Ramana Nanda, HBS: Amazon Web Services Changed the Way VCs Fund Startups
May 15, 2017
Starting companies is becoming so quick and cheap that venture
capitalists have shifted strategy funding entrepreneurs. Now, more
startups get backing—but they have to prove themselves in a hurry,
according to research by Ramana Nanda and colleagues.
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
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.
Nanda, Professor of Business Administration in the Entrepreneurial
Management unit at Harvard Business School
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
second round of funding—a phenomenon that became known as the “Series A
“The benefit is that [today] more firms are being funded,” says Nanda.
“In the past, you would be less likely to fund a long-shot bet because
it would not be profitable. Now, because it’s so cheap to start
companies, you can be willing to give more firms a try, and shut them
down quickly if they don’t work out.”
On the positive side, the firms that did succeed substantially increased
their valuation after second-round funding, implying that the spray and
pray approach has been effective in identifying long-shot companies that
show real promise over and above what was expected.
As one example, Nanda cites Airbnb. “You might think it was not going to
work to put money into a firm that rents out mattress space on the
floor. But then it turns out it actually does, and Airbnb becomes a
super-valuable company,” he says. “Airbnb would have been very hard to
be backed in the previous period because it was such as long-shot bet.”
Startups receive less guidance
The strategy does have some drawbacks, however. Among them is the
concern that with the rapid-fire approach to funding, VCs have been less
likely to fill their traditional role of providing advice and guidance
to startups, putting less resources into firm governance.
For instance, the researchers found that for the group of firms they
looked at, VCs were 14 to 21 percent less likely to place an investor on
the board of directors in the first round of financing/funding.
“It shifts the governance to the later stages of the company,” says
Nanda, “in part because it’s not really worth it for VCs to dedicate a
lot of time and resources into that when the rate of failure is so
high.” Some of that slack, he adds, has been picked up by accelerators
such as Y Combinator or Techstars, which are able to provide guidance to
startups as a group, offering them business and technical advice until
they are able to prove themselves and grow to a size that a VC is
willing to invest more time and money into ensuring their success.
Another worry with the spray and pray approach is that by emphasizing
investments in companies that can prove their worth quickly, VCs may be
underfunding other more complex types of startups that require more time
to bear fruit.
“One of the challenges with this approach is it really directs attention
of investors to projects where you can learn cheaply and quickly,” says
Nanda, “so it may disproportionately de-emphasize those problems that
are more complex and where it is more costly to learn.”
unclear whether those types of startups are being underfunded on an
absolute basis or merely a relative basis compared with faster
projects—that is, says Nanda, if the number of companies in more complex
industries such as clean technology stays the same while the number of
software companies increases, then the approach is still a net benefit.
If, however, the number of complex companies that get funded decreases
in favor of quicker and easier companies, then that could signal a
problem. Nanda hopes to address this question in future research.
On the bright side, he says, technological innovations have come so
quickly in recent years that there are few industry sectors that have
not seen their development costs dramatically decrease. For example,
CRISPR technology has allowed gene editing in biotech, 3D printing has
allowed for rapid prototyping for hardware startups, and reusable
rockets have brought down the cost to build and launch a small satellite
to under a million dollars.
“And we often see advances in one area power technological advances in
another,” says Nanda. “Supercomputing has opened up massive innovations
in nuclear startups by allowing us to simulate the inside of a nuclear
reactor for a mere $200 million instead of $6 billion!” As new
technologies such as artificial intelligence, machine learning, and
virtual reality bring more advances, the cost to fund startups will only
get lower, and the number of startups that can get a shot to succeed can
“With the pace at which each of these innovations are influencing other
innovations,” says Nanda, “it’s a fascinating time to be an entrepreneur
or an investor.”