What will happen this year as the droves of seed funded startups crash up against the Series A crunch? And was the glut of investment just dumb money chasing bad startups, or a rational response to better opportunities?

These aren’t easy questions to answer, but a paper by two Harvard economists released in December offers some interesting insights. It finds evidence of investors’ changing investment preferences during boom times (and not just due to new investors entering the market). In other words, the kind of startups VC’s fund differes in hot and cold investment cycles.

For that reason, the startups that come out of frothy investment cycles (like what we’ve just seen for the seed stage) perform differently than those funded in tougher environments. The authors argue that investors take more risks during investment booms, that more startups funded during them fail, but that the successes are bigger than normal:

We find that startups receiving their initial funding in more active investment periods were significantly more likely to go bankrupt than those founded in periods when fewer startup firms were funded. However, conditional on being successful, and controlling for the year they exit, startups funded in more active periods were valued higher at IPO or acquisition, led more patents in the years subsequent to their funding (controlling for capital received), and had more highly-cited patents than startups funded in less active investment periods. That is, startups funded in hot markets were more likely to be in the “tails” of the distribution of outcomes than startups funded in cold markets: they were both more likely to fail completely and more likely to be extremely successful and innovative.

This offers at least a tentative reason to think that at least some of the the companies that raise Series A and beyond might go on to big and disruptive things. Not only are those few successful firms valued higher, but they are more innovative by some measures:

…we document a robust correlation between firms funded in boom times being simultaneously more likely to go bankrupt but having bigger successes in the fewer instances when they do have an IPO or get acquired. We also show that the bigger successes are not just limited to a financial measure of valuation, but also extend to real outcomes such as the level of a firm’s patenting and the citations to its patents. This suggests that VCs also invest in more innovative firms in boom times.

I won’t get into the methodology; you can read the paper for yourself. A while back I blogged about research suggesting that additional capital committed to VC funds tends to be followed by decreased performance by the asset class. That doesn’t necessarily contradict the analysis above, but it points to the diminishing returns to marginal capital.

If there’s a lesson here it’s simply that VCs’ appetite for risk is likely impacted by their perceptions about the investment environment. Secondarily, it’s a reminder that additional risk-taking is associated with more innovative companies, at least up to a point.

Of course, VC is constantly changing, and what was true of past cycles may not be true of future ones. Moreover, that a few companies will excel may be little comfort to the countless startups nervously searching for that next round of funding. The flip side of more homeruns in boom times is more total failures.