Entrepreneurs and Investors: Funding-Induced Distortions in Lean Start-up Product Experiments and Innovation

The lean start-up method (LSM) is an experimentation-driven approach to learning about product-market fit and improving start-up success, yet it overlooks the entrepreneur’s funding needs. This paper models an LSM process in which an entrepreneur tests a product to gauge consumer preferences and seeks funding for a product launch from an investor with incomplete information about the entrepreneur’s type. We show that the investor cannot deduce the entrepreneur’s type from his actions and must rely on the test product’s sales outcome for inference. This reliance can incentivize the entrepreneur to distort his experimentation strategy. Our analysis identifies two distortions in product experimentation relative to LSM without the need for external funding; one prioritizes funding over learning, whereas the other minimizes false positives but discards promising innovations. Consequently, the learning-funding trade-off may induce systemic inefficiency in the LSM ecosystem. Moreover, our model implies that negative investor stereotypes toward certain entrepreneur groups (e.g., women or minorities) may cause them to sacrifice learning to secure funding; hence, when funded, they launch less successful ventures, reinforcing the stereotype. Remarkably, although the inefficiency cost of positive stereotypes is borne by investors, the inefficiency cost of negative stereotypes falls on high-type entrepreneurs from the stereotyped groups.