Venture Capital to Innovate, But Don't Get Carried Away (Finance and Accounting)

private equ 2The form of equity financing – either public or private – affects managers’ incentives to innovate. Researcher: André Castro Silva

 

 

Venture capital and private equity funds provide more incentives to innovation than firms with shares traded in stock markets. But don’t overemphasize private equity. Firms with shares traded in stock markets provide better incentives to manage existing projects. There is an optimal time to open or to close a firm. Managers can best decide.

Innovation

We distinguish two types of innovation: conventional and radical. Both have a probability of success and failure. Radical innovations have a smaller probability of success but they are revolutionary. Conventional innovations have a higher probability of success, but their contribution has an incremental nature. A search engine able to obtain millions of texts in 0.4 seconds is a radical innovation. An incremental innovation is the ability to sell linked ads to search results.

Incentives

The challenge is to find the set of incentives for managers to undertake conventional or radical projects at the right time. Sometimes it is better to undertake radical projects. Other times to focus on the day-to-day chores of the firm. It all depends on the chances of success and potential gains of the two projects.
A high penalty for failures encourages managers to focus on safe projects; firms would produce conventional innovation only. The correct compensation balances the higher chances of success of conventional innovation and the higher rewards of radical innovation.

Going Public or Private

We find that the decision on the time to become private or public provides the correct incentives. The correct compensation is provided by the time to enter or exit the stock market!

The difference between private firms and firms with shares in stock markets is on the information sent to markets. Stock prices signal the result of management decisions fast, which is good to make managers keep on track of existing projects, but bad to induce radical innovation.

When firms start private, they encourage managers to try out ambitious projects. When firms make their initial public offering, they change incentives for the management of existing projects.
If a firm needs a radical organizational restructuring, it is better to close the firm temporarily and return to markets later. Radical changes are tried out far from the daily scrutiny of markets. After the implementation of the successful changes, the firm returns to the market.

Our findings imply that private firms pursue more radical innovations. However, encouraging private equity or venture capital is not a solution for all cases. The reason is that focusing on radical or conventional projects depends on the life-cycle of the firm. There can be too much innovation or too much management of conventional projects.

It is then better to let the firms themselves to decide the moment to exit or to enter the stock market. In this way, the incentives for innovation and for managing existing technologies will be aligned with the life-cycle of the firm.

 

This Article is based on the paper “Incentives to Innovate and the Decision to Go Public or Private” authored by Andre C. Silva, Assistant Professor at Nova SBE, Daniel Ferreira (LSE) and Gustavo Manso (Haas-Berkeley), and published in 2014, issue 27(1) of the Review of Financial Studies.