Production, Process Investment, and the Survival of Debt-Financed Startup Firms

Whether to invest in process development that can reduce the unit cost and thereby raise future profits or to conserve cash and reduce the likelihood of bankruptcy is a key trade-off faced by many startup firms that have taken on debt. We explore this trade-off by examining the production quantity and cost reducing R&D investment decisions in a two period model wherein a startup firm must make a minimum level of profit at the end of the first period to survive and operate in the second period. We specify a probabilistic survival measure as a function of production and investment decisions to track and manage the risk exposure of the startup depending on three key market factors: technology, demand, and competitor's cost. We develop managerial insights by characterizing how to create operational hedges against the bankruptcy risk: if a startup makes a conservative investment decision, then it also selects an optimal quantity that is less than the monopoly level and hence sacrifices some of first period expected profits to increase its survival chances. If it decides to invest aggressively, then it produces more than the monopoly level to cover the higher bankruptcy risk. We also illustrate that debt constraint shrinks the decision space, wherein such process investments are viable.