Professor Alexander Ljungqvist is the recipient of the 2011 Ewing Marion Kauffman Prize Medal for Distinguished Research in Entrepreneurship. See a list of previous prize recipients at www.kauffman.org/prizemedal.
Venture capitalists serve a vital economic function by identifying, funding, and nurturing promising entrepreneurs in industries associated with high risk and great potential for innovation and growth. However, the effectiveness of venture capitalists in these tasks and whether they provide capital and services on competitive terms to entrepreneurs is much debated. My work in the entrepreneurial arena seeks to shed light on these debates.
As the work of the 2007 Kauffman Prize Medal winner, Toby Stuart, has shown, networks feature prominently in entrepreneurial settings. In papers published in the Journal of Finance in 2007 and 2010, my co-authors, Yael Hochberg, Yang Lu, and I examine the role and consequences of networks among venture capitalists from the angles of financial economics, organization theory, and industrial organization. What we are primarily interested in is not whether networks exist or how extensive they are—we know that by now—but whether networks affect economic outcomes: that is, whether networks matter.
Our work suggests that they do. We use tools borrowed from economic sociology to show that networks among venture capitalists in the United States contribute to both the success of the startups that VCs fund and the VCs' own performance. It is the better-networked venture capitalists whose backing helps startups succeed, and that, in turn, is associated with superior returns. But there also appears to be a dark side. We show that networks among venture capitalists also may serve as barriers to entry into local VC markets, such as Silicon Valley in California or Route 128 in Massachusetts.
Extensive contacts in the VC community allow a VC fund to tap into information about up-and-coming entrepreneurs and to screen out undeserving requests for funding.
Let me be more specific. In a paper titled, "Whom you know matters," we show that venture capitalists who are better networked in the VC industry generate better outcomes for their investee companies as well as better returns for their investors, even after controlling for skill and other known determinants of investment performance. Our research focuses on the co-investment networks to which VC syndication gives rise. Syndication relationships are a natural starting point, not only because they are easy to observe, but also because there are good reasons to believe they affect the two main drivers of a VC's performance, namely, the ability to source high-quality deal flow (i.e., select promising companies) and the ability to nurture investments (i.e., add value to portfolio companies).
Networks at Work
Networks can improve the quality of deal flow in a number of ways. Extensive contacts in the VC community allow a VC fund to tap into information about up-and-coming entrepreneurs and to screen out undeserving requests for funding. The main reason other VC funds will play along is reciprocity: They expect the favor to be repaid in the future, and we show evidence consistent with such behavior. By checking each other's willingness to invest in potentially promising deals, VCs can pool their investment expertise and thereby select better investments in situations of extreme uncertainty about the viability and return potential of investment proposals.
Once a VC fund has made an investment, it can draw on the resources of its network contacts to help its investment grow and succeed. Networks facilitate the sharing of information, contacts, and resources among the VCs, for instance, by expanding the range of launch customers or strategic alliance partners for their portfolio companies. No less importantly, strong relationships with other VCs likely improve the chances of securing follow-on VC funding for portfolio companies and may indirectly provide access to other VCs' relationships with service providers, such as headhunters and prestigious investment banks.
It seems plausible that the better-networked venture capitalists are also the older and more experienced ones.
Our empirical results suggest that VCs who are better-networked at the time they raise a fund subsequently enjoy significantly better fund performance, as measured by the rate of successful portfolio exits over the next ten years. At the portfolio company level, we find that a VC's network centrality—its importance in its network—has a positive and significant effect on the probability that a portfolio company survives to a subsequent funding round or exits successfully. Given the very high failure rates of VC-backed companies—around three-quarters of them tend to be written off—even relatively small improvements in a fund's ability to avoid investing in the wrong startup and avoid having a startup flounder for lack of support can have a large impact on the returns VC funds can generate for their investors, as our results show.
Perhaps the leading alternative explanation for the performance-enhancing role of VC networking is simply experience. It seems plausible that the better-networked venture capitalists are also the older and more experienced ones. Interestingly, however, once we control for VC networks, the beneficial effect of experience on performance is much reduced. It is also not the case that the better-networked venture capitalists are simply those with better track records. While we do find evidence of performance persistence from one VC fund to the next, networking continues to have a positive and significant effect on fund performance, even when we control for persistence.
Denser Networks, Less Competition?
In another paper, "Networking as a barrier to entry and the competitive supply of venture capital," my coauthor and I go on to examine whether strong networks among incumbent venture capitalists in local markets help restrict entry by outside venture capitalists, thus improving the bargaining power of incumbent VCs over the entrepreneurs they negotiate with in their local markets. Consistent with this hypothesis, we find that local VC markets in which the incumbent VCs have established denser networks among themselves experience substantially less entry. Of course, entry still happens, but it is interesting to see when it does. We find that entry is accommodated (rather than deterred) if the entering VC firm has established a relationship in its own home market with one of the incumbent VC firms in the market it seeks to enter.
We also find evidence of strategic reactions to an increased threat of entry. We find that the emergence of a tie between an incumbent in market A and another firm in market B increases the likelihood of entry into market A, which implies that such a tie is a potential threat to the other incumbent VCs in market A. It would not be surprising, therefore, to find that the other incumbents seek to deter such ties from forming. Specifically, we see that the other incumbents react strategically to an increased threat of entry by excluding from their network (i.e., "freezing out") any incumbent VC firm that builds a relationship with a potential entrant in another market.
... we show that entrepreneurs seeking venture capital receive funding on significantly worse terms in more densely networked markets, while increased entry is associated with higher valuations.
Finally, we show that entrepreneurs seeking venture capital receive funding on significantly worse terms in more densely networked markets, while increased entry is associated with higher valuations. This, in turn, may help explain why better-networked VCs enjoy better performance, as our earlier article suggests. Part of the explanation for this may be due to the lower prices VCs pay for investments in more densely networked markets. Of course, an unanswered question is whether networks provide offsetting benefits to entrepreneurs. For instance, raising money in a more densely networked market may take less time.
My study of venture capital networking builds on extensive prior research describing the existence and extent of networking among VCs. It extends this prior research in two ways: first, by showing that networking benefits VCs, their investors, and—in terms of a greater likelihood of survival—the companies the VCs back. At the same time, networking can have a potentially darker side, by making it harder for VC firms to enter local markets that they haven't previously operated in, and thereby reducing the competitive supply of venture capital.
This essay is an excerpt from the Kauffman Thoughtbook 2011.