Are All Your Investors Buddies? Why That's Really Bad News
You may love it when a board member who used to work at Salesforce, say, refers your deal to another Salesforce alum. You might get excited when investors pass along your pitch to the other guys they went to B-School with. Hold your enthusiasm.
Research appearing in the June 25 issue of Harvard Working Knowledge suggests that when investors cluster along their personal interests or preferences, the companies they invest in tend to suffer.
The researchers--Paul Gompers, Yuhai Xuan, and Vladimir Hukharlyamov, all from Harvard Business School--looked at 3,510 venture capitalists investing in 12,577 companies between 1973 and 2003. They then collected biographical information on each investor, who invested alongside whom, and what those people had in common.
Their first finding was that VCs do tend to invest with other investors that are similar to them in significant ways. Two VCs with undergraduate degrees from the same university were 42.5 percent more likely to co-invest than VCs who didn't go to the same school. If two the VCs were of the same ethnic minority, they were 39.2 percent more likely to invest together. Having a previous employer in common increases the chances that two people will co-invest by 64 percent.
Unfortunately, birds of a feather do not necessarily make good co-investors. The probability of a company filing for an initial public offering actually decreased by 17 percent if two or more investors had previously worked for the same company, even if they hadn't worked there at the same time. If investors went to the same undergraduate school, the success rate dropped by 19 percent. Investors of the same minority ethnic background were 20 percent less likely to see their companies go public.
This particular study does not estimate how likely women were to invest together, because there weren’t enough women in the sample, and not enough women co-invested, to accurately calculate the number. (Yep. Out of 3,510 investors.) One recent, separate study of Kickstarter found that one reason women are so successful on that platform is because there is a relative plethora of women investors on Kickstarter, and those women are more likely to invest in women than men are.
Ironically, the Harvard Working Knowledge researchers--all affiliated with Harvard Business School--did not seem to detail the effect of having two or more investors from the same business school. They did find that having two or more investors from a "top" school was beneficial to a company's chances of filing for an IPO. They said this is because graduating from a top school is indicative of ability, not of a preference or of like wanting to be with like.
Warning: Groupthink Ahead
The researchers wondered if their findings could be explained if investors with dud deals on their hands were only able to recruit their pals as co-investors. That doesn't seem to be the case. Instead, it appears that investors with too much in common have a harder time making really good decisions for their companies. They have similar perspectives, they're reluctant to challenge each other, and often, groupthink sets in.
It's not just in venture capital that this happens. Since boards of directors at public companies are overwhelmingly male, the addition of multiple women boosts a board’s diversity. And research on the board composition of public companies has found that companies with the highest percentages of board directors had a return on equity 53 percent higher than companies with the fewest women on their boards. The companies with the most women directors had a return on invested capital 66 percent higher than the companies with the fewest.
Since these findings were published in 2007, shareholders haven't exactly revolted, demanding more women be appointed to board seats. The percentage of women on public company boards has barely budged, to 17 percent, according to not-for-profit Catalyst.
So even in the face of clear evidence, non-diverse boards clearly think they're the exception to the rule that diverse boards perform better. In a few years, we’ll be able to tell if Silicon Valley and Sand Hill Road are any different. Or, perhaps, if it's not just in Lake Wobegon that everyone is above average.