Entrepreneurs and Investors: Funding-Induced Distortions in Lean Start-up Product Experiments and Innovation.

This article focuses on how information asymmetry and funding incentives distort the lean start-up method (LSM), an experimentation-driven approach to product development aimed at learning product-market fit. It develops a game-theoretic model where entrepreneurs, differentiated by type (high or low), conduct product experiments and seek funding from investors who cannot perfectly observe entrepreneur quality. The model reveals that investors cannot distinguish entrepreneur types from actions alone, relying instead on test product sales outcomes, which incentivizes entrepreneurs to distort experimentation strategies—either prioritizing funding probability over learning or minimizing false positives at the cost of discarding promising innovations. Furthermore, investor stereotypes about entrepreneur groups (e.g., based on race or gender) exacerbate these distortions, causing negatively stereotyped high-type entrepreneurs to sacrifice learning to secure funding, resulting in less successful ventures and reinforcing stereotypes; notably, the inefficiency cost of negative stereotypes disproportionately burdens these high-type entrepreneurs, while positive stereotypes impose costs mainly on investors. Overall, the findings highlight systemic inefficiencies in innovation ecosystems arising from the interplay of learning, funding, and bias, with implications for understanding disparities in entrepreneurial outcomes.