New research offers insights into how venture capitalists make funding decisions.
When a venture capitalist is deciding whether to invest in a young company, there are many variables at work besides the strength of the business plan. New research examines two of them--who referred the founders to the VC, and what other investors are already on board--and asks, how important are they?
Previous research has shown that social ties between entrepreneurs and venture capitalists play a role in funding decisions. Popular thinking is that VCs use these personal connections to help overcome a paucity of information with which to evaluate a start-up's probability of success. A new study, conducted by Rolf Wüstenhagen and Nina Hampl of the University of St. Gallen in Switzerland and Robert Wuebker of the University of Utah, has found that these personal ties between VCs and founders carry more weight than whether a prestigious VC firm, such as Kleiner Perkins, has decided to invest. The researchers also unearthed other interesting insights into how VCs weigh decisions.
In an email survey, 86 venture capitalists responded to a series of scenarios involving a hypothetical early-stage clean-energy company seeking its first round of funding. The survey used conjoint analysis, which asks indirect questions that get respondents to reveal how they weigh or prioritize different variables. Researchers manipulated factors such as product development (sometimes VCs were told the company had a finished product; other times that it was still in the design phase) and founders' backgrounds (sometimes VCs were told the founders had run another start-up; other times that they were just out of grad school). To better understand how a VC's background influenced the choices, the researchers also collected each respondent's location, age, industry experience, and job title.
As one might expect, attributes related to the deal's fundamentals (including the potential return and the company's market readiness) were found to be the most important drivers of venture capitalists' investment decisions. The social network effect was small but significant. Overall, VCs were notably less inclined to fund companies that had sent pitches via random e-mail. Whether these VCs had social connections to the founders accounted for 6.4 percent of the decision to invest, say the researchers. The identity of the lead investor, on the other hand, accounted for only 3.2 percent.
Entrepreneurs who want VC funding should spend time networking. "Cold calling Kleiner Perkins is not a very promising route to explore," says Wϋstenhagen, a management professor at the University of St. Gallen. "You are more likely to get funded by building your social network." However, it's important to keep these results in perspective. A personal connection may help you get a foot in the door, but when making investment decisions, VCs still give far more weight to the business prospects.
What Matters: The Breakdown In a survey, VCs revealed that social connections influenced their investment decisions, but other factors were more important.