratic with many future contingencies that are impossible to foresee. Holmstrom thus argues that innovation activity requires exceptional tolerance for failure and the standard pay-for-performance incentive scheme is ineffective. Manso (2011) explicitly models the innovation process and the trade-off between exploration of new untested actions and exploitation of well known actions. Manso shows that the optimal contracts that motivate exploration involve a combination of tolerance for failures in the short run and reward for success in the long run.1 In this paper we examine whether tolerance for failure indeed spurs corporate innovation. We adopt a novel empirical approach. We start with venture capital (hereafter VC) investors attitude towards failure and investigate how such attitude affects innovation in VC-backed startup firms. VC-backed startup firms provide an ideal research setting for our study. These firms generally have high innovation potentials and also high failure risk. Therefore, both tolerance for failure and innovation are very relevant for these firms. Further, innovation in entrepreneurial firms has been an important driver of economic growth in the United States. Thus it is important to understand what factors help to spur innovation in startup companies. We believe that VC investors tolerance for failure is crucial for the innovation productivity of VC-backed startups. VC investors are active investors and important decision makers in the startup firms they finance. They typically have the final decision power on whether to continue investment or to terminate a project. If VC investors are not tolerant of early failure, then the ventures they finance are likely to be liquidated prematurely upon initial unsatisfactory progress and therefore lose the chance to be innovative. Therefore, VC investors tolerance for failure can prevent premature liquidation and allow entrepreneurial firms to realize their innovation potentials. We infer a VC investors failure tolerance by examining its tendency to continue investing in a project conditional on the project not meeting milestones. A simple model of VC project termination suggests that a reasonable proxy for a VCs failure tolerance is the VC firms average investment duration (from the first investment round to the termination of follow-on investments) in its past failed projects. The intuition is that the staging of capital infusions in VC investments gives VC investors the option to abandon underperforming projects. Such option is particularly pertinent in projects that eventually fail because these projects may have failed to meet stage targets even before the liquidation decisions are made. If a project does not show progress towards stage targets, then the choice between giving the entrepreneur a second chance by continuing to infuse capital and writing off the project immediately should to some extent reflect a VC investors attitude towards failure. Other things equal, the longer the VC firm on average waits before terminating funding in underperforming projects, the more tolerant the VC is for early failures in investments. We then link a VC investors failure tolerance to IPO firms backed by the VC investor. For each IPO firm, the relevant VC failure tolerance is the VC investors failure tolerance at the time when the VC investor makes the first-round investment in the IPO firm. This approach is least subject to the reverse causality problem because the failure tolerance measure captures the investing VC investors attitude towards failure before its very first investment in a startup firm, which is well before the observed innovation activities of the startup firm. Our main empirical finding is that IPO firms backed by more failure-tolerant VCs are significantly more innovative. They not only produce a larger number of patents but also produce patents with larger impact (measured by the number of citations each patent receives). The results are robust to alternative measures of VC failure tolerance and alternative empirical and econometric specifications. While the baseline results are consistent with the hypothesis that VC investors failure tolerance leads to higher ex-post innovation productivity in VC-backed ventures, an alternative interpretation could be that failure-tolerant VCs are in equilibrium matched with projects that have high ex-ante innovation potentials, and high ex-ante potentials lead to high ex-post outcomes. In other words, it is some ex-ante project or VC characteristics rather than VC failure tolerance that drive the main results. To address this identification concern, we do a rich set of analysis. Our first identification strategy relies on the intuition that both failed and successful projects undertaken by the same VCs during the same time period should share similar ex-ante characteristics. Therefore, we compute the average investment duration in a VCs past successful projects as an alternative VC failure tolerance measure. If our results are driven by unobservable ex-ante project or VC characteristics rather than VC failure tolerance, then we expect this alternative measure to have a similar predictive power for startup innovation as our failure tolerance measure does. However, this is not what we find, which provides support for our identification of the failure tolerance effect. Our second identification strategy is to directly control for VC firm characteristics that are known to affect its project selection ability or investment preference. We show that the effect of VC failure tolerance on startup firm innovation cannot be explained away by controlling for the lead VC firm fixed effects, which absorb the time-invariant differences in project selection abilities across lead VC investors, and proxies for the possible time-varying component of VC project selection abilities such as VCs past investment experiences and expertise. Our last set of identification tests relies on the cross-sectional heterogeneity in the VC failure tolerance effect. If our failure tolerance measure indeed captures a VC investors attitude towards failure, then the marginal impact of our measure on innovation reflects how valuable a VCs failure tolerance is for startup innovation and thus should be stronger in ventures where the failure risk is higher. However, if our measure instead captures the ex-ante innovation potentials of ventures as under the alternative interpretation that failure-tolerant VCs are endogenously matched with high-potential ventures, then the marginal impact of our measure reflects how likely ex-ante potentials can turn into successful ex-post outcomes and thus should be stronger in ventures where the failure risk is lower. We find that the effect of VC failure tolerance on startup innovation is much stronger when the failure risk is higher and thus failure tolerance is more needed and valued. Being financed by a failure-tolerant VC is much more important for ventures born in recessions, ventures at early development stages, and ventures in industries in which innovation is difficult to achieve (e.g., the drugs industry). These findings provide further support for our empirical proxy of VC failure tolerance and identification of the failure tolerance effect. Finally, we explore the determinants of the cross-sectional heterogeneity in VC failure tolerance. We identify two frictions VC capital constraints and career concerns that can negatively distort VC failure tolerance. We use a large capital infusion from limited partners to the VC firm (that relaxes the VCs capital constraints) to gauge the VCs exposure to capital constraints and use the VCs recent investment success (that reduces the VCs pressure from career concerns) to gauge the VCs exposure to career concerns. We show that younger and less experienced VCs become more failure tolerant after receiving large capital infusions and after achieving some investment success. However, more established VCs failure tolerance is insensitive to either capital infusions or recent success. These results suggest that younger and less experienced VCs are more exposed to these distortions, making them less failure tolerant than older and more established VCs. Our paper contributes to a growing empirical literature in corporate finance on innovation. Several recent papers show that the legal system matters for innovation. Acharya and Subramanian (2009) find that a debtor-friendly corporate bankruptcy code encourages innovation. Fan and White (2003) and Armour and Cumming (2008) show that forgiving personal bankruptcy laws encourage entrepreneurship. Acharya, Baghai, and Subramanian (2009) document that stringent labor laws spur innovation by providing firms a commitment device not to punish employees for short-run failures. In a similar spirit, Acharya, Baghai, and Subramanian (2010) find that wrongful discharge laws that make it costly for firms to arbitrarily discharge employees foster innovation. These papers show that if the law provides leniency in the case of either personal failure or corporate failure, then we observe more entrepreneurial activities and innovation. The forgiveness of the law is to some extent related to the notion of failure tolerance. Our paper contributes to this strand of research by documenting a more direct effect of failure tolerance on corporate innovation.2 Our paper also contributes to the literature on VC investors role in firm value creation. This literature has shown that VC investors experiences, industry expertise, staged capital infusions, and network positions can all increase the value of VC-backed startup firms (see Gompers 2007 for a survey of this literature, the latest studies include Hochberg, Ljungqvist, and Lu 2007, Sorensen 2007, Bottazzi, Da Rin, and Hellmann 2008, Hochberg 2008, Gompers, Kovner, and Lerner 2009, Puri and Zarutskie 2011, and Tian 2011). In particular, Kortum and Lerner (2000) find that increases in VC activity in an industry lead to significantly more innovations. Our paper shows that the variation in VCs tolerance for failure can explain the heterogeneity in the observed innovation productivity of VC-backed firms. The rest of the paper is organized as follows. Section 2 discusses the empirical measure of VC failure tolerance. Section 3 describes the empirical specification. Section 4 discusses the main results and robustness issues. Section 5 addresses identification issues. Section 6 studies the heterogeneity in VC failure tolerance. Section 7 concludes. 2. MEASURING FAILURE TOLERANCE 2.1 VC Failure Tolerance: A Conceptual Framework Failure in this study means unsatisfactory progress in the innovation process. Manso (2011) shows tolerance for failure is crucial to motivate innovation, and such tolerance can be reflected in the principals choice of the termination threshold for a project. A failure-tolerant principal would choose a threshold lower than the ex-post optimal level, and this tends to encourage innovation from the agent. A failure-intolerant principal would choose a threshold higher than the ex-post optimal level, which tends to discourage innovation. The implication in Manso (2011) can be well applied to the venture investment setting. VC investors are active and powerful investors in a startup company. They have the final decision power on whether to continue investment or to terminate a project. Such power stems from the staging of capital infusions in VC investments (Gompers 1995 and Tian 2011). Staging allows VC investors to gather information and monitor the project progress. It also allows VC investors to maintain the option to abandon underperforming projects. If a project does not show progress towards stage targets after the initial rounds of investments, then the choice between continuing to infuse capital and terminating funding immediately should to some extent reflect a VCs attitude towards failure in the investment process. Put differently, a VCs failure tolerance resides in its power of termination. Thus, in the VC setting Mansos theory implies that the VCs choice of project termination threshold can be a measure of its failure tolerance. Empirically, we do not directly observe the VCs choice of termination threshold. However, it is straightforward to show that such choice will directly affect the VCs investment duration in a failed project. We present a simple model of the VCs project termination decision to illustrate this point and to motivate our empirical measure of VC failure tolerance. The distributions of failure tolerance measures are right skewed. Also, from an economic perspective there is a large difference between waiting for two years rather than one year before terminating an investment, but probably a smaller difference between waiting for seven years versus six years. Both the skewness and the likely nonlinearity in the economic impact of VCs tolerance for failure suggest that a logarithm transformation of the failure tolerance measure is appropriate. We then use the natural logarithm of Failure Tolerance as the main measure in the rest of the analysis.

Q) Your business partner skims the abstract of the paper about failure tolerance. He tells you that the paper is flawed, because VC's probably stop funding both successful and failing ventures at similar rates because VC's have a limited amount of money and are always looking to move their money to the projects with the highest upside. At a certain point, VC's will withdraw their money from funding successful ventures, he says. You read the entire introduction of the paper. What do you tell him?