In with the “In” Crowd

The social life of the American teenager is not where you would expect to find venture capitalists looking for inspiration on how to enter new markets. But much like the cool kids in high school discourage those who “don’t belong” from getting too close to their “turf,” Yael Hochberg (Professor of Finance at the Kellogg School of Management) and her colleagues Alexander Ljungqvist (Professor of Finance and Entrepreneurship at the Stern School of Business, New York University) and Yang Lu (Assistant VP at Barclays Capital) show that venture capitalists in tightly networked geographic markets discourage new entrants by using some of the same behaviors exhibited in high school hallways.

Like other, more commoditized industries, venture capital (VC) has no obvious natural or regulatory barriers to entry; a new VC firm is free to open up shop in any place it wants. Because of the low cost of entry, incumbent VC firms are forced to defend their territory using a combination of economic and social tactics—such as creating exclusive cliques for deal referrals and even ostracizing those incumbent VC firms that decide to associate with outsiders.

“Venture capital is a relatively opaque and—above all—private business,” said Hochberg. But while the internal workings of VC firms may be hidden, the VC firms that see the highest flow of ideas and possible investments are those that have high local visibility and credibility among entrepreneurs. For an entry VC firm trying to establish visibility, acquiring credibility and local knowledge puts the entrant at an obvious time and cost disadvantage. Although these entry costs are pervasive across nearly all industries, the research of Hochberg and her colleagues shows that the greatest hindrance to entry into a new market is the network effects associated with the VC industry.

Bad News for New Entrants
“VCs routinely cooperate by referring deals and people to each other,” says Hochberg. “By referring promising deals they cannot fund themselves to their friends, incumbent VCs reduce the time entrepreneurs spend searching for funding and thus reduce the likelihood that potential entrants see deal flow.” In fact, there is a statistically significant inverse relationship between the connectivity of a VC network and the number of entrants allowed into its market: the tighter the network of incumbents, the less likely a new VC firm will enter the network.

The effect is that VC firms that have enjoyed generous returns from their continuous investments in innovation hubs—such as Route 128 in Boston or Silicon Valley in California—have been able to prevent the entrance of new VC firms by creating a tight cluster among themselves and local entrepreneurs, sharing board meetings, and referring deals to each other. Thus, they have been able to decrease valuations of the start up companies and keep generous returns for themselves throughout an economic boom. In fact, average valuations in the most densely networked markets are almost $10 million less than those in the least densely networked markets.

But why are individual incumbent VC firms so reluctant to associate with outsiders? Since each VC firm has its own profit motivations, it might seem that an incumbent firm should participate in profitable syndication offers from VC firms outside its own geographic network. However, Hochberg’s research shows that incumbent VC firms that exhibit this behavior receive punishment—often quite severe— from their local networks. Incumbent VC firms that do business with a potential entrant can expect a 2.3 percent reduction in their own network’s syndication opportunities in the first year and a steady decrease in syndication opportunities in subsequent years, reaching a 4.6 percent reduction in Year 4. The fact that this punishment is both economically severe and persistent shows that even though VC firms may have a short memory for failed investments, they certainly do not forget unfaithful behavior.

Good News for New Entrants
Fortunately, unlike in high school where you were condemned to your clique for eternity, there is a way for VC firms to enter new markets. “The price of admission appears to be letting incumbents in on the entrant’s deal flow in unrelated markets,” says Hochberg. The research suggests that incumbents are willing to make deals with potential entrants when the possibility of entering their market is sufficiently tempting. As in other markets, being large and successful has its advantages. Large VC firms are much more likely than small ones to enter new markets. By offering greater reciprocity in their home markets, large VC firms are able to offer incumbents a potential reward that may outweigh the reduction in syndication from the incumbents’ network. Venture capitalists are generally very faithful to their geographic network, but, as with all humans, they are not immune to temptation.

In addition to offering economic reciprocity, new VC firms need to pay attention to the human side of the equation. Matt McCall, a partner at Draper Fisher Jurvetson Portage, says that reputation is the key: “It’s no different than with any other product; the stronger your brand is, the more likely you are able to enter a new market.” But as with other products, brands take a long time to cement into the community’s collective consciousness. “You need to spend time in the network,” says McCall, “maybe one or two years until people trust you. Once you reach the tipping point, you’ll have a shot. And once you have a success in that particular ecosystem, you will begin to reap the advantage of the halo effect.” VC firms entering new markets must not only be willing to offer reciprocity but also have the time, money, and patience to invest in building their networks and getting known within their geographic ecosystems.

So does this mean that entrepreneurs should pick up their business plans and go searching for a less dense VC network that offers a better valuation? “Venture capital is still a local business,” says McCall. He believes that the value of the network might actually be worth the reduction in valuation for entrepreneurs. As he states, “Network effects allow [venture capitalists] to offer better partners and access to good lawyers, accountants, and executives that increase the likelihood of success for entrepreneurs.” For entrepreneurs with promising ideas, money is a commodity. These entrepreneurs want more from an investor than just a good valuation—because they value the ecosystem and network that the VC firm belongs to. The research of Hochberg and her colleagues proves that tight networks are valuable for incumbent VC firms, but tight networks may also be valuable for entrepreneurs who may benefit from the partners that well-connected venture capitalists bring to the table.

To an outsider, the behavior of venture capitalists is sometimes inexplicable, but Hochberg’s research sheds light on the motivation and modus operandi of this intriguing industry. While venture capitalism will continue to be a private business, the closer we look at its behavior the more rational it seems. Venture capitalism is much more dependant on human instinct than most industries, and this research suggests it also relies heavily on trust and reciprocity.