Learning-Funding Tradeoffs at Lean Startups: Impact on Product Experiments and Innovation

Abstract

The lean startup method (LSM) is an experimentation-driven approach to learning about product-market fit and to improve startup success, but it abstracts away from the funding needs of the entrepreneur. This paper models the LSM process where an entrepreneur experiments with a test product to learn about consumer preferences and seeks funding for a product launch from an investor that has incomplete information about the entrepreneur's private type. We show that the investor cannot infer the entrepreneur's type based on the entrepreneur's actions, and therefore must rely on the test product's sales outcome for inference. This can create an incentive for the entrepreneur to distort the experimentation strategy. Our analysis identifies two possible types of distortions relative to the LSM without external financing: one prioritizes funding at the expense of learning; the other minimizes false positive outcomes, but wastes potentially good innovation ideas. Thus the learning-funding tradeoff can create systemic inefficiency in the LSM innovation ecosystem. An implication of our model is that entrepreneur groups facing negative investor stereotypes (e.g., women, minorities) endogenously sacrifice learning for funding. Hence, when funded, they launch less successful ventures and obtain lower payoffs, making the stereotype self-reinforcing.