A curated list of academic studies on venture capital market structure, firm strategies and networks.
Does Reputation Limit Opportunistic Behavior in the VC Industry? Evidence from Litigation against VCs
VCs who are sued by founders do fewer, and less successful deals; more experienced VCs are less likely to be sued.
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- Vladimir A. Atanasov - College of William and Mary
- Vladimir I. Ivanov - US Securities & Exchange Commission
- Kate Litvak - Northwestern University
We examine the role of reputation in limiting opportunistic behavior by venture capitalists towards four types of counterparties: entrepreneurs, investors, other VCs, and buyers of VC-backed startups. Using a hand-collected database of lawsuits, we document that more reputable VCs (i.e., VCs that are older, have more deals and funds under management, and syndicate with larger networks of VCs) are less likely to be litigated. We also find that litigated VCs suffer declines in future business relative to matched peers. These declines are larger for more reputable VCs, and for VCs that are defendants to multiple lawsuits or sued by entrepreneurs.
The most reliable predictor of a VC's future performance is their past market share of VC-backed IPOs.
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- Vladimir I. Ivanov - University of Kansas
- C.N.V. Krishnan - Case Western Reserve University
- Ronald W. Masulis - Vanderbilt University
- Ajai K. Singh - Case Western Reserve University
Venture capitalist (VC) reputation is a valuable trait, which yields important competitive benefits. Yet a generally accepted measure is lacking. To address this need, we investigate the relation of alternative VC reputation measures to especially successful venture investments, namely IPOs and post-IPO long-run firm performance. Post-IPO firm performance is measured by three well known standards: industry-adjusted operating performance, market-to-book ratio, and long-run listing survival. We find that a VC’s market share of VC-backed IPOs has the strongest and most consistent positive association with these post-IPO long-run performance metrics and with the frequency with which a VC’s portfolio firms subsequently successfully go public. We also explore the relation between VC reputation and private equity networks, IPO demand, post-IPO VC involvement and corporate governance. We find that more reputable VCs excel on all these dimensions, which helps explain why firms backed by more reputable VCs have greater IPO success and better post-IPO performance.
The more interconnected the established players in a region's VC sector are, the harder it is for new entrants to establish themselves - making deals "cheaper" for the incumbents.
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- Yael Hochberg - Rice University/NBER
We examine whether strong networks among incumbent venture capitalists (VCs) in local markets help restrict entry by outside VCs, thus improving incumbents’ bargaining power over entrepreneurs. More densely networked markets experience less entry, with a one-standard deviation increase in network ties among incumbents reducing entry by approximately one-third. Entrants with established ties to target- market incumbents appear able to overcome this barrier to entry; in turn, incumbents react strategically to an increased threat of entry by freezing out any incumbents who facilitate entry into their market. Incumbents appear to benefit from reduced entry by paying lower prices for their deals.
VCs who share the same ethnic, educational, or career background are more likely to syndicate with each other; this gives rise to "groupthink" and worse performance.
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Journal of Financial Economics, 2016{:target="_blank"}
- Paul A. Gompers - Harvard Business School
- Vladimir Mukharlyamov - National Bureau of Economic Research
- Yuhai Xuan - University of Illinois at Urbana-Champaign
We investigate how personal characteristics affect people’s desire to collaborate and whether this attraction enhances or detracts from performance in venture capital. We find that venture capitalists who share the same ethnic, educational, or career background are more likely to syndicate with each other. This homophily reduces the probability of investment success, and the detrimental effect is most prominent for early-stage investments. A variety of tests show that the cost of affinity is most likely attributable to poor decision-making by high-affinity syndicates after the investment is made. These results suggest that “birds-of-a-feather-flock-together” effects in collaboration can be costly.
VCs appear to delay the release of bad news about their portfolio until after they have finished raising a new fund.
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- Indraneel Chakraborty - University of Miami
- Michael Ewens - California Institute of Technology
This paper examines whether agency conflicts during venture capital (VC) fundraising im- pact investment behavior. Using novel investment-level decisions of VCs in the process of raising new funds, we find that venture capitalists take actions hidden from their investors, i.e. limited partners (LPs), that delay revealing negative information about VC fund performance until after a new fund is raised. After fundraising is complete, write-offs double and reinvestments in relatively worse off entrepreneurial firms increase. We find that these observations cannot be explained by strategic bundling of news or effort constraints due to the newly raised fund. Funds with both long and short fundraising track record exhibit this behavior and the delay is costly for fund investors (LPs). This strategic delay shows that fundraising incentives have real impacts on VC fund investment decisions, which are often difficult for LPs to observe.
The "human capital" of individual VCs is more important than their firm's organizational capital, and specific investors (even at the same firm at the same time) have recognizable differences in strategy.
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- Michael Ewens - Carnegie Mellon University
- Matthew Rhodes-Kropf - Harvard Business School
This paper investigates whether individual venture capitalists have repeatable investment skill and to what extent their skill is impacted by the VC firm where they work. We examine a unique dataset that tracks the performance of individual venture capitalists’ investments across time and as they move between firms. We find evidence of skill and exit style differences even among venture partners investing at the same VC firm at the same time. Furthermore, our estimates suggest the partner’s human capital is two to five times more important than the VC firm’s organizational capital in explaining performance.
When VCs replace startup founders, they improve the performance of their portfolios - particularly when they replace them with executives with substantial industry experience.
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- Michael Ewens - California Institute of Technology
- Matt Marx - Massachusetts Institute of Technology
We provide causal evidence that venture capitalists (VCs) improve the performance of their portfolio companies by replacing founders. Augmenting a database of U.S.- based, VC-backed startups from 1995–2008 with hand-collected information regarding turnover, we exploit shocks to the supply of outside executives via state-level changes in the enforceability of employee non-compete agreements. Although naive regressions of startup performance on founder replacement would suggest a negative correlation, this may be due to selection as founders are likely to leave or be pushed out of poorly-performing startups. Indeed, instrumented regressions reverse the sign of this effect, suggesting that replacing founders improves the performance of venture-backed entrepreneurial firms. Replacement helps more when founders hold CXO roles and when the incoming replacement has substantial work experience. The evidence points to the replacement of founders as a specific mechanism by which VCs add value.
Venture Capital Valuation, Partial Adjustment, and Underpricing: Behavioral Bias or Information Production?
Perceived valuation change from the last pre-IPO VC round to the IPO affects IPO underpricing in a nonlinear way.
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- Jan Jindra - U.S. Securities and Exchange Commission
- Dima Leshchinskii - Menlo College
Using a sample of venture capital (VC)-backed initial public offerings (IPOs), we analyze the role played by perceived valuation changes on IPO underpricing. We find that perceived valuation change from the last pre-IPO VC round to the IPO affects IPO underpricing in a nonlinear way. Further analysis indicates that information-based theories, not behavioral biases, explain this nonlinearity. We also find that the previously documented partial adjustment effect and its nonlinear impact on IPO underpricing are related to the trajectory of the perceived valuation changes, which stands in stark contrast to prior evidence of the importance of behavioral biases.
VC investments are typically concentrated in one geographical area; however, investors who are active in syndicated deals invest more often in more distant companies.
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- Olav Sorenson - University of California, Los Angeles
- Toby E. Stuart - University of Chicago
Sociological investigations of economic exchange reveal how institutions and social structures shape transaction patterns among economic actors. This article explores how interfirm networks in the U.S. venture capital (VC) market affect spatial patterns of exchange. Evidence suggests that information about potential investment opportunities generally circulates within geographic and industry spaces. In turn, the circumscribed flow of information within these spaces contributes to the geographic- and industry-localization of VC investments. Empirical analyses demonstrate that the social networks in the VC community — built up through the industry’s extensive use of syndicated investing — diffuse information across boundaries and therefore expand the spatial radius of exchange. Venture capitalists that build axial positions in the industry’s coinvestment network invest more frequently in spatially distant companies. Thus, variation in actors’ positioning within the structure of the market appears to differentiate market participants’ ability to overcome boundaries that otherwise would curtail exchange.
The more VCs are active in a market (whether "generalists" or industry specialists"), the more competitive pressure is added by each new player - particularly in densely-networked regions. Generalist VCs also compete strongly against industry specialists.
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- Yael V. Hochberg - Northwestern University
- Michael J. Mazzeo - Rice University
- Ryan C. McDevitt3 - Duke University
An important type of product differentiation in the venture capital (VC) market is industry specialization. We estimate a market structure model to assess competition among VCs — some of which specialize in a particular industry and others of which are generalists — and find that the incremental effect of additional same-type competitors increases as the number of same-type competitors increases. Furthermore, we find that the effects of generalist VCs on specialists are substantial, and larger than the effect of same-type competitors. Estimates from other industries typically show the incremental effects falling as the number of same-type competitors increases and the effects of same-type competitors as always being larger than the effects of different-type competitors. Consistent with the presence of network effects that soften competition, these patterns are more pronounced in markets that exhibit dense organizational networks among incumbent VCs. Markets with sparser incumbent networks, by contrast, exhibit competitive patterns that resemble those of other, non-networked industries.
Small fish, big fish: The performance effects of the relative standing in partners' affiliate portfolios
The outcome of startups depends to some extent on their relative rank among their VCs' other investments: companies that are among a VC firm's best investments do better.
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- Umit Ozmel - Purdue University
- Isin Guler - Sabancı University School of Management, İstanbul, Turkey
This study argues and demonstrates that the value of a venture’s affiliations depends in part on its relative standing in the portfolio of affiliations held by its partners. Relative standing refers to how the venture ranks among other ventures in the partner’s portfolio with respect to observable signals of quality. The relative standing of a venture in its partner’s portfolio influences the venture’s access to the partner’s resources and, subsequently, the venture’s performance. We also argue that a venture’s relative standing becomes a more important predictor of performance when the partner has a larger portfolio or higher status. An empirical test of the equity investments by venture capital firms in 878 private biotechnology ventures between 1980 and 2004 provides support for the hypotheses.
Throwing Good Money after Bad? A Multi-Level Study of Sequential Decision Making in the Venture Capital Industry
Venture capital firms become less likely to terminate investments as they participate in more rounds of financing, despite evidence that expected returns are declining over rounds.
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- Isin Guler - University of North Carolina at Chapel Hill
This study focuses on the political and institutional influences that lead organizational decision makers to avoid terminating unsuccessful investments, even when there is competition and they have the experience and incentives to maximize profits. I examine multilevel influences on sequential investment decisions in the U.S. venture capital industry through a qualitative study of the investment process and a quantitative examination of venture capital investments between 1989 and 2004. Results show that venture capital firms become less likely to terminate investments as they participate in more rounds of financing, despite evidence that expected returns are declining over rounds.
Intraorganizational politics, as well as coercive and normative pressures from co-investors and limited partners, may influence the decisions to continue or terminate investments, regardless of the expected returns. The findings suggest that organizational safeguards designed to mitigate individual biases may give rise to political and institutional influences, which may in turn undermine the effectiveness of the decision process.
A model based on the idea that venture capitalists favor industries where they have significant experience and industries with a large pool of good investment opportunities; investment (predation) then “uses up” opportunities and therefore tends to deplete the pool of unexploited opportunities (prey).
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- James A. Brander - University of British Columbia
- Jean-Etienne de Bettignies - University of British Columbia
This paper suggests that endogenous dynamics of the “predator-prey” type can provide a contributing explanation for both high venture capital concentration by industry and “boom and bust” industry-level investment dynamics. We propose a model based on the idea that venture capitalists favor industries where they have significant experience and industries with a large pool of good investment opportunities. However, investment “uses up” opportunities and therefore tends to deplete the pool of unexploited opportunities. The resulting industry-level interactive dynamics naturally give rise to venture capital investment cycles similar to observed patterns.
Venture Capital Investment Strategies under Financing Constraints: Evidence from the 2008 Financial Crisis
In response to liquidity supply shocks, VCs reposition by increasing their share of, and per-round funding to, startups operating in the VCs’ core sectors. These effects are driven by more-experienced VCs, and are strongest in early-stage portfolio startups.
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- Annamaria Conti - Georgia Institute of Technology
- Nishant Dass - Georgia Institute of Technology
- Stuart J.H. Graham - Georgia Institute of Technology
Employing the 2008 financial crisis as an empirical setting, we examine the investment strategies of venture capitalists (VCs) in response to liquidity supply shocks. While predictably VCs reduce investment, our difference-in-differences approach demonstrates that VCs reposition by increasing their share of, and per-round funding to, startups operating in the VCs’ core sectors. These effects are driven by more-experienced VCs, and are strongest in early-stage portfolio startups. Complementing these results, we find superior ex-post performance among crisis-funded portfolio startups operating in more-experienced VCs’ core sectors. Overall, our findings point to more-experienced VCs possessing information advantages, especially in their core sectors.
VCs' on-site involvement with their portfolio companies leads to an increase in innovation and the likelihood of a successful exit.
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Journal of Finance, 2016{:target="_blank"}
- Shai Bernstein - Stanford University
- Xavier Giroud - MIT; NBER
- Richard R. Townsend - University of California, San Diego
We show that venture capitalists’ (VCs) on-site involvement with their portfolio companies leads to an increase in (1) innovation and (2) the likelihood of a successful exit. We rule out selection effects by exploiting an exogenous source of variation in VC involvement: the introduction of new airline routes that reduce VCs’ travel times to their existing portfolio companies. We confirm the importance of this channel by conducting a large-scale survey of VCs, of whom almost 90% indicate that direct flights increase their interaction with their portfolio companies and management, and help them better understand companies’ activities.
When Do Entrepreneurs Accurately Evaluate Venture Capital Firms’ Track Records? A Bounded Rationality Perspective
It is proposed that founders' accurate evaluations of potential investors depend not only on their motivation and ability to access information but on the convergence of these factors with attributes of the potential investor being evaluated.
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Academy of Management Journal, 2016{:target="_blank"}
- Benjamin L. Hallen - University of Washington
- Emily Cox Pahnke - University of Washington
There has been substantial research on the value of young firms engaging high-quality partners. This literature, as well as the broader firm reputation literature, has tended to assume that individuals leading such firms find it relatively easy to accurately assess potential partner quality as reflected in their track record of past performance and behavior. Yet this prior work has largely focused on information-rich environments where potential partners are generally large and receive substantial public attention, and with whom evaluators may have high familiarity. In contrast, we draw on bounded rationality to theorize about how in information-sparse environments, individuals may misperceive the quality indicated by a firm’s objective track record. We argue that accurate evaluations depend not only on individuals’ motivation and ability to access information but on the convergence of these factors with attributes of the potential partner being evaluated. We test and find support for our framework using a novel dataset of 1,278 ratings of the quality of 153 early-stage venture capital firms by entrepreneurs that approached these firms for investments. Overall, this paper extends understanding of firm reputation dynamics to information-sparse contexts, and explores why individuals such as entrepreneurs may at times have difficulty accurately evaluating partners.
(Un)Tangled: Exploring the Asymmetric Coevolution of New Venture Capital Firms’ Reputation and Status
Reputation and status positively influence each other but that reputation has a greater effect on status, particularly when firms are older; participating in "blockbuster initial public offerings" has a positive relationship with status when firms are young and a positive relationship with reputation when firms are older, and it helps low-status and low-reputation firms more than it helps high-status and high-reputation firms.
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Administrative Science Quarterly, 2015{:target="_blank"}
- Timothy G. Pollock - Pennsylvania State University
- Peggy M. Lee - Arizona State University
- Kyuho Jin - Seoul National University
- Kisha Lashley - University of Virginia
We explore the relationship between status and reputation, examining how its dynamics change over time as these two intangible assets coevolve and how reputation and status are influenced by participation in highly visible events. Using a sample of more than 400 newly founded venture capital (VC) firms, we find that reputation and status positively influence each other but that reputation has a greater effect on status, particularly when firms are older. We also find that the effect of past status on current status weakens as VC firms age, but the relationship between past and current reputation remains consistent with age. Furthermore, our findings show that participating in big hits—blockbuster initial public offerings—has a positive relationship with status when firms are young and a positive relationship with reputation when firms are older, and it helps low-status and low-reputation firms more than it helps high-status and high-reputation firms. This study helps differentiate status and reputation, shows how they coevolve, and provides insight into how new firms build these important intangible assets.