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Innovation and the Financial Guillotine

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  • Ramana Nanda
  • Matthew Rhodes-Kropf

Abstract

Our paper demonstrates that while failure tolerance by investors may encourage potential entrepreneurs to innovate, financiers with investment strategies that tolerate early failure endogenously choose to fund less radical innovations. Failure tolerance as an equilibrium price that increases in the level of experimentation. More experimental projects that don't generate enough to pay the price cannot be started. In equilibrium all competing financiers may choose to offer failure tolerant contracts to attract entrepreneurs, leaving no capital to fund the most radical, experimental projects. The tradeoff between failure tolerance and a sharp guillotine helps explain when and where radical innovation occurs.

Suggested Citation

  • Ramana Nanda & Matthew Rhodes-Kropf, 2013. "Innovation and the Financial Guillotine," NBER Working Papers 19379, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19379 Note: CF PR
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    File URL: http://www.nber.org/papers/w19379.pdf
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    References listed on IDEAS

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    Cited by:

    1. Nanda, Ramana & Rhodes-Kropf, Matthew, 2013. "Investment cycles and startup innovation," Journal of Financial Economics, Elsevier, vol. 110(2), pages 403-418.

    More about this item

    JEL classification:

    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G39 - Financial Economics - - Corporate Finance and Governance - - - Other
    • O31 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Innovation and Invention: Processes and Incentives

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