Experienced entrepreneurs can predict the quality of startup ideas in science-based fields, but not consumer or enterprise software.
Download{:target="_blank"}
- Erin L. Scott - National University of Singapore
- Pan Shu - Harvard University
- Roman M. Lubynsky - MIT
Entrepreneurs face high uncertainty, and often make costly investments in new business ideas without knowing the expected payoff. This paper empirically examines whether ex-ante assessment of early-stage startup ideas can predict their subsequent commercialization. We leverage an entrepreneurship program at the Massachusetts Institute of Technology in which early-stage venture ideas, presented in the form of succinct standardized summaries, elicit subjective evaluations from a large set of experienced entrepreneurs and executives. Using data on 652 ventures in multiple industry sectors, evaluated over an 8-year period, we find that ideas that elicit more positive evaluations are significantly more likely to ultimately reach commercialization. We further show that these results are driven by venture ideas with documented intellectual capital in research-and-development-intensive sectors, such as life sciences and medical devices. We find no evidence, by contrast, that experts can effectively assess the commercial potential of venture ideas in non-R&D-intensive sectors such as consumer web and enterprise software. Finally, we find that industry-specific and scientific expertise is not critical to experts’ collective ability to predict ventures’ commercial viability.
A new model for assessing startup quality based on highly granular geographic data and other factors.
Download{:target="_blank"}
This paper was prepared for the NBER/CRIW Measuring Entrepreneurial Businesses: Current Knowledge and Challenges conference, Washington, DC, December, 2014.
- Jorge Guzman - MIT
- Scott Stern - MIT
A central challenge in the measurement of entrepreneurship is accounting for the wide variation in entrepreneurial quality across firms. This paper develops a new approach for estimating entrepreneurial quality by linking the probability of a growth outcome (e.g., achieving an IPO or a significant acquisition) as a function of start-up characteristics observable at or near the time of initial business registration (e.g., the firm name or filing for a trademark/patent). Our approach allows us to characterize entrepreneurial quality at an arbitrary level of geographic granularity (placecasting) and in advance of observing the ultimate growth outcomes associated with any cohort of start-ups (nowcasting). We implement this approach in Massachusetts from 1988-2014, yielding several key findings. First, consistent with Guzman and Stern (2015), we find that a small number of observable start-up characteristics allow us to distinguish the potential for a significant growth outcome: in an out-of-sample test, more than 77% of growth outcomes occur in the top 5% of our estimated quality distribution. Second, we propose two new economic statistics for the measurement of entrepreneurship: the Entrepreneurship Quality Index (EQI) and the Regional Entrepreneurship Cohort Potential Index (RECPI). We use these indices to offer a novel characterization of changes in entrepreneurial quality across space and time. For example, we are able to document changes in entrepreneurial quality leadership between the Route 128 corridor, Cambridge and Boston, as well as more granular assessments that allow us to distinguish variation in average entrepreneurial quality down to the level of individual addresses. Third, we find a high correlation between an index that depends only on information directly observable from business registration records (and so can be calculated on a real-time basis) with an index that allows for a two-year lag that allows the estimate of entrepreneurial quality to incorporate early milestones such as patent or trademark application or being featured in local newspapers. Finally, we find that the most significant “gap” between our index and the realized growth outcomes of a given cohort seem to be closely related to investment cycles: while the most successful cohort of Massachusetts start-ups was founded in 1995, the year 2000 cohort registered the highest estimated quality.
A "two-sided matching" model of the process by which more experienced "top-tier" VCs end up investing in the highest quality startups.
Download{:target="_blank"}
- Morten Sørensen - Stanford
In capital markets, top-tier investors may have better abilities to monitor and manage their investments. In addition, there may be sorting in these markets, with top-tier investors investing in the best deals, second-tier investors investing in the second-best deals, and so forth. To separate and quantify these two effects, a structural model of the market for venture capital is developed and estimated. The model is a two-sided matching model that allows for sorting in equilibrium. It is found that more experienced venture capitalists make more successful investments. This is explained both by their value-adding influence on their investments, and by their access to late stage and biotechnology companies, companies that are more successful on average. Sorting is found to be prevalent and has general implications for the interpretation of empirical evidence of the impact of investors on their investments.
Entrepreneurs with a track record of success are more likely to succeed than first time entrepreneurs and those who have previously failed, and funding by more experienced venture capital firms enhances the chance of success, but only for entrepreneurs without a successful track record.
Download{:target="_blank"}
- Paul Gompers - Harvard/NBER
- Anna Kovner - Harvard/NBER
- Josh Lerner - Harvard/NBER
- David Scharfstein - Harvard/NBER
This paper argues that a large component of success in entrepreneurship and venture capital can be attributed to skill. We show that entrepreneurs with a track record of success are more likely to succeed than first time entrepreneurs and those who have previously failed. Funding by more experienced venture capital firms enhances the chance of success, but only for entrepreneurs without a successful track record. Similarly, more experienced venture capitalists are able to identify and invest in first time entrepreneurs who are more likely to become serial entrepreneurs. Investments by venture capitalists in successful serial entrepreneurs generate higher returns for their venture capital investors. This finding provides further support for the role of skill in both entrepreneurship and venture capital.
Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies
Changes in management lead to improved firm outcomes, suggesting that the business is more important to success than the founders.
Download{:target="_blank"}
- Steven Kaplan - University of Chicago Graduate School of Business/NBER
- Berk Sensoy - University of Southern California
- Per Stromberg - Swedish Institute for Financial Research.
We study how firm characteristics evolve from early business plan to initial public offering (IPO) to public company for 50 venture capital (VC)-financed companies. Firm business lines remain remarkably stable while management turnover is substantial. Management turnover is positively related to alienable asset formation. We obtain similar results using all 2004 IPOs, suggesting that our main results are not specific to VC-backed firms or the time period. The results suggest that, at the margin, investors in start-ups should place more weight on the business (“the horse”) than on the management team (“the jockey”). The results also inform theories of the firm.
A wide-ranging survey of decision making processes, deal structures and outcomes, comparing VC to private equity.
Download{:target="_blank"}
Stanford University Graduate School of Business Research Paper No. 16-33 / European Corporate Governance Institute (ECGI) Finance Working Paper No. 477/2016
- Paul A. Gompers - Harvard Business School; NBER; European Corporate Governance Institute (ECGI)
- Will Gornall - University of British Columbia
- Steven N. Kaplan - University of Chicago; NBER
- Ilya A. Strebulaev - Stanford GSB; NBER
We survey 885 institutional venture capitalists (VCs) at 681 firms to learn how they make decisions across eight areas: deal sourcing; investment decisions; valuation; deal structure; post-investment value-added; exits; internal organization of firms; and relationships with limited partners. In selecting investments, VCs see the management team as more important than business related characteristics such as product or technology. They also attribute more of the likelihood of ultimate investment success or failure to the team than to the business. While deal sourcing, deal selection, and post-investment value-added all contribute to value creation, the VCs rate deal selection as the most important of the three. We also explore (and find) differences in practices across industry, stage, geography and past success. We compare our results to those for CFOs (Graham and Harvey 2001) and private equity investors (Gompers, Kaplan and Mukharlyamov forthcoming).
A review of the existing literature on VC investment criteria; the most significant factors in investment decisions are identified.
Download{:target="_blank"}
- Marija Šimić - University of Split
Different funders, like bankers, business angels or venture capitalists, put the accent on various investment criteria while making investment decisions. Entrepreneurs need to be familiar with these criteria or different requirements of potential investors in order to adjust their business plans. Motivated by the phenomenon of venture capital, numerous researchers worldwide are trying to identify the venture capitalists’ investment criteria. Despite the large number of studies, there is still no unambiguous answer to what the key venture capitalists’ investment criteria are. This paper provides an overview of research about investment criteria set by different suppliers of capital with a special emphasis on venture capitalists’ investment criteria. The most used VCs’ investment criteria discussed in the literature are identifed and analysed in order to provide a new set of VC investment criteria.
A Review of Research into Venture Capitalists' Decision Making: Implications for Entrepreneurs, Venture Capitalists and Researchers
A discussion of the research on VC decision making and the gaps in the research in this field, and suggestions for improving pitches based on the evidence.
Download{:target="_blank"}
- Edward Hudson - Southern Cross University
- Michael Evans - Southern Cross University
A recent review of the current literature on how venture capitalists make their investment decisions suggests that the decision-making process adopted by venture capitalists is more an art than a science. The review also highlights the fact that researchers have not been able to identify the key decision-making variables that lead to making a successful investment choice. Nor do venture capitalists understand their own decision-making process. This paper addresses these issues and suggests how entrepreneurs attempting to obtain equity finance from venture capitalists may structure proposals to have a better chance of acceptance. The paper concludes with a discussion of directions for future research.
A proposed new method for early stage venture valuation and the prediction of firm performance.
Download{:target="_blank"}
- Dingkun Ge Assistant - San Francisco State University
- James M. Mahoney Economist - Federal Reserve Bank of New York
- Joseph T. Mahoney - University of Illinois at Urbana-Champaign
How to valuate accurately a new venture is a critical and under-researched question in entrepreneurial financing. Leveraging established theories in strategic management, this research study develops an integrative theoretical framework to examine whether venture capitalists’ valuation of a new venture can be explained by variables identified in the strategy literature as important to predicting firm-level economic performance. A systematic linkage between well-developed theories in strategy and venture capital valuation practice are corroborated empirically. This research study proposes a complementary method to extant valuation methods to valuate a new venture.
A discussion of the issues arising from using VCs' self-reports of their decision making criteria in research.
Download{:target="_blank"}
- Dean A. Shepherd - Rensselaer Polytechnic Institute
Researchers of venture capitalists’ decision making must be aware of potential biases and errors associated with self reported data especially in light of this study’s findings that venture capitalists’ lack introspection into the policies they “use” to assess likely profitability. Surprisingly, venture capitalists demonstrate some introspection into the policies they “use” to assess probability of survival.
What matters, matters differently: a conjoint analysis of the decision policies of angel and venture capital investors
Angel investors are more concerned about strategic readiness and founder passion than VCs; VCs are more concerned with economic potential, and both groups are interested in the "human capital" of entrepreneurs.
Download{:target="_blank"}
Venture Capital, 2014{:target="_blank"}
- Dan K. Hsua - Appalachian State University
- J. Michael Haynieb - Syracuse University
- Sharon A. Simmonsc - William Paterson University, Wayne, NJ
- Alexander McKelvie - Syracuse University
Prior studies have examined the importance of economic, strategic, and human factors to decision policies of angel investors and venture capitalists. As more angels professionalize into angel funds and as markets for technologies and ideas become more competitive, it is becoming more important to compare their decision policies with those of venture capitalists. Drawing upon agency theory, we examine whether economic potential, specific human capital, strategic readiness, and passion matter differently to venture capitalists and angel investors. Our study is an experimental conjoint analysis of more than 2700 investment decisions nested within a mixed sample of venture capitalists and angel investors. We find that strategic readiness for funding and affective passion matter more to angel investors, while economic potential matters more to venture capitalists. We also find that both investor types place similar weights on the specific human capital of entrepreneurs. These findings support the agency view that differences in the investment decision policies of angel investors and venture capitalists can be explained by examining the agency costs, market risks, information asymmetry, and control mechanisms that are structured into angel and venture capital deals.
Managing the Unknowable: The Effectiveness of Early-Stage Investor Gut Feel in Entrepreneurial Investment Decisions
Angel investors rely on a combination of expertise-based intuition and formal analysis in which intuition trumps analysis, and their intuition effectively predicts venture success.
Download{:target="_blank"}
- Laura Huang - The Wharton School, University of Pennsylvania
- Jone L. Pearce - University of California, Irvine
Based on an inductive theory-development study, a field experiment, and a longitudinal field test, we examine early-stage entrepreneurial investment decision making under conditions of extreme uncertainty. Building on existing literature on decision making and risk in organizations, intuition, and theories of entrepreneurial financing, we test the effectiveness of angel investors’ criteria for making investment decisions. We use this prior work as an integrated lens to ground our empirical findings, and discover that angel investors’ decisions have several characteristics that have not been adequately captured in existing theory: angel investors have clear objectives (extraordinarily profitable investments rather than seeking to maximize return on each investment), and they rely on a combination of expertise-based intuition and formal analysis in which intuition trumps analysis, contrary to reports in other investment contexts. We also found, as proposed, that their reported emphasis on assessments of the entrepreneur accurately predict extraordinarily profitable venture success four years later. We develop this theory by examining situations in which uncertainty is so extreme that it qualifies as unknowable and propose using the term of art, “gut feel,” to describe their dynamic emotion-cognitions in which they blend analysis and intuition in ways that do not impair intuitive processes, and in turn, effectively predict extraordinarily profitable investments.
Prior experience as a founder (particularly when financially successful) increases likelihood of funding and valuation; higher valuations improve founders' ability to recruit managers themselves, and founding teams with at least one PhD receive higher valuations.
Download{:target="_blank"}
- David H. Hsu - University of Pennsylvania
This paper empirically investigates the sourcing and valuation of venture capital (VC) funding among entrepreneurs with varied levels of prior start-up founding experience, academic training, and social capital. Social ties with VCs have been identified as an important precursor to organizational resource attainment and performance, and so this study analyzes the correlates of heterogeneous social links with VCs. I also examine venture valuation, as it reflects enterprise quality and entrepreneurs’ cost of financial capital. Using data from a survey of 149 early stage technology-based start-up firms, I find several notable results. First, prior founding experience (especially financially successful experience) increases both the likelihood of VC funding via a direct tie and venture valuation. Second, founders’ ability to recruit executives via their own social network (as opposed to the VC’s network) is positively associated with venture valuation. Finally, in the emerging (at the time) Internet industry, founding teams with a doctoral degree holder are more likely to be funded via a direct VC tie and receive higher valuations, suggesting a signaling effect. The paper therefore underscores some important dimensions of heterogeneity among VC-backed entrepreneurs.
Entrepreneurial quality is assessed in similar ways by both VCs and crowdfunders, but crowdfunding alleviates some of the geographic and gender biases associated with the way that VCs look for signals of quality.
Download{:target="_blank"}
- Ethan R. Mollick - University of Pennsylvania
Venture Capitalists (VCs) are experts in assessing the quality of entrepreneurial ventures. A long tradition of research has examined the signals of quality that VCs look for in new ventures, and the biases that result from the VC selection process. Recently, an alternative form of new venture funding has arisen in the form of crowdfunding, which relies on the judgement of millions of amateurs about which entrepreneurial projects are worth funding. Little is known about the degree to which amateurs respond to the same signals of quality as VCs, and whether they are subject to the same biases. To address this gap, I examine 2,101 crowdfunded projects that match characteristics of more traditional VC-backed seed ventures. Despite the radical differences in selection environments, I find that entrepreneurial quality is assessed in similar ways by both VCs and crowdfunders, but that crowdfunding alleviates some of geographic and gender biases associated with the way that VCs look for signals of quality.
Venture-Backed Firms: How Does Venture Capital Involvement Affect Their Likelihood of Going Public or Being Acquired?
The prominence of VCs, the number of VCs invested in a company, and the timing, duration, and magnitude of investments all affect exit outcomes, although their effects tend to differ depending on whether the exit occurs via an acquisition or IPO.
Download{:target="_blank"}
- Roberto Ragozzino - University of Tennessee
- Dane Blevins - Clemson University
This paper investigates how venture capitalists' involvement in new ventures affects the likelihood of entrepreneurial exit, either via an acquisition or via an initial public offering. We examine the prominence of venture capitals (VCs), the number of VCs invested in a company, as well as the timing, duration, and magnitude of their investments in new ventures. We find that each of these dimensions directly explains entrepreneurial exit, although their effects tend to differ depending on whether the exit occurs via an acquisition or an initial public offering (IPO). These results withstand several robustness checks and offer a more precise account of how the relationship between new ventures and VC firms unfolds in the early years of the entrepreneurial cycle.
Investors who are typically not primarily active in the VC market are most affected by increasing media coverage; valuations are driven to a large extent by increasing media coverage before a funding round.
Download{:target="_blank"}
- Severin Johannes Zörgiebel - Goethe University Frankfurt
Within the last years, start-ups have achieved extraordinary high valuation levels which have never been seen in such dimensions before. These high-valued start-ups with valuations above or equal to US$1bn are also called unicorns. Similarly, media coverage of start-ups has increased significantly. In this paper the impact of media coverage on global unicorn valuations between 1990 and October 2015 is empirically analyzed. In addition, the impact of technology advancements on the media and start-ups is discussed. The here presented results indicate that technology advancements increase media coverage for start-ups. Investors which are typically not primarily active in the VC market are most affected by increasing media coverage. Start-up and especially unicorn valuations are driven to a large extent by increasing media coverage before a funding round. These results add new insights on the driving factors of start-up valuations and are consistent across a variety of different regression models and robustness checks.
Each additional IPO among a VC's first five investments predicted a 13% higher IPO rate for its subsequent 50 investments; early success in venture investing appears to yield better deal flow in subsequent investments.
Download{:target="_blank"}
- Ramana Nanda - Harvard University
- Sampsa Samila - National University of Singapore Business School
- Olav Sorenson - Yale School of Management
We used data on individual investments in the portfolios of venture capital firms to study persistence in their performance. Each additional IPO among a VC's first five investments predicted a 13% higher IPO rate for its subsequent 50 investments. Roughly half of this performance persistence stemmed from investment "styles" ― investing in particular regions and industries. We found no evidence of performance persistence stemming from a differential ability to select or govern portfolio companies. Rather, our results suggest that early success in venture investing yields better deal flow in subsequent investments, thereby perpetuating differences in the outcomes of initial investments.
The value of increasing the number of deals evaluated increases with the tail weight of the distribution of deal values; when the right tail is heavy, the value of increasing the number of deals is likely to more than compensate for the cost of capacity.
Download{:target="_blank"}
- Suzanne de Treville - University of Lausanne
- Jeffrey S Petty - University of Lausanne
- Stefan Wager - Stanford University
An organization's ability to exploit extreme events - such as exceptional opportunities - depends on its capacity strategy. The venture capital industry illustrates the interplay of expensive capacity and negative externalities from high utilization. The cost of adding a venture capitalist provides a strong incentive to run lean, but such leanness may make it impossible to evaluate all interesting investment opportunities. Using concepts from extreme-value theory, we analyze the trade-off between the costs and benefits arising from an increase in the number of evaluated deals. We ground our analysis in 11 years of archival data from a venture capital firm, representing 3,631 deals, the decisions made, the reasons for those decisions, and the decision lead times. The firm identified 20% of arriving deals as worth evaluating during the screening process, but was not able to evaluate approximately 9% of those interesting deals due to a lack of capacity. We show that the value of increasing the number of deals evaluated increases with the tail weight of the distribution of deal values. When the right tail is light, increasing the number of deals evaluated may provide too modest a benefit to justify the cost. When, however, the right tail is heavy, the value of increasing the number of deals is likely to more than compensate for the cost of capacity. Our results provide new insight into the relative value of a chase capacity strategy that emphasizes responsiveness versus a high-utilization heuristic that emphasizes productivity. Our approach can be applied to other search operations such as personnel selection, quality circles seeking to identify root causes, and making employee capacity available for innovation.
Broad access to information by virtue of having top management team members that have worked for many different employers (diverse prior company affiliations) and have diverse prior experiences (functional diversity) tend to be associated with positive outcomes.
Download{:target="_blank"}
- Christine M. Beckman - University of California, Irvine
- M. Diane Burton - Cornell University
- Charles O'Reilly - Stanford University
This study investigates how top management team (TMT) demographic characteristics affect firm outcomes for young high technology firms in Silicon Valley. We study how team composition and turnover shape an entrepreneurial firm’s ability to attract venture capital and its ability to successfully complete an initial public offering. We find that broad access to information by virtue of having top management team members that have worked for many different employers (diverse prior company affiliations) and have diverse prior experiences (functional diversity) tend to be associated with positive outcomes. In addition, entrants to and founder exits from the TMT increase the likelihood that affirm achieves an IPO. TMT exits, in turn, reduce the likelihood of achieving an IPO. Results also suggest that prior human capital experience is consistently associated with positive firm outcomes. These findings suggest that team experiences, composition and turnover are all important for bringing new insights to the firm and are associated with the likelihood that an entrepreneurial firm will succeed.
VCs' "process values" (values governing the types of means to an end that an individual values) influence the perceived worth of founders' human capital.
Download{:target="_blank"}
- Sharon F. Matusik - University of Colorado Boulder
- Jennifer M. George - Rice University
- Michael B. Heeley - Colorado School of Mines
We examine how judgments in the context of uncertainty vary, depending on the values of those making these judgments. We test these ideas in the context of venture capitalists' (VCs') evaluations of founders. Drawing on theoretical and empirical research on the role of values in judgment and decision making and on Schwartz's (1992, 1996) conceptualization of the basic motivational dimensions underlying human values, we hypothesize and find that decision makers' process values (i.e., values governing the types of means to an end that an individual values) influence the perceived worth of founders' human capital. We discuss implications of these findings for judgment and decision-making research, as well as practical implications for entrepreneurs and venture capitalists.
Investors emphasize predictive information more than they might suppose, especially early in the selection process, but once a venture has moved through the funding process to due diligence and investment, non-predictive information is the key factor.
Download{:target="_blank"}
- Robert Wiltbank - Willamette University
- Richard Sudek - Chapman University
- Stuart Read - IMD, Switzerland
Early stage investors openly discount/ignore the predictions that entrepreneurs show in their business plans as they pitch to investors. At the same time, many predictions about the venture continue to anchor investor evaluations. However, investors’ use of predictive and non-predictive information varies based on their own approach to dealing with uncertainty, their own entrepreneurial experience, and the steps in the evaluation process (i.e. screening, due diligence, and funding). Evaluating data from more than 2,700 individual investor evaluations of 150 new ventures, we find that investors with more entrepreneurial experience are more effectual in how they approach the development of new ventures. We also find that investors grade their area of emphasis more stringently, i.e. those who weight predictive information grade it “tougher.” Overall, investors emphasize predictive information more than they might suppose, especially early in the selection process, but once a venture has moved through the funding process to due diligence and investment, non-predictive information is the key factor.