Finance & Accounting Entrepreneurship Nov 1, 2009

In with the In” Crowd

In ven­ture cap­i­tal, high school rules prevail

Based on the research of

Yael Hochberg

Alexander Ljungqvist

Yang Lu

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 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.

Featured Faculty

Yael Hochberg

Member of the Department of Finance faculty from 2005 to 2013.

About the Writer

Santiago Carbonell is a 2008 MBA graduate of the Kellogg School of Management.

About the Research

Hochberg, Yael V., Alexander Ljungqvist, and Yang Lu. 2010. Networking as a Barrier to Entry and the Competitive Supply of Venture Capital. Journal of Finance, June, 65(3): 829-859.

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