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MIT Sloan study shows how technology shocks lead to innovation

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CAMBRIDGE, Mass., March 1, 2017––It’s often said that technology drives innovation, but how does this actually occur? A recent study by MIT Sloan School of Management Visiting Associate Professor of Finance Matthew Rhodes-Kropf systematically documents how technological shocks have substantially lowered the cost of starting new businesses, opening up a new range of investment opportunities and triggering radical innovation.

“The price of developing a business idea has dramatically dropped thanks to technology, which has led to more innovative breakthroughs than ever. It also has led to a substantial change in the funding model over the last decade, particularly in the early-stage financing of software and service-oriented startup ventures where it’s easier to bootstrap or get smaller amounts of funding,” explains Rhodes-Kropf. “As a result, entrepreneurs are testing more innovative ideas with a few ‘long shots’ achieving massive success.”

Combining data on investments and the composition of venture capital portfolios with a theoretical framework, Rhodes-Kropf and his colleagues found evidence that one of the significant technology shocks was the advent of Amazon’s Web Services (AWS) in early 2006. This introduction of cloud computing services by Amazon was a defining moment that dramatically lowered the cost of starting internet and web-based startups.

Such ventures could rent infrastructure in small increments and scale up as demand grew rather than making large upfront investments when the probability of success for the startup was still very low. This enabled entrepreneurs and investors to learn about the viability of the business before making large investments, thus lowering the cost of initial experiments.

Rhodes-Kropf says, “You can really see this change in the cost of starting an internet company in the 1990s when a minimum of $5 million in funding was required to purchase all of the equipment and talent necessary. After 2006, you could essentially start the same company at a coffee shop from your laptop for almost nothing using AWS.”

Indeed, the study showed that after the shock of AWS, startups founded in sectors benefiting it the most raised 20% less in their initial VC funding as compared to sectors that were not affected. Yet the total capital raised in those sectors by firms that survived three or more years was unchanged. Further, startups impacted by the shock were more likely to be shut down relative to those that did not benefit. They also had younger, less experienced founders. However, for those that were successful, the success was even greater.

“This supports the notion that the primary effect that AWS had was on the initial fundraising by startups rather than on the cost of running the business at scale – effectively allowing startups to shift their large capital investments to later stages when uncertainty was resolved,” he says.

As for VCs, they responded to the shock by providing less funding and limited governance to an increased number of startups, which they were more likely to abandon after the initial round, says Rhodes-Kropf, noting that this investment approach is referred to as one where investors “spray and pray.” This coincided with, and my have driven, the entry of new players such as micro-VCs, angel investors, incubators, and crowdfunding platforms, which specialize in early-stage investing with this approach.

“Our data clearly shows how an innovative shock that lowers the cost leads to more innovation and adaptations in funding models. I expect this explosion will continue, as it’s even cheaper today –and cheaper across more fields from biotech to moviemaking – to test ideas,” he notes. “Technological shocks to the cost of experimentation play a central role in shaping both the rate and trajectory of startup innovation.”

Rhodes-Kropf is coauthor of, “Cost of Experimentation and the Evolution of Venture Capital,” with Michael Ewens at California Institute of Technology and Ramana Nanda at Harvard University.

The MIT Sloan School of Management is where smart, independent leaders come together to solve problems, create new organizations, and improve the world. Learn more at mitsloan.mit.edu.

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