Can Starving Start‐ups Beat Fat Labs? A Bandit Model of Innovation with Endogenous Financing Constraint*

• Published date: 01 April 2020
• Author: Alessandro Spiganti
• Date: 01 April 2020
• DOI: http://doi.org/10.1111/sjoe.12333

Scand. J. of Economics 122(2), 702–731, 2020

DOI: 10.1111/sjoe.12333

Can Starving Start-ups Beat Fat Labs?

A Bandit Model of Innovation with

Endogenous Financing Constraint*

Alessandro Spiganti†

University of Edinburgh, Edinburgh EH8 9JT, UK

alessandro.spiganti@ed.ac.uk

Abstract

Is there any such thing as too much capital when it comes to the financing of innovative projects?

We study a principal–agent model in which the principal chooses the scale of the experiment,

and the agent privatelyobser vesthe outcome realizations and can privately choose the novelty of

the project. When the agent has private access to a safe but non-innovative project, the principal

starves the agent of funds to incentivize risk-taking. The principal quickly scales up after early

successes, and can tolerate early failures. If the principal is equally informed about the outcome,

then the agent is well-resourced, resemblinga large research and development department.

Keywords: Arm’s length versus relationship-based financing; cash-flow diversion; exploration

versus exploitation; financing constraints; firm dynamics

JEL classification:D82; D86; D92; O31

I. Introduction

Is there any such thing as too much capital when it comes to the financing

of innovative projects? Why do small start-ups make most breakthroughs,

even though giant enterprises supply most research and development (R&D)

spending (Baumol, 2010)? Anecdotal evidence suggests that more financial

resources do not necessarily lead to more and better innovation. It is

surprising how many projects fail, despite pursuing ideas that are eventually

successful, with well-resourced and competent teams. Nokia, for example,

had always been an adaptive company and hardly a technological laggard:

its engineers built a prototype of an internet-enabled phone with a touch-

*Special thanks go to Jonathan Thomas, AndrewClausen, and three anonymous referees. I also

thank Stuart Baumann, Arnab Bhattacharjee, Catherine Bobtcheff, Elena Lagomarsino, John H.

Moore, J´ozsef S´akovics, Carl Singleton,Andy Snell, Tim Worrall, and participants at 2018 RES,

2017 EWMES, 2017 SIE, 2016 ASSET, 2015 ALdE, and 2015 SIRE. This workwas supported

by the Economic and Social Research Council (grant number ES/J500136/1).

†Current affiliation: European University Institute, 50014 San Domenico di Fiesole, Italy

(alessandro.spiganti@eui.eu).

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2018 The Author.The Scandinavian Journal of Economics published by John Wiley & Sons Ltd on behalf of F¨oreningen

f¨orutgivande av the SJE/The editors of The Scandinavian Journal of Economics.

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution

and reproduction in any medium, providedthe original work is properly cited.

A. Spiganti 703

screen at the end of the 1990s.1Nokia spent in R&D almost four times

what Apple spent,2but saw its market share fall from 40 percent in 2007

to 11 percent in 2014. Similarly, because of hefty investment in research,

Kodak developed one of the first digital cameras in 1975, and launched a

photo-sharing web site in 2001.3However, in January 2012, the company

filed for bankruptcy. Conversely, many successful innovative firms have

started small, with limited resources, but enjoyed high growth rates after

a few years. Airbnb, Dropbox, and Reddit are among the 1,000 start-

ups funded by Y Combinator, an American seed accelerator: Sam Altman,

the president, considers frugality “incredibly important for start-ups”4and

Jessica Livingston, a co-founder, underlines that “you don’t want to give

the founders more than they need to survive”.5Fred Wilson, a venture

capitalist with early investments in Twitter and Tumblr, writes on his blog

that “less money raised leads to more success”.6According to Mr Altman,

this is due to the “focusing effect of limited resources” (emphasis added;

see the article cited in footnote 4), and Ms Livingston adds that “being lean

forces you to focus” (emphasis added; see the article cited in footnote 5).

In this paper, we are interested in understanding the mechanisms through

which frugality can help the innovation process. When does an innovative

project benefit from a lack of resources?

We offer a two-period principal–agent model of innovation investments,

in which a representative investor can use the scale of an experiment to

incentivize an entrepreneur, with limited liability, to be more innovative,

and to learn the business potential of a new project. To study how to

incentivize the agent to focus on innovation, while emphasizing that the

principal might lack technical competence, we assume that the agent can

privately choose between exploring a new technology that involves a small

1See the article by James Surowiecki published in The New Yorker on 3 September 2013,

“Where Nokia went wrong” (available online at http://www.newyorker.com/business/currency/

where-nokia-went-wrong).

2See the article by AntonTroianovski and Sven Grundberg published in The WallStreet Journal

on 18 July 2012, “Nokia’s bad call on smartphones” (available online at http://www.wsj.com/

articles/SB10001424052702304388004577531002591315494).

3See the article “The last Kodak moment?” published by The Economist on 14 January 2012

(available online at http://www.economist.com/node/21542796).

4See the article by Eugen Kim published in Business Insider UK on 24 March 2015, “A warning

to startups from the head of Silicon Valley’smost important star tup factory” (availableonline at

http://uk.businessinsider.com/sam-altman-raising-too- much-money-early-is- bad-2015-3).

5See the article by Tad Friend published in The New Yorker on 10 October 2016, “Sam

Altman’s manifest destiny. Is the head of Y Combinator fixing the world, or trying to take

over Silicon Valley?” (available online at http://www.newyorker.com/magazine/2016/10/10/

sam-altmans-manifest- destiny).

6See FredWilson’sblog post of 18 September 2013, “Maximizing runway can minimize success”

(available online at http://avc.com/2013/09/maximizing-runway-can-minimize-success/).

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2018 The Author.The Scandinavian Journal of Economics published by John Wiley & Sons Ltd on behalf of F¨oreningen

f¨orutgivande av the SJE/The editors of The Scandinavian Journal of Economics.