Risky business: venture capital, pivoting and scaling

The creation and scaling of startups are inherently linked to risk-taking, with various types of owners handling these risks differently. This paper investigates the influence of an active venture capital (VC) market on startups' decisions regarding research and scaling. It outlines conditions under which VC-backed startups prefer riskier, yet potentially more rewarding strategies compared to independent startups. VC firms, by means of temporary ownership and compensation structures, introduce "exit costs" that make high-risk strategies more attractive to VC-backed startups. Moreover, an active VC market prompts startups to undertake higher initial risks, as VC firms provide support for pivoting after setbacks. Additionally, the presence of VC intensifies research risk among established firms, as their research initiatives are strategic complements to the risk choices of startups. Active venture capital markets encourage risk-taking among VC-backed startups and their rivals. This study investigates the impact of venture capital (VC) markets on startup risk-taking behaviors. Our analysis reveals that, compared to their independently funded counterparts, VC-backed startups adopt aggressive scaling and research strategies, characterized by high-potential rewards and commensurate risks of failure. This result can be explained by the distinctive ownership and compensation structures in the VC sector, which entail high fixed costs, rendering low-reward, low-risk projects unappealing. At first sight, it might seem that the increased risk-taking by VC-backed startups would deter non-venture-backed firms from taking risks. On the contrary, we find that non-VC-backed startups then engage in greater risk-taking. This behavior is motivated by the potential to secure VC funding for a "second-chance" project should their initial venture fail prematurely. For policymakers, these findings underscore the importance of fostering ecosystems that support diverse ownership and financial structures. Such an approach nurtures a culture of creative destruction, driven by research and scaling efforts.