TOLERANCE FOR FAILURE AND CORPORATE INNOVATION

Xuan Tian
Kelley School of Business
Indiana University
tianx@indiana.edu
(812) 855-3420

Tracy Y. Wang
Carlson School of Management
University of Minnesota
wangx684@umn.edu
(612) 624-5869

First version: April, 2009

Key words: corporate culture, tolerance for failure, innovation, patents, venture capital, IPO
JEL classification: M14, O31, G24, G34

TOLERANCE FOR FAILURE AND CORPORATE INNOVATION

Abstract
In this paper, we examine whether a failure-tolerant corporate culture spurs
corporate innovation and increases firm value based on a sample of venture capital (VC)
backed IPO firms. We develop a novel firm-specific measure of a failure-tolerant
corporate culture hinging on the idea that the formation of corporate culture is largely
determined by the attitudes and beliefs of its founders and early active investors. VC
firms are such investors and their attitudes towards failures can have a profound impact
on the formation of a failure-tolerant culture in the entrepreneurial firms in which they
invest. We find that firms with a more failure-tolerant culture are significantly more
innovative. The failure tolerance effect is persistent and robust to controlling for other
VC firm characteristics. Further, the failure tolerance effect on firm innovation is stronger
in industries in which innovation is more difficult to achieve. We also find opposite roles
of insider equity ownership and failure tolerance in motivating innovation. Finally, we
find that a failure-tolerant corporate culture increases firm value in industries in which
innovation is important. Overall, our findings are consistent with implications in recent
theories on corporate innovation that failure tolerance is critical in motivating innovation.
Our work also contributes to the literature on corporate culture by making the first
attempt at measuring a specific aspect of corporate culture and providing empirical
evidence that corporate culture does matter in significant ways for firms decisions and
performances.

TOLERANCE FOR FAILURE AND CORPORATE INNOVATION

1. INTRODUCTION
Corporate culture, the shared beliefs and organizational preferences within a firm about
the optimal course of action, has received growing attention in the economics and finance
literature. 1 Economic theories have long argued that corporate culture is an important part of
corporate internal incentivizing and governance mechanisms and thus should have profound
impact on corporate decisions and performances (see an extensive review of this literature in
Hermalin 2001). However, empirical study on the effect of corporate culture remains sparse for
two reasons. First, corporate culture is difficult to define or measure in econometric analysis.
Second, corporate culture has different aspects and there is inadequate theoretical guidance on
how a specific cultural aspect affects firm performance (Ostroff, Kinicki, and Tamkins 2003).
The recent theoretical literature on corporate innovation, however, provides a specific
context to examine the effect of corporate culture on firm performance. This literature shows that
tolerance for failure is critical in motivating innovation (see, e.g., Hellmann and Thiele 2008,
Manso 2008). This is because unlike standard tasks, exploration of new untested approaches is
subject to a high probability of failure. However, there has been little empirical work in this area
because measuring failure tolerance in a firm is difficult.
This paper contributes to both the literature on corporate culture and the literature on
corporate innovation by constructing a novel measure of a failure-tolerant corporate culture. This
measure enables us to examine how such an important aspect of corporate culture affects a firms
innovation productivity, which is vital for the long-term competitive advantage of the firm.
The starting point of our intuition is that for a firm the formation of corporate culture is
largely determined by the attitudes and beliefs of its first-generation insiders, namely, founders
and early active investors. Therefore, our empirical approach hinges on the idea that early active
investors attitudes towards failure have a profound impact on the formation of a failure-tolerant
culture in the firm. Venture-capital-backed IPO firms provide an ideal research setting. First,
venture capital (hereafter VC) investors provide not only capital but also intensive monitoring
and value-added services to entrepreneurial firms from the very beginning stages to the firms

See, e,g., Kreps (1990), Cremer (1993), Lazear (1995), Hermalin (2001), Van den Steen (2005a, 2005b), and
Bernhardt, Hughson, and Kutsoati (2006).

maturity. Second, entrepreneurial firms receiving VC financing typically have high growth
potential but also substantial failure risk, especially during the earlier stages of the firms life
cycle. Thus VC investors attitudes towards early failures may significantly influence the
entrepreneurs attitudes towards failures and the projects eventual outcomes. Put differently,
entrepreneurial firms backed by failure-tolerant VC investors are more likely to develop a
failure-tolerant culture.
We infer a VC firms failure tolerance by examining how long the VC firm invests in its
eventually failed projects (i.e., entrepreneurial firms that were written off by their VC firms).
Failure tolerance is captured by the VC firms average investment duration in those projects from
the first participation investment round to the time when it decides to terminate its follow-on
investments. Longer investment duration in eventually failed projects indicates larger tolerance
for early failure. We examine how a VC firms failure tolerance is correlated with its other
characteristics. We find that VC firms with more past investment experience, more industryspecific skills and expertise, and tougher local competition are more tolerant of early failures.
However, a VC firms past successful experience does not impact its failure tolerance.
We then link a VC firms failure tolerance to the IPO firms backed by the VC firm. An
IPO firms failure tolerance is determined by its investing VC firms failure tolerance at the time
when the VC firm makes the first round investment. The key intuition is that IPO firms
internalize their investing VC investors attitudes towards failure into their own corporate culture,
which in turn affects their subsequent innovation productivity.
Our empirical analysis generates a number of interesting new findings. First, we find that
firms with a more failure-tolerant culture are significantly more innovative. They not only
produce a larger number of patents but also produce patents with significantly larger impact
(measured by the number of citations each patent receives), after controlling for other firm and
industry characteristics. The failure tolerance effect on innovation is robust after controlling for
other VC firm characteristics such as VC firm experience and industry expertise and lead VC
firm fixed effects. This implies that both observable and non-observable VC firm characteristics
are unlikely to be the omitted variables that cause the correlation between failure tolerance and
innovation of IPO firms. We also find that the failure tolerance effect persists long after the VC
firms exit their investments in the IPO firms. This suggests that the failure tolerance effect does

not simply reflect a temporary VC firm influence, but is likely to reflect a persistent cultural
effect.
Second, we find that the effect of failure tolerance on firm innovation is stronger in
industries in which innovation is more difficult to achieve in the sense that time and resources for
innovation are more demanding and chances of success are lower. For example, the impact of
failure tolerance on innovation productivity is almost four times higher in industries developing
new drugs than in industries producing new computer software.
Third, we contrast the effect of standard incentive schemes such as insider equity
ownership with the effect of a failure-tolerant corporate culture in motivating innovation. We
find that large insider equity ownership is associated with lower innovation productivity, which
is opposite to the effect of failure tolerance. Our finding is consistent with the implication of the
recent theoretical literature on corporate innovation that motivating innovation is very different
from motivating efforts on standard activities such as production and marketing.
Finally, we examine the effect of failure tolerance on firm value. We find that a failuretolerant corporate culture increases firm value (measured by Tobins Q) in industries in which
innovation is important. The evidence suggests that a failure-tolerant corporate culture increases
firm value through its impact on a firms innovation productivity and such impact is more
pertinent when innovation is more important.
The most important contribution of our paper is the construction of a firm-specific
measure for an important aspect of corporate culturetolerance for failure. Our paper contributes
to the literature on corporate innovation because this measure allows us to directly test the
implications in economic theories about motivating innovation, which is an important topic
given the vital role of innovation in creating competitive advantages for a firm and for an
economy. We discuss the relevant theories on innovation in detail in Section 2. There is also a
growing empirical literature in corporate finance on corporate innovation. Several papers show
that the legal system matters for innovation (see, e.g., Acharya and Subramanian 2009 on the
effect of a creditor-friendly bankruptcy code, Armour and Cumming 2008 on forgiving
personal bankruptcy laws, Acharya, Baghai-Wadji, and Subramanian 2009 on the effect of
stringent labor laws, and Sapra, Subramanian, and Subramanian 2009 on the effect of antitakeover laws). Another set of papers find that a firms ownership structure and financing matter
for innovation (see, e.g., Ayyagari, Demirgc-Kunt, and Maksimovic 2007 on private versus

state ownership and access to external financing, Aghion, Van Reenen, and Zingales 2009 on the
role of institutional equity ownership, Belenzon and Berkovitz 2007 on the effect of business
group affiliation and internal capital market, and Atannassov, Nanda, and Seru 2007 on the
effects of arms length financing versus relationship-based bank financing). Our paper
contributes to this literature by documenting the effect of a failure-tolerant corporate culture on
firm innovation.
Our paper is also one of the very first papers that empirically examine the effect of
corporate culture on corporate performance. The only other empirical paper we are aware of that
is related to corporate culture is Cronqvist, Low, and Nilsson (2009). 2 The authors find that spinoff firms investment and financing decisions are similar to those of their parent firms, and such
similarity persists over a long period. They also find that the commonality is stronger for
internally grown spin-offs, and the commonality exists even when a new outside CEO is hired to
run the spin-off firms. The authors argue that their findings are consistent with a corporate
culture effect. The common culture between the parent firm and the spin-off firm leads to
persistent similarities in their decisions. Their work is an interesting and important attempt at
understanding corporate culture effects.
While Cronqvist et al. identify the corporate culture effect by examining the role of a
common firm origin between spin-off firms and their parent firms in their decision-making, our
approach of identifying corporate culture starts at the very beginning of a firms history. We
show that the failure tolerance of a firms first-generation insiders (VC investors) have a
significant and long-lasting impact on the firms innovation productivity.
Another advantage of our approach is that our failure tolerance measure is least subject to
the reverse causality problem in corporate finance research. This is because our failure tolerance
measure captures the investing VC firms attitude towards failure before its very first investment
in an IPO firm, which is well before the observed innovation activities of the IPO firm. Therefore,
our empirical design allows us to examine the causal effect of failure tolerance on an
entrepreneurial firms innovation productivity and firm value.

The organizational behavior literature has also studied corporate culture (see Ostroff, Kinicki, and Tamkins 2003
for a review). But this literature tends to rely on case studies or surveys of employees on some selected dimensions,
and thus the studies are limited to a small sample of firms. This literature also does not focus on how corporate
culture affects a firms investment and financing decisions and performance.

Finally, our paper also contributes to a broader literature on culture and corporate finance.
This literature has focused on the effects of national culture, examining how differences in
principal religion, language, social normal, and history across countries affect cross-country
variation in corporate finance decisions and policies (see, e.g., Stulz and Williamson 2003 on the
effect of a countrys principal religion on creditor rights, Guison, Sapienza, and Zingales 2009
on perceptions rooted in culture and economic growth among European countries, Bottazzi, Da
Rin, and Hellmann 2007 on the effect of trust in venture capital investment, and Griffin, Li, Yue,
and Zhao 2009 on the role of national culture in corporate risk-taking.) Although national culture
must influence corporate culture, the two are not the same. Exploring the effect of corporate
culture may help us understand the substantial heterogeneity among firms within a country.
Understanding the corporate culture effect may also help us understand the economic meaning of
the significant firm fixed effects in corporate financing and investment decisions documented in
the corporate finance research (see, e.g., Lemmon, Roberts and Zender 2008).
The rest of the paper is organized as follows. Section 2 develops the hypotheses. Section
3 discusses the construction of our failure tolerance measure. Section 4 describes the empirical
specification. Section 5 reports the results regarding the effects of failure tolerance on firm
innovation and the robustness tests. Section 6 contrasts the effect of standard incentive schemes
with that of a failure-tolerant corporate culture on firm innovation. Section 7 presents the results
on the effect of failure tolerance on firm value. Section 8 concludes.

2. HYPOTHESIS DEVELOPMENT
We derive our hypotheses from the recent theoretical literature on motivating innovation.
Holmstrom (1989), in a simple principle-agent model, shows that innovation activities may mix
poorly with relatively routine activities in an organization because these two types of activities
require different incentive schemes. Innovation activity requires exceptional tolerance for failure
and a weak incentive scheme because of the high-risk and low-predictability nature of innovation.
Manso (2008) explicitly models the innovation process and the trade-off between
exploration of new untested actions and exploitation of well known actions. Manso shows that
while standard pay-for-performance incentive scheme can motivate exploitation, the optimal
contracts that motivate exploration involve a combination of tolerance for failures in the short-

run and reward for success in the long-run. Ederer and Manso (2009) conduct a controlled
laboratory experiment and provide evidence supporting the implications in Manso (2008).
While Manso (2008) assumes contractibility of innovation activities, Hellmann and
Thiele (2008) argue that innovative tasks are better characterized by incomplete contracts and
ex-post bargaining (also see Aghion and Tirole 1994). The authors focus on the interaction
between standard tasks and innovation in a multi-task model in which employees choose
between the two types of activities, and show that the amount of innovation is negatively related
to the strength of incentives provided for the standard task. The optimal amount of failure
tolerance also reflects the trade-off between the two types of tasks: Failure tolerance may
encourage innovation, but may also undermine incentives for standard tasks.
The essential message from the above theories is that motivating innovation is very
different from motivating efforts on standard tasks. Tolerance for failure is critical in motivating
innovation, and standard incentive schemes such as pay-for-performance can fail to do so. These
insights form the theoretical foundation of our empirical analysis.
Our main task in this study is to examine the effect of failure tolerance on corporate
innovation and firm value. Tolerance for failure may be an explicit contractual specification as in
Manso (2008), or an implicit organizational norm as in Hellmann and Thiele (2008). In our study
we take the latter aspect and examine the effect of a failure-tolerant corporate culture. Our main
hypothesis is summarized below.
Hypothesis 1: A failure-tolerant corporate culture increases a firm's innovation
productivity.
If failure tolerance is important for innovation because innovation activities often involve
substantial risk of failure, then a natural cross-sectional implication is that the effect of failure
tolerance should be particularly strong in industries in which innovation is difficult to achieve.
The difficulty can come from a low probability of success and large resources demanded. This
insight leads to our next hypothesis.
Hypothesis 2: The effect of failure tolerance on corporate innovation is stronger in
industries in which innovation is more difficult to achieve.
The theoretical work discussed in this section contrasts the effect of tolerance for failure
with that of standard incentive schemes in motivating innovation. Although standard pay-forperformance incentive schemes are effective at motivating efforts on standard tasks, they may

fail to motivate innovation. In particular, Hellmann and Thiele (2008) show that when employees
can choose between standard tasks and innovation, high-powered incentives on standard tasks
will discourage innovation. We thus empirically examine and compare the effects of these two
incentive schemes.
Hypothesis 3: Failure tolerance and standard incentive schemes have opposite effects on
a firms innovation productivity.
If failure tolerance enhances a firms innovation productivity and if such productivity is
priced by investors, then we expect a failure-tolerant culture to increase firm value. But if the
firms operation focuses on standard tasks such as production and marketing rather than
innovation, then as argued in Hellmann and Thiele (2008), failure tolerance may decrease firm
value by undermining incentives for standard tasks. This insight leads to our last hypothesis.
Hypothesis 4: A failure-tolerant corporate culture increases firm value in industries in
which innovation is important.
With these four hypotheses in hand, we turn to the specifics of our empirical research
design.

3. FAILURE TOLERANCE
3.1 The Idea
Corporate culture is defined as the shared beliefs and organizational preferences among a
firms employees about the optimal course of action (see, e.g., Kreps 1990, Cremer 1993, Lazear
1995, and Hermalin 2001). As Edgar Schein points out, the process of culture formation in an
organization begins with the founding of the group. Culture is created by shared experience, but
it is the leader who initiates this process by imposing his or her beliefs, values and assumptions
at the outset (Schein 2004). Thus our starting point is that the formation of a corporate culture is
largely determined by the beliefs and values of its first-generation leadersfounders and early
active investors.
VC-backed IPO firms provide an ideal research setting for our study. Unlike other
passive investors such as angel investors and banks, VC investors not only provide capital but
also interact intensively with the entrepreneurial firms they back. They get heavily involved in a
firms everyday business: on-site visiting the firm, helping the professionalization of the
management team, and sitting in board meetings (e.g., Sahlman 1990, Gompers 1995, Lerner

1995, Hellmann and Puri 2000 and 2002, Chemmanur and Loutskina 2006, and Bottazzi, Da Rin,
and Hellmann 2008). During the process of active and intensive interactions with the
entrepreneurs, VC firms, usually the first-generation active investors in an entrepreneurial firm,
can help the firm build up its own corporate culture.
Tolerance for early failure is one of the most important aspects of corporate culture that
VC investors can help their portfolio firms build up. Entrepreneurial firms receiving VC
financing are typically premature and highly innovative with high growth potential but also
significant failure risk. The failure risk is especially high during the earlier stages of the
entrepreneurial firms life cycle. A VC investors attitude towards early failure of the
entrepreneurial firms projects may significantly influence the entrepreneurs attitude towards
failure later on. For example, if the VC investor is very much tolerant for early failure and
willing to give the entrepreneur a second chance when the entrepreneurial firm fails to meet
stage financial or non-financial targets, such failure tolerance from the VC investor gives the
entrepreneur greater incentives to continue his innovation activities. It may also significantly
influence the entrepreneurs attitude towards failure.
In sum, our intuition is that VC investors attitude towards failure can be inherited or
internalized by the entrepreneurs and become a part of the entrepreneurial firms culture, which
in turn affects the firms subsequent innovation activities and performance.

3.2 VC Firms Failure Tolerance

In this section we construct a time-varying measure of a VC firms tolerance for failure.
In Section 3.4 we link a VC firms failure tolerance to the IPO firms it invests in.
We construct our measure for a VC investors failure tolerance based on a sample of
failed investments the VC investor made in the past. Failure tolerance measures how long a VC
firm waits before terminating its follow-on investments in an under-performing entrepreneurial
firm that eventually failed. It is well know that the VC industry is full of failure risks and the
organizational structure of VC partnerships gives VC firms limited investment horizon. A typical
VC fund is constructed for 10 years and can be extend to a maximum of 12 years. If a project
does not show immediate progress towards stage targets after the VC firms initial few rounds of
investment, the choice between giving the entrepreneur a second chance by continuing to infuse
capital and writing off the project reflects a VC investors attitude towards early failure. We

therefore use the VC firms investment duration between its first capital infusion and the time
when it decides to terminate the investment in an eventually failed project to capture its tolerance
for failure.
We obtain data on round-by-round VC investments from the Thomson Venture
Economics database for entrepreneurial firms that received VC financing between 1980 and
2006. 3 From the initial set of 282,752 VC investment round observations, we exclude investment
rounds obtained by financial firms and those with missing or inconsistent data. 4 We also exclude
entrepreneurial firms that are in their late or buyout stage when they receive the first round of
VC financing. This is because entrepreneurial firms at later stages are more mature and the
failure risk is significant reduced. Thus a VC firms investment duration may not reflect its
failure tolerance. We correct for the Venture Economics over-reporting problem, which leaves
us with 228,805 individual financing rounds made by 7,384 distinct VC firms in 46,875 distinct
entrepreneurial firms. 5
To construct our VC failure tolerance measure, we focus on the sub-sample of VC firms
failed investments, i.e., entrepreneurial firms that were written off by their investing VC
investors. Venture Economics provides detailed information on the date and type of the eventual
outcome of each entrepreneurial firm (i.e., IPO, acquisition, or write-off). However, the database
does not mark all written-down firms as write-offs. Therefore, based on the fact that the VC
industry requires investment liquidation within 10 years from the inception of the fund in the
majority of the cases, in addition to the write-offs market by Venture Economics, we classify a
firm as a written-off firm if it did not receive any financing rounds within a 10-year span after
the last financing round it received.

We choose 1980 as the beginning year of our sample period because of the regulatory shift in the U.S. Department
of Labors clarification of the Employee Retirement Income Security Acts prudent man rule in 1979. This Act
allowed pension funds to invest in venture capital partnerships, leading to a large influx of capital to venture capital
funds and a significant change of venture capital investment activities.
4
For example, some entrepreneurial firms first VC financing round dates occur before the founding dates of their
investing VC firms, and some entrepreneurial firms founding dates occur later tan their IPO dates.
5
Gompers and Lerner (2004) document that the Venture Economics database reports 28% more financing rounds
than actually occurred because Thomson frequently splits financing rounds. To correct Venture Economics overreporting of financing rounds, we collect financial information from IPO prospectuses and S-1 registration
statements for firms that eventually go public. For firms acquired by public firms, we collect financial information
from the acquirers proxy, 10-K, or 10-Q statements, which are generally available in the Securities and Exchange
Commissions (SEC) EDGAR database. For firms that are written off or remain private, we eliminate repeated
rounds within three months if they share the same amount of round financing.

There are 18,546 eventually failed entrepreneurial firms receiving 67,367 investment
rounds from 4,910 VC firms in our sample. For each eventually failed entrepreneurial firm a VC
firm invested in, we calculate the VC firms investment duration (in years) from its very first
investment round date to its last participation round date. If the entrepreneurial firm continues to
receive additional financing rounds from other VC investors after the VC firms last participation
round, we then calculate the duration from the VC firms very first investment round date until
the next financing round date after its last participation round. This is because the VC firm may
make the decision not to invest follow-on funds, i.e., not to tolerate the poor performance of the
entrepreneurial firm any more, only after its detailed evaluations of the firm, which typically
happens right before the next round of capital infusions. 6
We then calculate our main variable of interest, Failure Tolerance, by taking the
weighted average of a VC firms investment duration in its eventually failed projects up to a
given year. The weight is the VC firms investment in a project as a fraction of its total
investment up to that year. For example, if a VC firm has invested in 12 eventually failed
entrepreneurial firms between 1980 and 1987, the weighted average of the investment duration in
these 12 firms is assigned as the value of its Failure Tolerance measure in 1987. Our intention is
to use the variation in VC firms investment duration in their eventually failed entrepreneurial
firms to capture their tolerance for failure. Intuitively, the longer the duration between the VC
firms first participation round and the time when it decides to terminate its follow-on capital
infusions, the more tolerant the VC firm is for its eventually failed investment.
Table 1 provides the descriptive statistics for our VC failure tolerance variable. There are
18,993 VC firm-year observations with Failure Tolerance information available in our sample.
On average, VC investors wait for about one and half years before deciding to terminate their
follow-on investments in an unpromising deal. Half of the VC firms intend to write-off their
under-performing entrepreneurial firms within one year and three months since its very first
participation financing round. The distribution of Failure Tolerance is right skewed with
skewness of 2.43. Moreover, from an economic perspective, there is a large difference between
waiting for two years rather than one year before terminating an investment, but probably a
6

It is important to note that based on our current algorithm of calculating the VCs investment duration in an
eventually failed entrepreneurial firm, the duration measure for the investing VC firm will be missing if the
entrepreneurial firms receives only one round of VC financing in its entire life. This is because we do not know
when exactly the VC investor decides to terminate his investments in the under-performing entrepreneurial firm.

10

smaller difference between waiting for ten years versus nine years. Both the skewness and the
likely nonlinearity of the economic impact of VCs tolerance for failure suggest that a logarithm
transformation of the failure tolerance measure is appropriate. We then use the natural logarithm
of Failure Tolerance as the main measure in the rest of the analysis.

3.3 Failure Tolerance and Venture Capital Firm Characteristics

In this section, we examine how a VC firms failure tolerance is correlated with its other
characteristics such as its investment experience, portfolio concentration, past successful
experience, local competition, and macro-level VC industry conditions.
The VC literature suggests that a VC firms past investment experience is an important
determinant of the performance of IPO firms it invests in (e.g., Lerner 1994, Gompers 1996,
Chemmanur and Loutskina 2006, Hochberg, Ljungqvist, and Lu 2007, and Sorensen 2007). Are
more experienced VCs also more tolerant of early failure in the entrepreneurial firms they back?
In theory it is not clear. A VC may learn to be more tolerant over time due to the high failure rate
in the VC industry. But past experience may also make a VC more decisive at cutting losses in
unpromising projects and moving on.
We first measure a VC firms overall past experience. For each VC firm and each year
we compute the following four VC experience measures: a) the total dollar amount the VC firm
has invested since 1980 (Past Amount Invested); b) the total number of firms the VC firm has
invested in since 1980 (Past Firms Invested); c) the total dollar amount the VC firm has raised
since 1965 (Past Fund Raised); and d) the age of the VC firm measured as the number of years
since its date of inception (VC Age).
It is also possible that not only a VCs overall past experience but also its past successful
experience matter in determining its attitude towards failure. Thus for each VC firm and each
year, we compute Past Successful Exit as the proportion of entrepreneurial firms financed by
the VC firm that exited successfully through either going public or acquisition by another
company since 1980. Previous literature also suggests that going public is a more desirable
outcome than acquisitions for both entrepreneurs and VC firms (see, e.g., Sahlman 1990, Brau,
Francis, and Kohers 2003). Therefore, only firms of the best quality may access the public
capital markets through an IPO (Bayar and Chemmanur 2008). Therefore, we calculate Past

11

IPO Exit as the proportion of entrepreneurial firms financed by the VC firm that went public
since 1980.
Another important dimension of a VC firms experience is its expertise in certain
industries. VC firms are generally highly specialized in a few industries. The concentration of a
VCs portfolio firms across industries can to some extend reflect such industry expertise. For
example, if a VC firm specializes in investing in biotechnology firms, its portfolio firms tend to
be highly concentrated in the biotechnology industry. Following Kacperczyk, Sialm, and Zheng
(2005), we construct an investment concentration index for each VC firm and each year. The
Venture Economics database assigns each entrepreneurial firm in a VCs investment portfolio to
one of 18 industries. 7 The investment concentration of VC firm-i at year t is defined as the sum
of the squared deviations of the weights (the number of portfolio firm) for each of the 18
different industries held by the VC firm wi ,t relative to the industry weights of the total venture
investment wi ,t :

18

(w
i =1

i ,t

wi ,t ) 2 . It measures how much a VC firms portfolio deviates from a

hypothetical VC market portfolio, which consists of all entrepreneurial firms in the industry in
which a VC firm could have invested. The measure equals zero if the VC firms portfolio has
exactly the same industry composition as the hypothetical VC market portfolio and increases as a
VC firms portfolio becomes more concentrated in a few industries.
The last VC-specific characteristic we consider is the degree of local competition a VC
firm faces. On the one hand, tough competition means that good projects are less available to
each VC firm, which may make VCs more tolerant of early failures in projects they invest in. On
the other hand, competitive pressure may make VCs less tolerant for projects that do not show
immediate promises. To capture the toughness of the local competition in the VC industry, we
count the number of VC firms located within the same zip code area (Local Competition). The
intuition is that the more VC firms located within the same zip code area, the tougher the
competition.
Gompers and Lerner (2000) find that a large VC industry fund supply increases the
valuation of a VC firms new investments. To see whether ample supply of venture funds make
7

The 18 industries assigned by Venture Economics database are Agriculture/Forestry/Fish, Biotechnology, Business
Services, Communications, Computer Hardware, Computer Other, Computer Software, Construction, ConsumerRelated, Financial Services, Industrial/Energy, Internet-Specific, Manufacture, Medical/Health, Other,
Semiconductor/Electronics, Transportation, and Utilities.

12

VC investors more failure tolerant, we construct a VC industry condition variable, Industry

Fund Inflow, which measures the total capital inflows into the VC industry each year.
Table 1 provides the descriptive statistics for these VC characteristics. The average VC
firm in a given year is 7.5 years old and has invested 395 million dollars in 24 entrepreneurial
firms. Among all entrepreneurial firms the average VC firm has financed, 53% had a successful
exit but only 16% went public. The average VCs portfolio firms are concentrated in a few
industries with the investment concentration index of 0.37 and it needs to compete with about six
other VC firms that are located within the same zip code area.
Table 2 reports the panel regression results with the natural logarithm of a VC firms

Failure Tolerance as the dependent variable. In all regressions, we include VC investors

investment concentration, past successful experience, local competition, VC fund inflows one
year and two years prior to the financing round year, and VC firm fixed effects and year fixed
effects. To control for potential differences in investment cycles in different industries, in all
regressions we control for the entrepreneurial firms industry fixed effects based on the 18industry classification in Venture Economics. 8 Robust standard errors are clustered by VC firms
because the residuals may be correlated across observations from the same VC firm. Since the
four VC experience variables are highly correlated with each other, we examine their correlation
with Failure Tolerance one by one in the regressions.
In models (1) and (2), the coefficient estimates of the total dollar amount and the total
number of entrepreneurial firms a VC firm has invested in are positive and significant. This
suggests that more past investment experience makes the VC more tolerant of its portfolio firms
early failure. The coefficient estimate of the total funds raised by a VC firm is positive and
significant as reported in model (3), suggesting that the VC firms tolerance for failure increases
with their fundraising experience. The coefficient estimate of VC age reported in model (4) is not
statistically significant, which suggests that the length of time the VC firm has been in the
profession does not have a significant impact on its attitude towards failure.
The coefficient estimate of a VC firms investment concentration index is positive and
significant across all regressions. Since the measure is meant to capture a VC firms industry

If a VC firm invests in multiple industries in a given year, we choose the industry in which the VC firm invests the
largest amount of capital in that year for the industry fixed effect.

13

expertise, the result suggests that the more specialized VC firms are more tolerant of early
failures in their portfolio firms.
A concern one may have is that our measure that is meant to capture a VC firms attitude
towards early failure may simply measure how smart a VC firm is in the sense that smarter VC
investors should be able to terminate unpromising projects earlier and less sophisticated ones
wait for too long. The positive relationship between our Failure Tolerance measure and VC past
investment experience presented in Table 2 is inconsistent with this argument. To further
examine the validity of this concern, we include the VCs past successful investment experience
in all regressions. If the argument was true, we should expect a negative relationship between

Failure Tolerance and the VCs past successful experience. That is, a more successful VC
investor is smarter and wont wait for too long before abandoning a bad project. However, the
coefficient estimates of a VCs past successful exit rate are statistically insignificant in all
regressions, which suggests that the VCs attitude towards failure is independent of its past
successful experience. For further robustness, we run the same regressions with the VCs past
successful exit rate replaced by its past IPO exit rate. We continue to find statistically
insignificant coefficient estimates. Overall, the Failure Tolerance measure seems not to capture
the smartness of the VC investors but rather the VCs attitude towards failure.
Table 2 also shows that local VC competition is significantly and positively related to VC
failure tolerance. This suggests that tougher competition in the local area makes a VC firm more
tolerant of its portfolio firms early failures. This may be because really promising projects are
relatively scarce due to tough competition.
Finally, a larger VC industry fund inflow in the prior year does not increase VC firms
failure tolerance, but a larger fund inflow two years earlier does. This suggests that it takes some
time for an increase in the capital supply of the industry to increase VC firms failure tolerance.
In sum, we find that a VC firms past investment experience, but not past successful
experience, and its industry expertise and competition in the local VC industry make the VC
more tolerant of early failure in the projects it invests in.

3.4 IPO Firms Failure Tolerance

14

In this section we link a VC firms failure tolerance to the IPO firms it invests in. Our
empirical analysis hinges on the idea that IPO firms internalize their investing VCs attitudes
towards failure into their own corporate culture.
Figure 1 illustrates how we match a VCs failure tolerance with an IPO firm backed by
the VC. Let us consider year t. VC firm-is failure tolerance in year t is the average investment
duration in all of its failed projects up to this year. In the same year the VC firm makes its firstround investment in a new start-up firm-j, and this firm later goes public. Then IPO firm-js
failure tolerance is determined by the VC firm-is failure tolerance in year t. In sum, an IPO
firms failure tolerance is determined by its investing VC firms failure tolerance at the time
when the VC firm makes the first round investment in it.
Figure 1: IPO Firms Failure Tolerance
VC-is starts to
invest in Firm-j
1980

t
VC-i has N failed projects.
Compute average investment
duration in them.

Firm-js IPO
t+k

VC-is failure
tolerance at t

Firm-js failure tolerance

We obtain the list of VC-backed IPOs between 1985 and 2006 from the Securities Data
Company (SDC) Global New Issues database. 9 Following the IPO literature, we exclude from
our initial IPO sample spin-offs, closed-end fund, REITs, ADRs, unit offerings, reverse LBOs,
foreign issues, offerings in which the offer price is less than $5, finance (SIC code between 6000
and 6999), and utilities (SIC code between 4900 and 4999). We also corrected for mistakes and
typos in the SDC database following Jay Ritters "Corrections to Security Data Companys IPO
database" (http://bear.cba.ufl.edu/ritter/ipodata.htm). In the end, we have 2,669 VC-backed IPO
firms. We then merge the IPO sample with the Venture Economics database, and exclude IPO
firms from consideration if the identities of the investing VC firms are unavailable through SDC.
9

We choose 1985 as the beginning year of our IPO sample because we want to have a long enough time gap
between the beginning year of our VC sample in which the Failure Tolerance measure is constructed and the
beginning year of our IPO sample in which the Failure Tolerance measure is utilized. By doing so, we minimize the
possibility that the VC-backed IPO firm has no Failure Tolerance information available.

15

For each IPO firm in our sample, we can observe the identity of its investing VC firms,
the value of each VC firms Failure Tolerance measure, and other characteristics of those VC
firms as reported in Table 1 at their first participation round dates. If an IPO firm receives
funding from a VC syndicate (about 86% of our sample), we then calculate the weighted-average
of our Failure Tolerance measure. The weight is the investment by a VC firm as a fraction of the
total VC investment received by the IPO firm. Consequently, there is a fixed failure tolerance
measure for each IPO firm in our final sample. Panel A of Table 3 reports the descriptive
statistics of the IPO firms Failure Tolerance measure. The mean Failure Tolerance measure is
about one year and ten months and it could be as large as six years and four months.
For each IPO firm we also calculate the weighted-average of VC characteristics including
past investment experience, past successful experience, investment concentration, and local
competition. All these VC characteristics are parallel to our IPO firm Failure Tolerance measure
by construction. The descriptive statistics of VC characteristics are reported in Panel A of Table
3. Compared with the summary statistics of all VC firms that has financed failed projects as
reported in Table 1, the VC investors of our IPO sample are older, have invested more money,
have participated in more firms, have raised more fund, have more diversified investment
portfolio, and have more successful past investment experience. There seems to be no significant
difference regarding the toughness of competition in the local market.
Finally, we extract financial information for our IPO firms from Standard & Poors
COMPUSTAT files, stock price and shares outstanding data from CRSP, insider ownership from
the Compact Disclosure database, and institutional investors ownership from the Thomson
Financial 13f institutional holdings database. Finally, there are 1,848 VCbacked IPO firms in
our sample with non-missing VC investor identity, financial and ownership information.

4. EMPIRICAL SPECIFICATION
Having constructed a measure of an IPO firms failure-tolerant culture, we now proceed
to the next step and examine how failure tolerance affects the firms performance after IPO. As
discussed in Section 2, we focus on the effect of failure tolerance on the firms innovation
productivity and firm value. Specifically, we estimate the following two models:

Ln( Innovationi ,t ) = 0 + Ln( FailureTolerancei ) + Z i ,t + Ind j + Yeart + ui ,t

(1)

Ln(Qi ,t ) = 1 + Ln( FailureTolerancei ) + Z i ,t + Ind j + Yeart + vi ,t

(2)

16

Innovation and Q are our dependent variables and we discuss their constructions in detail in
Sections 4.1 and 4.2. Failure Tolerance is a measure of an IPO firms failure-tolerant culture and
is defined in Section 3.4. Following the innovation literature, we control for a vector of firm
characteristics (Z) that may affect a firms innovation productivity and firm value. In the baseline
regressions, Z includes firm size (measured by the logarithm of sales), profitability (measured by
ROA), growth opportunities (measured by Tobins Q) investments in innovative projects
(measured by R&D expenditures over total assets), capital expenditure, leverage, institutional
ownership, firm age (measured by years since IPO), asset tangibility (measured by net PPE
scaled by total assets), and industry concentration (measured by the sales Herfindahl index).
Finally, Indj and Yeart capture two-digit SIC industry fixed effects and fiscal year fixed effects,
respectively.
One of the advantages of our empirical design is that the main variable of interest,

Failure Tolerance, is least subject to endogeneity or reverse causality concerns. This is because
Failure Tolerance captures the investing VC firms attitude towards failure before its very first
investment round in an IPO firm, which happens well before we observe the innovation activities
and valuation of the IPO firm. Therefore, Failure Tolerance is a relative clean exogenous
variable in the above empirical specifications.

4.1 Proxies for Innovation

We construct our innovation variables from the latest version of the NBER patent
database created initially by Hall, Jaffe, and Trajtenberg (2001), which contains updated patent
and citation information from 1976 to 2006. The patent database provides annual information
regarding patent assignee names, the number of patents, the number of citations received by each
patent, the technology class of the patent, the year when a patent application was filed, and the
year when the patent was granted. As suggested by the innovation literature (e.g., Griliches,
Pakes, and Hall 1987), the application year is more important than the grant year since it is closer
to the time of the actual innovation than the grant year. We then construct the innovation
variables based on the year when the patent applications are filed.
Although we use the application year as the relevant year for our analysis, the patents
appear in the database only after they are granted. Since there is a significant lag between patent
applications and patent grants (about two year on average), the patent database is subject to two

17

types of truncation problems. The first one is regarding patent counts. As we approach the last
few years for which there are patent data available (e.g., 2005 and 2006 in the data used here),
we observe a smaller number of patent applications that are eventually granted. This is because
many patent applications filed during these years were still under review and had not been
granted until 2006. Following Hall, Jaffe, and Trajtenberg (2001, 2005), we correct for the
truncation bias in patent counts using the weight factors computed from the application-grant
empirical distribution. The second type of truncation problem is regarding the citation counts.
This is because patents keep receiving citations over a long period of time, but we observe at best
only the citations received up to 2006. Following Hall, Jaffe, and Trajtenberg (2001, 2005), the
truncation in citation counts is corrected by estimating the shape of the citation-lag distribution.
We then use two proxies constructed from the truncation-adjusted NBER patent database to
measure an IPO firms innovative activity.
The first measure we employ is the truncation-adjusted patent count for an IPO firm each
year. Specifically, this variable counts the number of patent applications filed in a year that are
eventually granted. However, a simple count of patents may not distinguish breakthrough
innovations from incremental technological discoveries. Therefore, we construct our second
measure that intends to capture the importance of each patent by accounting for the number of
citations each patent receives in subsequent years.
We merge the NBER patent database with our IPO sample. Following the previous
literature (e.g., Atanassov, Nanda, and Seru 2007), we replace the patent and citation count with
zero for IPO firms that have no patent and citation information available from the NBER dataset.
Panel B of Table 3 presents the summary statistics of the innovation variables in the IPO sample.
The observation unit is IPO firm-year. As shown in the table, the distribution of patent grants in
the full IPO sample is very right skewed. Firm-year observations with zero patent represent
roughly 73% of the sample. But this percentage is still significantly lower than that reported in
Atanassov, Nanda, and Seru (2007) (84%) whose sample includes the universe of COMPUSTAT
firms. This suggests that VC-backed IPO firms are on average more innovative than firms
represented by the COMPUSTAT universe. On average, an IPO firm has 3.11 granted patents in
a given year and each patent receives 2.5 citations.
We also report summary statistics for the subsample of firm-year observations with
positive patent counts. This reduces our sample size to 5,264 firm-year observations. Half of the

18

firm-year observations in this subsample have 3 granted patents and the mean is about 11.5
patents. The table also shows that more than a quarter of the firm-year observations with positive
patent counts receive no citation. On average, each patent receives 9.4 citations in this subsample.
Not surprisingly, the distribution of patent counts and that of citations per patent are
highly right skewed. Moreover, from an economic perspective, there is a large difference
between receiving one patent rather than none, but probably a smaller difference between having
101 versus 100 patents. Both the skewness and the likely nonlinearity in the economic impact of
patent counts and citations per patent suggest that a logarithm transformation of these two
measures is appropriate. We then use the natural logarithms of patent counts and citations per
patent as the main innovation measures in our analysis.

4.2 Firm Value and Control Variables

Following the corporate finance literature (e.g., Kaplan and Zingales 1997), we use
Tobins Q as our proxy for firm value. Q is measured as a firms market value of assets divided
by the book value of assets at each fiscal year end. The market value of assets is defined as the
market value of equity plus the book value of assets minus the book value of equity.
All the financial variables in our analysis are winsorized at the 1st and 99th percentiles to
mitigate the influence of outliers on our results. Details of variable constructions are described in
the appendix table. Panel C of Table 3 reports the summary statistics of IPO firm characteristics.
In our IPO sample, Q ranges from 0.58 to 19.44 with a mean value of 3.01, a median value of
2.08, and a standard deviation of 2.94. The average firm has total book assets of 485.5 million
dollars, sales of 375 million dollars, leverage of 34.6%, and net PPE ratio of 17.36%.

5. FAILURE TOLERANCE AND CORPORATE INNOVATION

5.1 Baseline Results

Table 4 reports the baseline results on how a corporate culture that tolerates early failure
affects a firms innovation productivity. The dependent variables are the logarithm of patents in a
year and the logarithm of citations per patent. To facilitate the economic interpretation of our
regression results, we use the logarithm of our failure tolerance measure as our independent
variable so that the regression coefficient estimate gives us the elasticity of innovation to Failure

Tolerance. All regressions include year fixed effect and industry fixed effect, and report

19

coefficient estimates and the Huber-White-Sandwich robust standard errors clustered by IPO
firms (in parentheses).
Model (1) of Table 4 shows that firms with a failure-tolerant culture tend to produce
more patents. The elasticity of patents to failure tolerance is 0.258. This means that a one
percent increase in failure tolerance on average leads to more than a quarter percent increase in
the number of patents in a year. To be more concrete, consider a VC firm at the 25th percentile
of the failure tolerance distribution. According to Table 3 Panel A, this VC firm on average
invests for 1.3 years in a project before acknowledging failure and liquidating it. If this VC firm
is willing to invest for 2.3 years before giving up a project (roughly the 75th percentile of the
failure tolerance distribution), then everything else equal the IPO firms backed by this VC firm
tend to have 20% ( = 2.3 1.3 * 0.258 ) more patents a year later on.
1.3

In model (2) we restrict our analysis to firms with at least one patent during our sample
period (1985-2006) and are thus included in the NBER patent dataset. 10 We expect the effect of
failure tolerance to be stronger in the subsample of firms for which innovation is absolutely
relevant. This is exactly what we find. The elasticity of patents to failure tolerance increases to
0.422 in this subsample and is even more statistically significant.
Models (3) and (4) of Table 4 show that firms with a failure-tolerant culture also tend to
produce patents of higher quality (measured by the number of citations per patent). Model (3)
shows that a one percent increase in failure tolerance on average leads to a 0.2 percent increase
in citations per patent. Again, the effect of failure tolerance is much stronger in the subsample of
firms with nonzero patents. In un-tabulated regressions, we also exclude self-citations when
computing citations per patent. Our results are robust to such modification. 11
As we have discussed in Section 3, by construction our failure tolerance measure is
determined long before an entrepreneurial firm starts to produce patents. Therefore, the effect of
failure tolerance on innovation we document here is not subject to any reverse causality issue.
We control for a comprehensive set of firm characteristics that may affect a firms

10

The number of observations in Table 4 model 2 is 7,607, while it is 5,264 in Table 3 Panel B for the subsample
with patents>0. The discrepancy is due to a difference in the definition of subsample with patents>0. In Table 4
model 2, Patents>0 means that the firm has at least one patent over the entire sample period (but not necessarily in
each year). In Table 3 Panel B, Patents>0 means that the patent count is nonzero for a firm-year observation.
11
For example, the coefficient estimate of Ln(Failure Tolerance) is 0.238 (p-value=0.03) in model 3 of Table 4
when the natural logarithm of the modified citations per patent is the dependent variable.

20

innovation productivity. We find that firms that are larger (higher sales), more profitable (higher
ROA), have more growth potential (higher Q) and lower exposure to financial distress (lower
leverage) are more innovative. A larger R&D spending, which can be viewed as a larger
innovation input, is associated with more innovation output. Higher investment (higher capital
expenditures) is also associated with higher innovation productivity. Further, higher institutional
ownership is associated with more innovation, which is consistent with the findings in Aghion,
Van Reenen and Zingales (2009). Finally, firm age, asset tangibility (measured by the net PPE
over assets), and industry competition (measured by the Herfindahl index) do not significantly
impact a firms innovation productivity.
Overall, our baseline results suggest that a corporate culture that is tolerant of early
failure can increase a firms innovation productivity. These results provide support for the
implications of Holmstrom (1989) and Manso (2008) that tolerance for failure is critical in
motivating innovation.

5.2 Robustness

5.2.1 Alternative Econometric Specifications

We conduct a comprehensive set of robustness tests for our baseline results. The first set
of robustness is on alternative econometric specifications. Besides the pooled OLS specification
reported in Table 4, we have used the Fama-MacBeth regression adjusting for auto-correlations
of coefficient estimates. We have also used a Tobit regression that takes into consideration the
non-negative nature of patent data and citation data. We have run a Poisson regression when the
dependent variable is the number of patents to take care of the discrete nature of patent counts.
We have also run a firm random-effect model, which is generally more efficient than a pooled
OLS regression (Wooldridge 2009, page 493). Our baseline results are robust in all the above
alternative models. We thus do not report these additional results.

5.2.2 Controlling for Other VC Firm Characteristics

The second set of tests is to check whether the failure tolerance effect is robust to
controlling for other characteristics of an IPO firms VC investors. Table 2 shows that VC
investors that are more experienced are more tolerant of early failure in projects. VC firms
portfolio concentration and local competition also make them more tolerant of failures. Does our

21

failure tolerance measure simply reflect these characteristics? In other words, can other VC firm
characteristics be the omitted variables in our baseline regressions? The answer is no.
We first control for the observable VC firm characteristics that are correlated with the VC
firms failure tolerance as indicated in Table 2. As discussed in Section 3.4, for each IPO firm in
our sample we compute the weighted average characteristics of its VC firms at their first
investment in the firm. These VC characteristics are parallel to our failure tolerance measure by
construction. To save space, we only report results for the key explanatory variables in the table.
Table 5 Panel A shows that the failure tolerance effect on a firms innovation
productivity is robust to controlling for observable VC firm characteristics. If more experienced
VCs are more tolerant of failure, and at the same time are better at selecting more innovative
entrepreneurial firms, then we would expect the effect of VC experience to be positive and
significant and the effect of failure tolerance to disappear or substantially weaken. But we find
that failure tolerance still has a positive and significant effect on patent generation and patent
quality in all models. The magnitude of the effect also remains stable. For example, the average
elasticity of patents to failure tolerance in the four models is 0.264, which is comparable to the
magnitude in model (1) of Table 4 (0.258) in which we do not control for the other VC firm
characteristics. In addition, after controlling for the failure tolerance effect, none of the other VC
firm characteristics significantly affect the innovation productivity of the IPO firms.
Another possibility is that the omitted variables are unobservable VC firm characteristics.
Including a VC firm fixed effect can absorb the effect of any time-invariant unobservable VC
firm characteristics. However, controlling for VC firm fixed effect in our study is tricky because
86% our IPO firms are financed by VC syndicates rather than a single VC firm. We therefore
control for lead VC firm fixed effects as well as observable VC firm characteristics in Table 5
Panel B. We define the lead VC firm as the one that invests the most in an IPO firm. 12 We find
that the failure tolerance effect is still positive and significant. The average estimate for the
elasticity of patents to failure tolerance is 0.248 in Panel B, which is comparable to the
magnitude in Panel A where we just control for observable VC firm characteristics.
Taken together, the results in Table 5 suggest that the effect of failure tolerance on
innovation documented in Table 4 does not simply reflect the effects of observable time-varying
12

In our IPO sample, about 60% of the lead VC firms (based on our definition) had participated since the very first
VC financing round received by the IPO firm, and about 90% of the lead VC firms started their investment in the
first three VC financing rounds received by the IPO firm.

22

VC firm characteristics or unobservable time-invariant VC characteristics. Even though these

characteristics affect the VC firms attitudes towards early failure as shown in Table 2, they
generally do not have any significant and direct effect on innovation.

5.2.3 Persistence of the Failure Tolerance Effect

Our last set of robustness tests is related to the persistence of the failure tolerance effect.
Economic theories suggest that a corporate culture, once formed, can persist over time (see e.g.,
Lazear 1995, Akerlof and Kranton 2000, 2005). This implies that a corporate culture should have
a persistent effect on corporate decisions and performances. Our empirical approach to the effect
of corporate culture hinges on the idea that a VC firms attitude towards early failure has a
profound impact on the formation of a failure-tolerant culture in the entrepreneurial firms backed
by the VC firm.
However, VC investors do not stay forever in the IPO firms they invest in. Existing
studies show that VC investors on average cash out about 70% of their investment in an IPO firm
within two years after the IPO (see, e.g., Gompers and Lerner 1998). If the VC investors
tolerance for failure is not internalized into the corporate culture of the entrepreneurial firm, then
we should expect the effect of failure tolerance to wane after the VC investors exit their
investment. In this case, the failure tolerance effect we have documented simply reflects a
transitory VC investor influence, not the effect of a corporate culture. As Hermalin (2001) puts it,
corporate culture resides with the firm, not an individual.
Our full sample panel regression analysis includes innovations generated long after a
firms IPO and after the exit of venture capital investment. 13 In the Fama-Macbeth approach, we
run year by year regressions and then take the average failure tolerance effect across years. This
approach tells us whether the failure tolerance effect is stable over time. Both approaches give us
a significant failure tolerance effect during the entire sample period, and thus provide some
support for a persistent cultural effect.
To further check the persistence of the failure tolerance effect as an IPO firm ages, in
Table 6 we restrict the sample to firms that existed for at least seven years after their IPOs. We
then examine how the failure tolerance effect on innovation evolves within the first seven years

13

In our sample we have nonzero patent and citation data for 1,513 firms that went public between 1985 and 2006.
We have nonzero patent and citation data for 693 of these firms more than four years after their IPOs and up to 22
years after IPO.

23

after these firms IPOs. 14 The sample restriction mitigates the survivorship bias when we
compare the effect over time.
Models (1)(3) of Panel A report the average failure tolerance effect on patent counts for
the same set of firms in the first two years, five years, and seven years after their IPOs,
respectively. Panel B reports the results for the number of citations per patent. We find that the
failure tolerance effects on both patent counts and patent quality are positive and significant in
all three windows. This suggests that the effect persists for at least seven years after IPO and five
years after the bulk of the venture capital investment exits.
It is true that there is some attenuation in the magnitude of the failure tolerance effect
over time. In both panels the effect is the strongest in the first two years, and then it gradually
declines as we extend the window. However, the differences across the three windows are not
statistically significant, as shown in the bottom row of each panel. Also, some attenuation can be
expected and can still be consistent with a persistent cultural effect. As a firm matures over time,
its operational focus may gradually shift from innovation to standard mass production.
Overall, our analysis suggests that the failure tolerance effect on firm innovation persists
after VC firms exit the IPO firms. This implies that the failure tolerance effect we document does
not simply reflect a transitory influence of VC firms. VC firms attitude towards failure seems to
be internalized by the IPO firms they invest in.

5.3 Difficulty of Innovation and Effect of Failure Tolerance

Failure tolerance is critical in motivating innovation because exploration of new methods

often involves a large chance of early failure compared to exploitation of well-known methods.
This insight implies that in industries in which innovation is more difficult to achieve (i.e., the
chance of failure is high), having a corporate culture that tolerates failure is more important for
innovation productivity.
Different types of patents can involve different degrees of difficulty. Following the work
of Hall, Jaffe, and Trajtemberg (2005), we classify patents in our sample into four categories
based on the nature of the patents: (1) drugs, medical instrumentation, and chemicals; (2)
14

We choose seven years as our cutoff for two reasons. First, if VC firms largely cash out of the IPO firms within
two years after the IPOs as shown in Gompers and Lerner (1998), then we still have at least five years to examine
the persistence of the failure tolerance effect. Second, this cutoff leaves us with a good sample size for the analysis.
We have used other cutoffs such as five years, eight years and ten years, and results are similar.

24

computers, communications, and electrical; (3) software programming; (4) other miscellaneous
patents. 15 If a firm has no patent, then we classify it into one of the above four categories based
on the most frequent type of patents produced by the firms 3-digit SIC industry. For example, if
a firm in the industry with 3-digit SIC 283 has no patent in our sample period, then it is classified
under category (1) because 77% of the patents generated by the firms industry are related to
drugs and chemicals.
Common sense suggests that among the above four categories patents of new drugs are
probably the most difficult to produce. A new drug development process involves many steps
requiring different levels of experimentation. Existing studies suggest that the cost of developing
a new drug varies from $500 million to $2 billion (see, e.g., Adams and Brantner 2006). Hall,
Jaffe, and Trajtemberg (2005) also show that the market value impact of drug patents is much
higher than that of all other types of patents. Thus we expect that having a failure-tolerant culture
is most important in industries producing new drugs.
Table 7 reports the baseline regressions within each patent category. Panel A shows that
in each category a failure-tolerant culture has a significantly positive effect on patent generation.
But as we have expected, the effect of failure tolerance is the strongest in industries producing
drugs, medical instrumentation, and chemical patents. The elasticity of patents to failure
tolerance is 0.743 in category (1), almost triples the effect in the computers and electrical
category (0.255), and almost quadruples the effect in the software programming category (0.190).
As shown in the bottom row of Panel A, the differences in the failure tolerance effect between
category (1) and other categories are highly statistically significant. Table 7 Panel B shows
similar results for citations per patent. Failure tolerance is most important for patent quality in
industries producing drugs-related patents.
In sum, the results in Table 7 suggest that having a more failure-tolerant corporate culture
is more important for innovation productivity when innovation is more difficult to achieve. This
cross-sectional comparison provides further support for our empirical measure of failure
15

Hall, Jaffe, and Trajtemberg (2005) have six categories: chemicals, drugs and medical instrumentation, computers
and communications, electrical, metals and machinery, and miscellaneous. We group chemicals with drugs because
we only have a few observations of chemical patents. Software programming patents (computer-related patents
generated by the 3-digit SIC industry 737) belong to the computers and communications category. For finer
comparisons between different types of patents, we single out software programming. We then group patents related
to computer hardware, communications, and electrics together. Finally, we group metals, machinery and
miscellaneous together because we do not have many observations of these patents and label this category as
miscellaneous patents.

25

tolerance and the recent theories on motivating innovation.

6. STANDARD INCENTIVE SCHEME AND FAILURE TOLERANCE

Economic theories suggest that although the standard incentive scheme such as pay-forperformance is effective at motivating effort on standard tasks, it can fail to motivate innovation
(see, e.g., Manso 2008). In Table 8 we contrast the role of the standard incentive scheme with
that of failure tolerance in motivating innovation.
In the classical corporate finance literature (e.g., Holmstrom 1982), insider equity
ownership plays an important role in the motivation of efforts. Thus we use insider equity
ownership as our proxy for the standard incentive scheme. Compact Disclosure database
provides annual data of equity ownership of executive officers and directors for a large fraction
of our IPO firms in our sample period. 16 Also, insiders generally still hold significant amount of
their firms equity at IPO and for some years after IPO. The average insider ownership in the
first two years after IPO in our sample is 25%. This implies that equity ownership should
account for the bulk part of the total equity incentives provided to executive officers and
directors. To facilitate the interpretation of the regression results, we use the logarithm of insider
ownership as our independent variable.
Model (1) of Table 8 shows that insider ownership is negatively related to the number of
patents generated by a firm. The elasticity of patent counts to insider ownership is 0.073 and is
statistically significant. 17 In model (2) we include our failure tolerance measure. Insider
ownership still has a significantly negative association with innovation, while failure tolerance
has a significantly positive effect as we have shown before.
In models (3)(4) we find similar contrasting effects of insider ownership and failure
tolerance on patent quality. While a failure-tolerant corporate culture contributes to high-impact

16

Publicly traded companies in the United States are required to report equity ownership of executive officers and
directors in their annual proxy statements. The equity ownership includes equity shares held by officers and
directors, underlying shares in their vested stock options, and underlying shares in their stock options exercisable
within 60 days of the reporting date. Annual compensation data for most of our IPO firms is not available. Thus we
cannot include the full incentive effect of stock options. However, we believe that the insider ownership data should
capture the bulk part of total equity incentives provided to executive officers and directors.
17
In an unreported regression we add a firm-fixed effect in model 1 of Table 8. We find that Ln(Insider Ownership)
is still negatively and significantly related to Ln(Patents). The elasticity of patents to insider ownership is -0.038 (pvalue=0.012).

26

patents, insider equity ownership fails to do so.18

In unreported regressions we also examine whether the insider ownership effect on
innovation is nonlinear. When using a quadratic specification for insider ownership, we find no
nonlinearity in the effect on patent counts and a convex effect on citations per patent (but not a
U-shape effect). When using a spline regression with cutoffs being 5% and 25% (Morck, Shleifer
and Vishny 1988), we again find no nonlinearity in the effect on patent counts. The effect of
insider ownership on citations per patent is significantly negative when insider ownership is
between 5% and 25%, and is positive and insignificant in the lowest and the highest regions. In
both specifications, the effect of failure tolerance is always positive and significant.
In another unreported robustness test, we restrict our analysis to the period before 1993.
Stock options were not as commonly used back then, and insider equity ownership should be a
more precise measure of executives total equity incentives. We find that insider ownership is
still negatively related to patent generation (coefficient estimate= 0.091, p-value=0.04) and
citations per patent (coefficient estimate= 0.07, p-value=0.21).
Taken together, our findings in Table 8 are consistent with the implications in existing
economic theories that while tolerance for failure is critical in encouraging innovation, standard
incentive scheme such as insider equity ownership can fail to spur innovation. Clearly, insider
ownership is not as exogenous as our failure tolerance measure. Thus we do not claim any causal
effect of insider ownership on a firms innovation productivity.

7. FAILURE TOLERANCE AND FIRM VALUE

In Sections 5 and 6 we show that a failure-tolerant corporate culture motivates corporate

innovation. Does failure tolerance increase firm value? Is such a culture generally good for a
firm no matter whether innovation is important for the firm?
In Table 9 we examine the effect of failure tolerance on firm value measured by Tobins
Q. We measure Q at the first fiscal year end after IPO. To be consistent in our economic
18

Lerner and Wulf (2006) examine the relationship between the average long-term incentives (the sum of restricted
stock grants and stock option grants as a fraction of total expected compensation) given to corporate R&D heads and
the average innovation productivity of the firm (measured by the average patents granted, the average citations
received, and the originality of patents) in a cross-section of 278 large firms. They find a positive relationship
between long-term incentives given to R&D heads and innovation in 177 firms with centralized R&D organization,
but long-term incentives given to CEOs, CFOs, and human resource heads in those firms are negatively and
insignificantly related to innovation. Our insider equity ownership data is more likely to capture equity incentives of
CEOs and CFOs, and thus our results are consistent with their findings.

27

interpretation, we use the natural logarithm of Tobins Q as the dependent variable and the
natural logarithm of failure tolerance as the independent variable. To see whether failure
tolerance is more important for firms in more innovative industries, we calculate two industry
level measures. Ind. Total Patents is the total number of patents in the entire sample period by
4-digit SIC industries. Ind. Total Citations is the total number of citations in the entire sample
period by 4-digit SIC industries. A higher value of Ind. Total Patents or Ind. Total Citations
indicates a more innovative industry.
Model (1) of Table 9 shows that after controlling for other firm characteristics, firms with
a failure-tolerant culture have weakly higher firm value. The elasticity of firm value to failure
tolerance is 0.081 and is marginally significant.
Next, we allow the effect of failure tolerance on firm value to vary with the importance of
innovation in an industry. We expect investors to value failure tolerance more in industries in
which innovation is more pertinent. Thus in model (2) we include the interaction between failure
tolerance and the logarithm of Ind. Total Patents. The direct effect of failure tolerance becomes
negative and insignificant (0.077). But the interaction effect is positive and significant (0.027).
This implies that failure tolerance does not increase firm value in less innovative industries. The
effect of failure tolerance on firm value increases with the importance of innovation in an
industry. In model (3) we find similar effects when using Ind. Total Citations to identify more
innovative industries.
To see the economic impact of the interaction effect on firm value, let us consider one of
the drugs industriesthe 4-digit SIC industry of 2834. The total patent count in this industry in
our sample period is 1,124. Model (2) implies that the elasticity of Q to failure tolerance in this
industry is 0.19 (= 0.027Ln(1,124)). An average firm in this industry has book assets of $143
million and Tobins Q of 4.4. Thus a ten percent increase in failure tolerance can increase the
market value of the average firm by about $20 million (=10%0.19%1434.4). 19
In addition, the direct effect of Ln(Ind. total Patents) and Ln(Ind. Total Citations) are
significantly positive (0.044 in model (2) and 0.043 in model (3)), implying that firm value is on
average higher in more innovative industries. This is consistent with the findings in the existing
literature (see, e.g., Hall 2000).
19

In this calculation we treat the coefficient estimate of Ln(Failure Tolerance) as zero because it is insignificantly
different from zero. If we treat it as it is (-0.077), then the market value impact of a 10% increase in failure tolerance
for the average firm is $7 million.

28

Overall, our analysis suggests that a failure-tolerant corporate culture increases firm value
through its impact on innovation. Failure tolerance increases a firms innovation productivity,
which in turn increases firm value. This link is more pertinent in industries where innovation is
more important.

8. CONCLUSION

In this paper, we examine whether tolerance for failure, an important aspect of corporate
culture, spurs corporate innovation and increases firm value based on a sample of VC-backed
IPO firms between 1985 and 2006. We develop a novel firm-specific measure of a failuretolerant corporate culture. Our key idea is that the formation of corporate culture is largely
determined by the attitudes and beliefs of its first-generation insiders, namely, founders and early
active investors. VC investors are such investors. Thus their attitudes towards failures should
have a profound impact on the formation of a failure-tolerant culture in the entrepreneurial firms
they invest in. In other words, the entrepreneurial firms can inherit or internalize their VC
investors failure tolerance.
Our firm-level failure tolerance measure allows us to directly test the key implications in
the recent theoretical literature on motivating innovation. Our empirical analysis generates a
number of interesting new findings. First, firms with a more failure-tolerance culture are
significantly more innovative. The failure tolerance effect is persistent and robust to including
other VC firm characteristics such as VC firms experience and industry expertise and lead VC
firm fixed effects. Second, we examine the cross-sectional effect of failure tolerance and find
that its effect on firm innovation is stronger in industries in which innovation is more difficult to
achieve. Third, we contrast the effect of standard incentive schemes such as insider equity
ownership with the effect of a failure-tolerant corporate culture in motivating innovation. We
find that while failure tolerance spurs innovation, large insider equity ownership is negatively
related to a firms innovation productivity. Finally, we find that a failure-tolerant corporate
culture increases firm value in industries in which innovation is important. Overall, our findings
are consistent with the theory implications in the corporate innovation literature that tolerance for
failure can motivate corporate innovation and increase firm value.

29

Our paper also contributes to the literature on corporate culture. This literature has
remained mostly theoretical because empirically identifying the corporate culture effect is very
challenging. Our paper is the first attempt at measuring a specific aspect of corporate culture, and
our work provides empirical evidence that corporate culture does matter in significant ways for
firms decisions and performances.

30

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35

Appendix: Variable Definitions and Data Sources

Failure Tolerance and Other VC Characteristics

Failure Toleranceit

The average number of years VC firm i invested in its projects that were
initiated in or after year 1980 and eventually failed in or before year t
(Source: Venture Economics)

Past Amount
Investedit

The total dollar amount invested by VC firm i since 1980 up to year t

(Source: Venture Economics)

Past Firms Investedit

The total number of firms VC firm i has invested in since 1980 up to

year t (Source: Venture Economics)

Past Fund Raisedit

The total dollar amount raised by VC firm i since 1965 up to year t

(Source: Venture Economics)

VC Ageit

Age of VC firm i in year t measured as the number of years since its date
of inception (Source: Venture Economics)

Investment
Concentrationit

Investment concentration index of VC firm i in year t measured as the

sum of the squared deviations of the weights (the number of portfolio
firms) for each of the 18 different industries held by the VC firm i
relative to the industry weights of the total venture investment (Source:
Venture Economics)

Past Successful
Exitit

The proportion of entrepreneurial firms financed by VC firm i that either

went public or were acquired between year 1980 and year t (Source:
Venture Economics)

Past IPO Exitit

The proportion of entrepreneurial firms financed by VC firm i that went

public between year 1980 and year t (Source: Venture Economics)

Local Competitionit

The number of VC firms located within the same zip code of VC firm i
in year t (Source: Venture Economics)

Industry Fund
Inflowt

The total dollar amount raised by all VC firms in year t (Source:

Venture Economics)

Innovation Variables
Patentit

Number of patents firm i applied for in year t. Only patents that were
later granted are included. The variable is also corrected for the
truncation bias in patents granted towards the end of the sample using
the weight factors provided by Hall, Jaffe, and Trajtenberg (2001,
2005). The weight factors are computed from an application-grant
empirical distribution. (Source: NBER Patent Data)

36

Citations/Patent it

The average number of citations per patent of firm i applied for in year t
(Source: NBER Patent Data)

IPO Firm Characteristics

Tobins Q it

Market to book ratio of firm i in year t: (total assets + year end closing
price*year end outstanding shares - book equity)/total assets (Source:
Compustat)

Sales it

Sales by firm i in year t (in $million) (Source: Compustat)

Assets it

Total assets of firm i in year t (in $million) (Source: Compustat)

ROA it

Operating income before depreciation to total assets ratio of firm i in

year t (Source: Compustat)

R&D/Assets it

Research and Development expenditure to total assets ratio of firm i in

year t (Source: Compustat)

CapExp/Assets it

Capital expenditure to total assets ratio of firm i in year t (Source:

Compustat)

Leverage it

Total debt of firm i in year t divided by its total assets (Source:

Compustat)

Firm Age it

Age of firm i in year t since its IPO (Source: SDC)

PPE/Asset it

Net property, plants and equipments to assets ratio of firm i in year t

(Source: Compustat)

Institutional
Ownership it

Total percentage of firm is equity held by institutional investors in year

t (Source: Thomson Financial 13f institutional holdings database)

Insider Ownershipit

Total percentage of firm is equity held by officers and board of

directors in year t (Source: Compact Disclosure)

Herfindahl Index it

Herfindahl index of firm is industry in year t constructed based on sales

at 4-digit SIC industries (Source: Compustat)

37

Table 1: Summary Statistics for the VC Sample

This table reports the summary statistics for variables constructed based on our venture capital
sample. The VC sample contains investments made by 2,857 VC firms from year 1980 to 2006.
All the variables listed below are time varying characteristics of a VC firm or the conditions of
the entire VC industry.
Variable
Failure Tolerance
Other VC Characteristics
Past Amount Invested (mil.)
Past Firms Invested
Past Fund Raised (mil.)
VC Age
Investment Concentration
Past Successful Exit (%)
Past IPO Exit (%)
Local Competition
VC Industry Conditions
Industry Fund Inflow (bil.)

25%
0.72

Median
1.23

Mean
1.41

75%
1.89

Std. Dev.
0.97

N
18,993

11.25
3.00
27.00
2.00
0.08
25.00
0
1.00

58.40
8.00
81.20
5.00
0.28
60.00
8.33
2.00

394.89
23.98
234.39
7.51
0.37
52.82
16.18
7.40

263.15
23.00
219.40
11.00
0.72
77.76
24.05
7.00

1298.07
50.14
558.41
8.04
0.33
34.41
22.74
12.37

35,662
35,662
16,128
28,789
34,270
35,689
35,689
27,256

8.37

32.41

41.93

57.03

41.93

35,689

38

Table 2: Failure Tolerance and VC Characteristics

The dependent variable is natural logarithm of a VC firms Failure Tolerance in a given year.
Portfolio firm industry fixed effects refer to the industry a VC firm invests in. If a VC firm
invests in multiple industries in a given year, we choose the industry in which the VC firm
invests the largest amount of capital in that year for the industry fixed effect. Coefficient
estimates and the Huber-White-Sandwich robust standard errors clustered by VC firm (in
parentheses) are reported. ***, ** and * indicate significance at 1%, 5% and 10% levels
respectively.

Ln(Past Amount Invested)

(1)
0.034***
(0.007)

Ln(Past Firms Invested)

(2)

(3)

0.023*
(0.012)

Ln(Past Fund Raised)

0.020***
(0.004)

Ln(VC Age)
Investment Concentration
Past Successful Exit (%)
Local Competition
Ln(Industry Fund Inflow 1 year prior)
Ln(Industry Fund Inflow 2 years prior)
Constant
VC firm fixed effects
Portfolio firm industry fixed effects
Year fixed effects
Observations
R2

(4)

0.033***
(0.008)
-0.004
(0.011)
0.023***
(0.009)
-0.016***
(0.004)
0.017
(0.016)
0.680***
(0.137)
Yes
Yes
Yes
18,159
0.151

39

0.026***
(0.008)
0.007
(0.011)
0.026***
(0.009)
-0.002
(0.006)
0.023**
(0.009)
0.551***
(0.154)
Yes
Yes
Yes
18,159
0.144

0.025***
(0.008)
0.009
(0.011)
0.024***
(0.009)
-0.003
(0.006)
0.022***
(0.008)
0.584***
(0.148)
Yes
Yes
Yes
18,159
0.150

-0.002
(0.011)
0.019**
(0.008)
0.014
(0.011)
0.028***
(0.009)
-0.030***
(0.004)
0.061***
(0.015)
0.535***
(0.138)
Yes
Yes
Yes
18,159
0.143

Table 3: Summary Statistics for the IPO Sample

Panel A: Failure Tolerance and Other VC Characteristics

Variable
Failure Tolerance
Past Amount invested (mil.)
Past Firms invested
Past Fund Raised (mil.)
VC Age
Investment Concentration
Past Successful Exit (%)
Past IPO Exit (%)
Local Competition

25%
1.32
123.92
17.62
53.77
5.81
0.04
63.26
17.85
2.18

Median
1.76
402.93
37.65
167.95
10.54
0.10
70.24
23.81
4.76

Mean
1.80
819.71
56.60
425.65
11.20
0.14
64.71
24.38
6.96

75%
2.26
882.87
70.97
398.64
15.47
0.17
75.55
30.16
9.00

Std. Dev.
0.69
1595.73
64.18
1047.76
7.38
0.15
21.33
13.06
7.28

N
1,848
1,848
1,848
1,848
1,848
1,848
1,848
1,848
1,848

Panel B: Innovation

Variable
Full Sample
Patents
Citations/Patent
Sub-sample with patents > 0
Patents
Citations/Patent

25%

Median

Mean

75%

Std. Dev.

0
0

0
0

3.11
2.54

1
0

23.71
11.56

19,437
19,437

1.04
0

3
2.55

11.48
9.39

7.25
8.91

44.51
20.72

5,264
5,264

Panel C: Control Variables

Variable
Tobins Q
Sales (mil.)
Assets (mil.)
ROA (%)
R&D/Assets (%)
CapExp/Assets (%)
Leverage (%)
Firm Age
PPE/Assets (%)
Institutional Ownership (%)
Insider Ownership (%)
Herfindahl Index

Mean
3.01
375.07
485.46
-10.43
14.06
6.15
34.64
2.91
17.36
37.58
19.07
0.24

Median
2.08
51.77
76.78
3.81
6.98
4.00
25.80
2.00
11.19
32.31
12.30
0.11

40

Std. Dev.
2.94
2122.73
2583.134
42.17
21.12
6.70
34.83
5.11
17.46
29.01
20.52
0.31

N
14,230
16,653
16,715
16,521
19,437
16,371
19,437
19,437
16,670
13,061
10,420
19,437

Table 4: Failure Tolerance and Corporate Innovation

The dependent variable is the natural logarithm of the number of patents in a year in models (1)
and (2), and is the natural logarithm of the number of citations per patent in a year in models (3)
and (4). Patents>0 refers to the subsample of firms with at least one patent during our sample
period. Coefficient estimates and the Huber-White-Sandwich robust standard errors clustered by
IPO firm (in parentheses) are reported. Industry fixed effect is by 2-digit SIC industries. ***, **
and * indicate significance at 1%, 5% and 10% levels respectively.

Ln(Failure Tolerance)
Ln(Sales)
ROA
R&D/Assets
CapExp/Assets
Leverage
Tobins Q
Institutional Ownership
Firm Age
PPE/Assets
Herfindahl Index
Constant
Industry fixed effects
Year fixed effects
Observations
R2

Ln(Patents)
Full Sample
Patents>0
(1)
(2)
0.258**
0.422***
(0.113)
(0.159)
0.097***
0.117***
(0.019)
(0.022)
0.677***
0.564***
(0.141)
(0.197)
1.520***
1.052***
(0.286)
(0.356)
2.017***
3.071***
(0.586)
(0.919)
-0.813***
-0.689***
(0.162)
(0.237)
0.093***
0.072***
(0.015)
(0.017)
1.006***
1.436***
(0.188)
(0.257)
0.058***
0.035
(0.018)
(0.024)
0.124
0.255
(0.361)
(0.563)
-0.252
-0.144
(0.181)
(0.279)
0.149
0.496
(0.607)
(0.836)
Yes
Yes
Yes
Yes
11,994
7,607
0.315
0.257

41

Ln(Citations/Patent)
Full Sample
Patents>0
(3)
(4)
0.201**
0.310**
(0.093)
(0.122)
0.030**
0.032**
(0.014)
(0.015)
0.388***
-0.014
(0.125)
(0.174)
1.066***
0.223
(0.248)
(0.310)
1.259**
1.968**
(0.584)
(0.880)
-0.755***
-0.691***
(0.133)
(0.195)
0.071***
0.040***
(0.012)
(0.014)
0.812***
1.142***
(0.145)
(0.188)
0.016
-0.013
(0.010)
(0.013)
-0.078
-0.198
(0.317)
(0.461)
-0.095
0.144
(0.158)
(0.225)
-3.139**
-4.235***
(1.386)
(0.508)
Yes
Yes
Yes
Yes
11,994
7,607
0.253
0.261

Table 5: Controlling for Other VC Characteristics

In this table we control for other observable VC firm characteristics and lead VC firm fixed effects. Coefficient
estimates and the Huber-White-Sandwich robust standard errors clustered by IPO firm (in parentheses) are reported.
***, ** and * indicate significance at 1%, 5% and 10% levels respectively.

Panel A: Controlling for Observable VC Characteristics

Dependent Variable: Ln(Patents)
Ln(Failure Tolerance)
Investment Concentration
Past Successful Exit
Local Competition
Ln(Past Amount Invested)

(1)
0.239**
(0.117)
0.203
(0.434)
0.205
(0.401)
0.083
(0.072)
-0.003
(0.050)

Ln(Past Firms Invested)

(2)
0.267**
(0.118)
0.024
(0.459)
0.393
(0.391)
0.102
(0.071)

(3)
0.251**
(0.119)
0.182
(0.402)
0.243
(0.311)
0.088
(0.070)

(4)
0.299**
(0.117)
0.068
(0.397)
0.515
(0.345)
0.103
(0.068)

-0.060
(0.076)

Ln(Past Fund Raised)

-0.014
(0.034)

Ln(VC Age)
Controls, industry, and year fixed effects
Observations
R2

Yes
11,994
0.316

Yes
11,994
0.317

Yes
11,994
0.316

-0.155*
(0.087)
Yes
11,994
0.317

Dependent Variable: Ln(Citation/Patents)

Ln(Failure Tolerance)

(1)
0.199**
(0.100)
0.096
(0.336)
0.219
(0.305)
0.105*
(0.056)
-0.031
(0.037)

(2)
0.222**
(0.101)
-0.056
(0.352)
0.336
(0.293)
0.114**
(0.055)

(3)
0.211**
(0.100)
0.137
(0.316)
0.175
(0.254)
0.101*
(0.053)

(4)
0.239**
(0.099)
0.068
(0.309)
0.366
(0.270)
0.108**
(0.054)

Investment Concentration
Past Successful Exit
Local Competition
Ln(Past Amount Invested)
Ln(Past Firms Invested)

-0.083
(0.054)

Ln(Past Fund Raised)

-0.031
(0.027)

Ln(VC Age)
Controls, industry, and year fixed effects
Observations
R2

Yes
11,994
0.254

42

Yes
11,994
0.255

Yes
11,994
0.254

-0.149**
(0.066)
Yes
11,994
0.255

Panel B: Controlling for Observable VC Characteristics and Lead VC Fixed-Effects

Dependent Variable: Ln(Patents)
Ln(Failure Tolerance)
Investment Concentration
Past Successful Exit
Local Competition
Ln(Past Amount Invested)

(1)
0.227*
(0.125)
0.207
(0.432)
0.441
(0.432)
0.084
(0.075)
-0.031
(0.052)

Ln(Past Firms Invested)

(2)
0.247**
(0.125)
0.006
(0.447)
0.633
(0.422)
0.102
(0.073)

(3)
0.246**
(0.125)
0.232
(0.397)
0.454
(0.330)
0.085
(0.073)

(4)
0.270**
(0.125)
0.161
(0.395)
0.701*
(0.370)
0.104
(0.072)

-0.105
(0.078)

Ln(Past Fund Raised)

-0.045
(0.039)

Ln(VC Age)
Controls, industry, and year fixed effects
Lead VC fixed effects
Observations
R2

Yes
Yes
11,994
0.354

Yes
Yes
11,994
0.354

Yes
Yes
11,994
0.354

-0.204**
(0.096)
Yes
Yes
11,994
0.355

Dependent Variable: Ln(Citation/Patents)

Ln(Failure Tolerance)

(1)
0.185*
(0.109)
0.177
(0.349)
0.335
(0.334)
0.074
(0.065)
-0.039
(0.041)

(2)
0.203*
(0.109)
-0.001
(0.361)
0.490
(0.320)
0.087
(0.064)

(3)
0.214**
(0.109)
0.199
(0.325)
0.373
(0.270)
0.079
(0.062)

(4)
0.217**
(0.109)
0.178
(0.320)
0.494*
(0.290)
0.083
(0.063)

Investment Concentration
Past Successful Exit
Local Competition
Ln(Past Amount Invested)
Ln(Past Firms Invested)

-0.105*
(0.060)

Ln(Past Fund Raised)

-0.062*
(0.032)

Ln(VC Age)
Controls, industry, and year fixed effects
Lead VC fixed effects
Observations
R2

Yes
Yes
11,994
0.274

43

Yes
Yes
11,994
0.274

Yes
Yes
11,994
0.275

-0.176**
(0.075)
Yes
Yes
11,994
0.275

Table 6: Persistence of the Failure Tolerance Effect

The dependent variable is the natural logarithm of the number of patents in a year in Panel A, and is the
natural logarithm of the number of citations per patent in Panel B. Firm Age is the number of years
since the IPO year. All regressions are our baseline regressions as in Table 4, but are restricted to firms
that existed for at least seven years after IPO (i.e., Firm Age7). The bottom row of each panel reports the
results from the Chi-square test of the difference in the failure tolerance effect between Model (1) and
another model. Coefficient estimates and the Huber-White-Sandwich robust standard errors clustered by
IPO firm (in parentheses) are reported. Industry fixed effect is by 2-digit SIC industries. ***, ** and *
indicate significance at 1%, 5% and 10% levels respectively.

Panel A: Ln(Patents)

Ln(Failure Tolerance)
Ln(Sales)
ROA
R&D/Assets
CapExp/Assets
Leverage
Tobins Q
Institutional Ownership
Firm Age
PPE/Assets
Herfindahl Index
Constant
Industry fixed effects
Year fixed effects
Observations
R2
Comparison of failure tolerance
effect with (1) (p-value)

(1)
Firm Age 2
0.359**
(0.161)
0.060*
(0.034)
0.401
(0.328)
2.270***
(0.702)
1.508
(1.239)
-0.585
(0.359)
0.087***
(0.022)
0.414
(0.299)
-0.677
(0.692)
-0.431
(0.279)
0.060*
(0.034)
-3.615*
(2.024)
Yes
Yes
1,910
0.323

44

(2)
Firm Age 5
0.314**
(0.149)
0.090***
(0.027)
0.678***
(0.259)
1.771***
(0.528)
1.478
(0.941)
-0.734**
(0.304)
0.107***
(0.018)
0.977***
(0.228)
0.028
(0.553)
-0.243
(0.249)
0.090***
(0.027)
-3.407*
(1.996)
Yes
Yes
3,831
0.323
-0.045
(0.584)

(3)
Firm Age 7
0.289**
(0.139)
0.100***
(0.024)
0.798***
(0.231)
1.751***
(0.456)
1.213
(0.862)
-0.770***
(0.248)
0.116***
(0.017)
0.919***
(0.207)
0.281
(0.492)
-0.295
(0.233)
0.100***
(0.024)
-3.140
(1.920)
Yes
Yes
5,114
0.309
-0.070
(0.449)

Panel B: Ln(Citations/Patent)

Ln(Failure Tolerance)
Ln(Sales)
ROA
R&D/Assets
CapExp/Assets
Leverage
Tobins Q
Institutional Ownership
Firm Age
PPE/Assets
Herfindahl Index
Constant
Industry fixed effects
Year fixed effects
Observations
R2
Comparison of failure
tolerance effect with (1)
(p-value)

(1)
Firm Age 2
0.323*
(0.178)
0.047
(0.035)
0.210
(0.363)
1.388*
(0.728)
2.427*
(1.382)
-1.152***
(0.384)
0.108***
(0.028)
0.497
(0.376)
-1.115
(0.746)
-0.218
(0.325)
0.323*
(0.178)
-3.051
(1.980)
Yes
Yes
1,910
0.252

45

(2)
Firm Age 5
0.298**
(0.149)
0.053**
(0.026)
0.390
(0.265)
1.049**
(0.529)
2.055**
(0.989)
-0.994***
(0.335)
0.122***
(0.021)
0.638***
(0.247)
-0.439
(0.570)
-0.058
(0.280)
0.298**
(0.149)
-2.919*
(1.757)
Yes
Yes
3,831
0.240
-0.025
(0.796)

(3)
Firm Age 7
0.257*
(0.135)
0.053**
(0.023)
0.515**
(0.228)
1.194***
(0.425)
1.971**
(0.934)
-1.035***
(0.260)
0.129***
(0.020)
0.453**
(0.214)
-0.140
(0.485)
-0.134
(0.253)
0.257*
(0.135)
-2.348
(1.654)
Yes
Yes
5,114
0.233
-0.066
(0.541)

Table 7: Difficulty of Innovation and the Effect of Failure Tolerance

The dependent variable is the natural logarithm of patents in a year in Panel A, and is the natural
logarithm of citations per patent in Panel B. The patents categories are based on the
classifications in Hall, Jaffe, and Trajtemberg (2005). The bottom row of each panel reports the
results from the Chi-square test of the difference in the failure tolerance effect between category
(1) and another patent category. Coefficient estimates and the Huber-White-Sandwich robust
standard errors clustered by IPO firm (in parentheses) are reported. ***, ** and * indicate
significance at 1%, 5% and 10% levels respectively.
Panel A: Ln(Patents)

Drugs &
Computers &
Chemical (1) Electrical (2)
Ln(Failure Tolerance)
0.743**
0.255**
(0.306)
(0.102)
Ln(Sales)
0.021
0.249***
(0.018)
(0.039)
ROA
0.774***
1.547***
(0.240)
(0.238)
R&D/Assets
2.165***
5.440***
(0.395)
(0.479)
CapExp/Assets
2.866**
2.779**
(1.329)
(1.082)
Leverage
-0.680**
-1.500***
(0.309)
(0.185)
Tobins Q
0.058**
0.121***
(0.026)
(0.019)
Institutional Ownership
0.835**
1.366***
(0.356)
(0.227)
Firm Age
0.019
0.132***
(0.025)
(0.015)
PPE/Assets
-1.854**
-0.924**
(0.749)
(0.418)
Herfindahl Index
-1.401***
-0.842***
(0.421)
(0.160)
Constant
-5.070***
-9.562***
(0.472)
(0.742)
Year fixed effects
Yes
Yes
Observations
3,177
3,580
R2
0.207
0.243
Comparison of Failure
-0.488***
(0.004)
Tolerance effect with (1)
(p-value)

46

Software
(3)
0.190**
(0.076)
0.210***
(0.038)
0.291*
(0.149)
0.754**
(0.319)
0.828
(1.294)
-0.982***
(0.170)
0.161***
(0.016)
0.110
(0.228)
0.082***
(0.016)
0.786
(0.717)
0.717**
(0.339)
-9.098***
(0.635)
Yes
2,911
0.155
-0.553***
(<0.001)

Miscellaneous
(4)
0.313***
(0.091)
0.071*
(0.038)
0.737**
(0.369)
10.458***
(1.153)
-0.899
(0.747)
-1.300***
(0.192)
0.066**
(0.032)
0.194
(0.212)
0.082***
(0.015)
-0.680***
(0.254)
-0.593***
(0.133)
-4.258***
(0.876)
Yes
2,277
0.296
-0.430***
(0.004)

Panel B: Ln(Citations/Patent)

Drugs &
Computers &
Chemical (1) Electrical (2)
Ln(Failure Tolerance)
0.576**
0.199**
(0.225)
(0.101)
Ln(Sales)
-0.003
0.074***
(0.016)
(0.027)
ROA
0.099
1.321***
(0.221)
(0.220)
R&D/Assets
0.739**
4.807***
(0.337)
(0.440)
CapExp/Assets
3.039**
1.328
(1.332)
(1.072)
Leverage
-0.643***
-1.183***
(0.234)
(0.166)
Tobins Q
0.027
0.072***
(0.023)
(0.019)
Institutional ownership
0.278
1.073***
(0.280)
(0.207)
Firm Age
0.027
0.019
(0.017)
(0.012)
PPE/Assets
-2.344***
-0.505
(0.605)
(0.401)
Herfindahl Index
-0.855**
-0.544***
(0.338)
(0.155)
Constant
-4.543***
-6.406***
(0.382)
(0.543)
Year fixed effects
Yes
Yes
Observations
3,177
3,580
R2
0.249
0.189
Comparison of Failure
-0.377**
(0.017)
Tolerance effect with (1)
(p-value)

47

Software
(3)
0.177**
(0.088)
0.104***
(0.026)
0.343**
(0.169)
0.696*
(0.362)
0.809
(1.493)
-0.932***
(0.163)
0.151***
(0.020)
0.573***
(0.208)
0.027**
(0.013)
1.003
(0.776)
0.971**
(0.402)
-7.460***
(0.481)
Yes
2,911
0.132
-0.399***
(0.008)

Miscellaneous
(4)
0.185**
(0.089)
0.019
(0.037)
0.720*
(0.384)
9.389***
(1.152)
-0.388
(0.791)
-1.066***
(0.186)
0.011
(0.032)
0.358*
(0.203)
0.057***
(0.014)
-0.918***
(0.255)
-0.623***
(0.134)
-3.785***
(0.700)
Yes
2,277
0.262
-0.391**
(0.010)

Table 8: Insider Ownership, Failure Tolerance and Corporate Innovation

The dependent variable is the natural logarithm of patent counts in a year in models (1) and (2),
and is the natural logarithm of citations per patent in models (3) and (4). Coefficient estimates
and the Huber-White-Sandwich robust standard errors clustered by IPO firm (in parentheses) are
reported. Industry fixed effect is by 2-digit SIC industries. ***, ** and * indicate significance at
1%, 5% and 10% levels respectively.

Ln(Insider ownership)
Ln(Failure Tolerance)
Ln(Sales)
ROA
R&D/Assets
CapExp/Assets
Leverage
Tobins Q
Institutional Ownership
Firm Age
PPE/Assets
Herfindahl Index
Constant
Industry fixed effects
Year fixed effects
Observations
R2

Ln(Patents)
(1)
(2)
-0.073***
-0.062***
(0.021)
(0.022)
0.264**
(0.125)
0.105***
0.102***
(0.021)
(0.021)
0.668***
0.702***
(0.162)
(0.166)
1.653***
1.513***
(0.337)
(0.344)
2.170***
2.082***
(0.677)
(0.669)
-0.925***
-0.902***
(0.186)
(0.190)
0.100***
0.100***
(0.016)
(0.016)
1.128***
1.048***
(0.208)
(0.212)
0.055**
0.065***
(0.022)
(0.023)
-0.187
0.171
(0.408)
(0.405)
-0.530***
-0.344*
(0.196)
(0.207)
-2.272
-3.241*
(1.955)
(1.718)
Yes
Yes
Yes
Yes
9,934
9,452
0.314
0.322

48

Ln(Citations/Patent)
(3)
(4)
-0.062***
-0.052**
(0.019)
(0.020)
0.194*
(0.108)
0.030*
0.030*
(0.017)
(0.016)
0.387***
0.396***
(0.146)
(0.149)
1.265***
1.168***
(0.299)
(0.304)
1.131*
1.080
(0.681)
(0.683)
-0.889*** -0.876***
(0.160)
(0.163)
0.084***
0.083***
(0.014)
(0.014)
0.974***
0.919***
(0.172)
(0.175)
0.005
0.011
(0.015)
(0.015)
-0.087
0.122
(0.364)
(0.370)
-0.311*
-0.156
(0.178)
(0.191)
-2.122
-3.010**
(1.740)
(1.433)
Yes
Yes
Yes
Yes
9,934
9,452
0.236
0.241

Table 9: Failure Tolerance and Firm Value

The dependent variable is the natural logarithm of a firms Tobins Q at the first fiscal year end after IPO.
Ind. Total Patents and Ind. Total Citations are the total number of patents and the total number of
citations in the entire sample period by 4-digit SIC industries, respectively. Coefficient estimates and the
Huber-White-Sandwich robust standard errors (in parentheses) are reported. Industry fixed effect is by 2digit SIC industries. ***, ** and * indicate significance at 1%, 5% and 10% levels respectively.

(1)
0.081*
(0.046)

Ln(Failure Tolerance)
Ln(Failure Tolerance) x Ln(Ind. Total Patents)
Ln(Ind. Total Patents)

(2)
-0.077
(0.082)
0.027**
(0.013)
0.044***
(0.013)

Ln(Failure Tolerance) x Ln(Ind. Total Citations)

Ln(Ind. Total Citations)
Ln(Insider Ownership)

0.029***
(0.011)
-0.013*
(0.007)
0.206*
(0.106)
1.040***
(0.210)
1.063***
(0.328)
0.255***
(0.086)
-0.106
(0.118)
-0.887***
(0.168)
-0.091
(0.077)
0.804***
(0.308)
Yes
Yes
1,367
0.277

Ln(Sales)
ROA
R&D/Assets
CapExp/Assets
Leverage
Institutional Ownership
PPE/Assets
Herfindahl Index
Constant
Industry fixed effects
Year fixed effects
Observations
R2

49

0.029***
(0.011)
-0.014*
(0.007)
0.166
(0.104)
0.822***
(0.209)
1.196***
(0.327)
0.287***
(0.085)
-0.076
(0.117)
-0.909***
(0.164)
0.090
(0.081)
0.393
(0.305)
Yes
Yes
1,367
0.294

(3)
-0.124
(0.086)

0.032**
(0.014)
0.043***
(0.014)
0.029***
(0.011)
-0.013*
(0.007)
0.175*
(0.105)
0.863***
(0.209)
1.168***
(0.323)
0.283***
(0.085)
-0.056
(0.118)
-0.860***
(0.163)
0.089
(0.081)
0.500*
(0.294)
Yes
Yes
1,367
0.292