The Risk and Reward of Venture Capital: An Interview with Michael Ewens

Michael J. Ewens recently joined the faculty at Caltech as associate professor of finance and entrepreneurship after four years at the Tepper School of Business at Carnegie Mellon University. A native of Wisconsin, Ewens attended Washington University in St. Louis, majoring in mathematics and economics before moving on to UC San Diego for graduate studies in economics.

Ewens explains how he discovered venture capital through a summer job in graduate school, and shares his ambitions for his future at Caltech.

What field do you specialize in?

Entrepreneurial finance. I study the financing and development of high-growth start-ups such as Twitter, biotech start-ups, or new clean-energy firms. I study how money and investors get matched to start-ups and what value is created after they are financed. What are the factors that lead to them receiving the right money at the right prices, or failing to? How is capital raised?

Entrepreneurship is a fascinating area because it is at the extreme of many problems that come up in economics. A classic issue in economics is what happens in a situation where one person knows a lot more than the other—information asymmetry—and can take advantage. This is often the case in entrepreneurship, where you have people who are new to the business world seeking venture capital from people who have expertise in finance and money.

Is your interest in what goes into making start-ups successful purely theoretical?

No, it's a very important issue in practical terms. For example, Caltech allocates a part of its endowment toward the private equity asset class, which includes venture capital. So understanding how investments in start-ups behave in terms of risk and return is fundamentally important.

And, of course, it's important for entrepreneurs and policy makers. Most government officials think it's good to have more start-ups, and they think they know how to set policy to lead to more start-ups. But every economist who studies entrepreneurship comes from the position that we really don't know how to encourage start-ups and make them more profitable. Take the example of health care. It is thought that one reason people don't leave large companies to start new ones is that they are locked into their health insurance plans. Now, with the introduction of the Affordable Care Act ("Obamacare"), we can begin to look at the data and see if this supposition is correct.

How did you get interested in venture capital?

It was happenstance. I was a graduate student in economics at UC San Diego, studying international trade. I wanted to live close to campus, near the beach, but not in graduate housing. To do that, I needed to earn more than my research-assistant salary. So I started consulting for a venture-capital firm called Correlation Ventures. They are a unique firm. They introduced a different kind of econometrics into venture capital, the sort of techniques used in Moneyball, which revolutionized the business of creating a winning baseball team. I fell in love with the idea.

I had initially planned to work for them just over the summer, but they offered me access to a wonderful set of data that I could use in my graduate studies, so I stayed on as their "data guy." I continue to work as a part-time advisor to the fund.

What inspires you to choose particular topics in venture capital for further research?

Venture capital is a very dynamic field, so new research topics are not hard to come by. The challenge is collecting rich data and using quality empirical strategies.  For example, changes on the legislative side over the last couple of years have provided unique research opportunities. The JOBS Act [Jumpstart Our Business Startups Act], passed by Congress in 2012, significantly alters the way start-ups are financed, who can invest in them, and how such firms can eventually go public. These policy changes provide what economists call natural experiments. For example, the legislative changes make it possible for us to test theories concerning the types and magnitudes of financing frictions facing start-ups.

The underlying assumption behind such policies is that having many new small businesses is great, because, as everyone says, they create the most jobs. But what people forget is that new small businesses also destroy the most jobs, because most small businesses fail. So that's part of my research: to shine a light on what makes start-ups succeed or fail.

Are there other important issues for venture capital that you study besides changes in legislation?

Yes. For example, I'm working on a paper now with some coauthors that investigates the impact of new cloud software that has grown rapidly in use since 2005. Think the Amazon cloud. This software has made it possible for individuals to start certain types of businesses with very little money: information technology businesses, say, but obviously not something like developing new drugs, for which you need laboratory space. Then we can ask how this changes the venture capital investment choice. For example, if an investor can give you ten thousand dollars rather than a million to get your company up and running, how does that affect the investor's selection of entrepreneurs and the fate of start-ups generally?

It's also becoming easier and easier to collect disparate sources of economic data from the web. So questions that economists have studied in the past using small datasets can now be checked against much larger datasets of hundreds of thousands of observations.

What will you be teaching at Caltech?

Next January I'm going to teach a graduate course in applied econometrics, and in the spring I will be teaching a class in venture capital finance [BEM 110] that mirrors a class I taught to MBA students at Carnegie Mellon. I'm not worried about the undergrads at Caltech handling the course though. In fact, I'm looking forward to being able to throw more mathematics into the course. This course will give students background on how investors and entrepreneurs behave through the lens of economics and finance.

What attracted you to Caltech?

I liked my time at Carnegie Mellon, because in a business school you have a very close connection to industry and the "real world." But Caltech is "research first" in a way that a business school cannot be. Writing as many quality papers as possible and teaching the kind of things I was taught as a PhD student is what I'm best suited for, I think, and Caltech is the perfect place for that. In 15 years, I want to look back and say that I took on some risk and made a small but significant impact, changing the way people think about economics. Caltech shares that interest.