How do competing interests from venture capitalists negatively affect innovation?

Having good investors on board is a dream for many entrepreneurs. But when conflicting agendas come into play, venture capitalists could cause more harm than good when it comes to innovation.

Emily Cox Pahnke and Benjamin Hallen, assistant professors of management at the University of Washington Foster School of Business, have taken a look at how competing interests when firms are indirectly tied to a direct competitor via a shared venture capital investor plays a role in the success of medical device makers.

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The most innovation-threatening aspects, according to Pahnke and Hallen include:

geographically distant from them, because venture capitalists take a more active advising interest in nearby firms;
less financially committed to them, because venture capitalists are more likely to share information with competitor firms in which they are more invested or reinvested; or
new to their industry, because a venture capital firm is most likely to learn from its first investment and share it with subsequent investments in the same industry.

“Lacking power, status and resources,” Pahnke said, according to Phys Org, “entrepreneurial firms wield little sway over the relationships that their investors form with other firms and may have little control over what information gets shared.”

To understand the effect of entangled venture capital alliances on innovation, Pahnke and Hallen collaborated with Rory McDonald of Harvard Business School and Dan Wang of Columbia University to study 22 years of activity in the minimally invasive medical device industry. Integrating 30 distinct data sources, they compiled a full picture of the companies and their investors, and identified the instances in which venture capitalists invested in two firms in the same sub-segment of the industry. This is not uncommon. Among venture capitalists in the medical device industry, the study revealed that 20 percent were invested in direct competitors at the same time.

This leads to what the authors refer to as “competitive information leakage.” Leakage can thwart efforts toward creating innovative products that lead to FDA approval.

“If someone gets a device approved ahead of you, it delays your own approval because you’re going to have to invent around them,” Pahnke said.

The message behind this research lends to warn entrepreneurs about who they decided to accept as investors – it should be a particularly thoughtful process.

“Later investees glean wisdom from earlier ones,” Pahnke noted. “You want an investor who knows your market, but you don’t necessarily want them to learn the market from you.

“If you were forming a direct relationship with a competitor—some kind of alliance—you’d be very careful about what you told them,” said Pahnke. “But when you’re forming a relationship with a venture capitalist, you have to be very open about everything. You don’t have control of what goes to your competitor and how.”

Photo: Flickr user Drew Leavy