Financing risk and bubbles of innovation

Investors in risky start-ups who stage their investments face financing risk — that is, the risk that later-stage investors will not fund the start-up , even if the fundamentals of the firm are still sound. When investors become worried, future investors will not support the project. Withdrawing support today leads to a self-fulfilling jump to a poor financing environment. Investors face a trade-off : either providing more capital to novel ideas to protect against financing risk, or providing less funding to maximise knowledge before providing more capital. The most innovative firms face the most acute trade-off situations , and thus, funding to these firms is the most unstable .

The additional capital that enters the market during “hot” times goes not only to weaker projects, but also to more innovative projects that are a good investment only when financing risk is low. Thus, the most innovative projects may need a hot funding environment to get funding at all. 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.