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Why Some VC Partners May Make Your Company Less Innovative

Startups that do business with Venture Capital partners that also fund competitors may find they get the short end of the attention stick and produce fewer new products concludes research by Harvard Business School Assistant Professor Rory M. McDonald and colleagues.

“Startups suffer from what researchers call ‘liability of newness,’” says McDonald, “which is a fancy way of referring to all of the things you don’t have as a new company—products, knowledge, connections, resources.” The most common and effective way to make up for that lack is to find someone who can help you overcome it—most often a venture capital partner that can infuse not only much-needed cash but also expertise and advice.

In a perfect world, everyone benefits. The VC firm takes an equity stake and makes money when the company succeeds, rewarding limited partners who have invested in the VC firm. But what happens when the interests of the VC firm and the startup don’t exactly align? For example, when the VC firm hedges its bet by investing in multiple startups that may be competitors?

Investing in multiple companies in the same sector and product category may not seem so nefarious from the standpoint of the VC firm. “Venture capital is a hit-driven business,” says McDonald. VC firms spread their wealth around to dozens of startups, hoping to hit that one jackpot that might be the next Facebook or Google.

The problem usually comes when a VC firm has to choose between supporting one company over another. The researchers therefore hypothesized that companies tied to a competitor—by at least one VC firm in common—would be less innovative.

To test this hypothesis, McDonald and colleagues looked at close to 200 medical device startups that developed products for minimally invasive surgery from 1986 to 2007. Using regulatory codes developed by the Food and Drug Administration (FDA), they were able to tell which companies were competitors in the same product classes and patient application areas (such as cardiology, oncology, urology).

Then, using commercial investor databases, they determined which companies were funded by the same VC firms. Finally, they determined how “innovative” each company was, based on the number of new products they introduced that were approved (cleared) by the FDA (averaging one product every two years).

The data showed that companies tied to a competitor by at least one VC firm in common were indeed less innovative than those unencumbered by such ties; in fact, they were 30 percent less likely to introduce a new product in any given year. The magnitude of the effect took the researchers by surprise. “We thought it might happen, but we didn’t expect the size to be as big as it was,” McDonald says.

What should startups do to inoculate themselves from the effects of these competitive ties? For starters, companies might benefit from looking beyond the traditional VC world to consider the wide range of funding options available—including super angel investors, micro VC firms, accelerators, and incubators.

The original article, Exposed: Venture Capital, Competitor Ties, and Entrepreneurial Innovation, was co-written with Emily Cox Pahnke, Benjamin Hallen of the University of Washington, and Dan Wang of Columbia University, and was published in the Oct 2015 Academy of Management Journal. Hat tip to Michael Blanding at the Harvard Business School for the reference.


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