Financing Risk and Bubbles of Innovation∗

New ventures that commercialize radical technologies tend to cluster in time. Funding for new ventures also ebbs and flows, often synchronous with significant innovations. We suggest that financial market activity is not purely a response to novel technologies but rather, financial markets drive innovation bubbles. We show that financing risk is inherent to the funding of new ventures, but varies across sectors and time and alters the type of project funded. In equilibrium, more innovative projects are funded in ‘hot’ markets when financing risk is low. Thus, the financing environment for new ventures may create and magnify bubbles of innovation. ∗Nanda: Harvard University, Rock Center, Boston, Massachusetts 02163 Phone: 617-496-2783. Email: [email protected]. Rhodes-Kropf: Harvard University, Rock Center 313, Boston, Massachusetts 02163. Phone: (617) 496-3911. Email: [email protected], respectively. We thank Philippe Aghion, Josh Lerner, Sam Kortum, Bill Kerr, Praveen Kumar, Robert Marquez, Peter Thompson, Carlos Serrano, Scott Stern, Morten Sorensen, Markus Reitzig , Uday Rajan, David Gaddis Ross, Elena Loutskina, Adriano Rampini, Itay Goldstein and Ulrich Hege for fruitful discussion and comments, and we thank seminar participants at Corporate and Financial Markets Theory Workshop at MIT, ISCTE Business School, Lisbon, World Bank, Tuck School of Business, Notre Dame, Harvard University, Darden Entrepreneurship and Innovation Research Conference, Research Symposium on the Economics and Law of the Entrepreneur at Northwestern, HEC Conference on Entrepreneurial Entry, London Business School, Economics of Innovation and Entrepreneurship Conference, Queens school of Business, European Finance Association meetings, Strategy Research Forum, Society for Financial Studies 2011 Cavalcade at Michigan, Western Finance Association, Entrepreneurial Finance and Innovation Conference. All errors are our own. Financing Risk and Bubbles of Innovation Abstract New ventures that commercialize radical technologies tend to cluster in time. Funding for new ventures also ebbs and flows, often synchronous with significant innovations. We suggest that financial market activity is not purely a response to novel technologies but rather, financial markets drive innovation bubbles. We show that financing risk is inherent to the funding of new ventures, but varies across sectors and time and alters the type of project funded. In equilibrium, more innovative projects are funded in ‘hot’ markets when financing risk is low. Thus, the financing environment for new ventures may create and magnify bubbles of innovation.New ventures that commercialize radical technologies tend to cluster in time. Funding for new ventures also ebbs and flows, often synchronous with significant innovations. We suggest that financial market activity is not purely a response to novel technologies but rather, financial markets drive innovation bubbles. We show that financing risk is inherent to the funding of new ventures, but varies across sectors and time and alters the type of project funded. In equilibrium, more innovative projects are funded in ‘hot’ markets when financing risk is low. Thus, the financing environment for new ventures may create and magnify bubbles of innovation.