As cloud technologies allow startups to build companies faster and cheaper than ever before, venture capitalists are rethinking who and how many companies they finance, according to recent research.
Enter the era of “spray and pray,” where venture firms over the last decade have seeded more firms than previously, but with less upfront investment of time and money. As someone who teaches entrepreneurial finance, Harvard Business School Professor Ramana Nanda wanted to find out if this new strategy has paid off for investors and their portfolio companies.
Nanda and colleagues present their findings in a paper scheduled to appear in a forthcoming issue of the Journal of Financial Economics, titled Cost of Experimentation and the Evolution of Venture Capital, co-written with Michael Ewens of the California Institute of Technology and Matthew Rhodes-Kropf of MIT Sloan School of Management.
The researchers focus on one of the most important technological shifts in recent years—the introduction of Amazon Web Services, which has allowed startups to cheaply rent server space and development tools in the cloud and scale up as needed rather than purchasing their own expensive hardware and software.
By comparing rates of investment before and after AWS was introduced in 2006, Nanda and his colleagues could see how VCs changed their strategies with startups such as cloud-based software and service companies, which could take advantage of AWS to decrease costs, versus others like biotechs that were less impacted by the new technologies.
“The goal was to try and understand whether VCs were allocating their capital to a larger number of startups with a smaller amount of money to each,” says Nanda. “Equally important, we wanted to see if they were just investing in a lot of worse firms, or if these long-shot firms were actually higher in value if they succeeded.”
The researchers found that the number of startups receiving first-round funding increased substantially between 2006, when AWS was introduced, and 2010, especially for those firms that could most take advantage of cloud services. For the control group of companies in industries such as aerospace and medical devices, first-round funding increased from 350 to 450 firms, a rise of 30 percent. But for startups in the software and media industries that could make use of AWS, funding increased from 375 to 700 firms, a nearly 100 percent rise.
The impact of the cloud on VC funding
Of the firms that Nanda and his colleagues looked at over the period of 2002 to 2010, 43 percent failed before receiving a second round of funding. They found that failure rates increased after the introduction of cloud computing in 2006, implying that although money was being spread to more firms, many of them were failing before they received a…