Financing innovation: The hurdle rate theory of procyclicality
New research reveals how economic cycles influence funding for innovative projects.
1What is hurdle rate?
Hurdle rate represents the minimum acceptable return on an investment project. This concept plays a critical role in venture capital and innovation financing. During economic expansions, low interest rates push hurdle rates downward. The researchers explain how this phenomenon drives the procyclical nature of innovative investments, aligning them with economic cycles.
2Key research findings
The study analyzed financing data from over 15,000 innovative projects between 2000-2025. Results show hurdle rates decrease by 3-5% during economic expansions, particularly noticeable in early-stage tech startups. During contractions, average hurdle rates rise to 8-12%, suppressing innovation investments. These cyclical patterns demonstrate how macroeconomic conditions directly impact funding decisions for breakthrough technologies.
3Impacts of procyclicality
The alignment of innovation investments with economic cycles (procyclicality) affects long-term technological progress. Researchers argue this dynamic slows post-crisis recovery. After the 2008 financial crisis, increased hurdle rates suppressed clean energy investments for three years, delaying green tech development. Such patterns create innovation valleys that extend beyond typical business cycles, with lasting economic consequences.
4Sectoral differences
The study reveals significant variations across industries. High-risk sectors like biotech and AI show more volatile hurdle rates. In contrast, software and industrial technologies maintain greater stability. SaaS startups' hurdle rates prove 25% less sensitive to economic cycles, reflecting differing risk perceptions. These disparities suggest sector-specific strategies are needed to maintain innovation pipelines during downturns.
5Policy recommendations
Researchers propose measures to counter procyclicality in innovation funding. Public risk-sharing programs and tax incentives could stabilize hurdle rates during contractions. Canada's SR&ED tax credit program increased innovation investments by 18% during crises. Scaling similar initiatives globally could smooth funding fluctuations. Targeted policies might particularly benefit capital-intensive deep tech sectors most vulnerable to cyclical swings.
6Institutional investors' role
The research highlights how institutional investor behavior amplifies procyclicality. Large funds consolidate portfolios during uncertainty, reducing early-stage investments. During the 2020 pandemic, institutional VC investments dropped 40% while individual angel investors increased their share by 15%. This underscores the importance of diversified funding sources to maintain innovation momentum throughout economic cycles.
7Long-term consequences
Procyclicality's delayed effects impact technological advancement speed. Investment cuts during downturns may clog technology pipelines 5-10 years later. Reduced dot-com crisis investments contributed to cloud computing talent shortages in the 2010s. Researchers estimate these lagged effects create annual GDP growth drag of 0.3-0.5%. Such findings challenge traditional views of innovation as purely countercyclical.
8Future research directions
The study outlines critical areas for future investigation. Central bank policies' impact on hurdle rates and alternative financing models (tokenization, revenue-based financing) require examination. Additionally, procyclicality dynamics in emerging economies remain poorly understood. Research in these areas would enhance our understanding of global innovation ecosystems and inform more resilient funding strategies across economic cycles.
Original article: Research Policy — Yenilikçi projelerin finansmanı: Hurdle oran teorisi