Teaming Up to Cash In
It has long been known that venture capital (VC) firms team up to cash in on joint deals, but it has not been clear how this practice affects competition between firms. But a pair of professors at the Kellogg School of Management recently found that for networked markets in the venture capital industry—that is, for markets where firms work cooperatively on shared deals—increased competition impacts firms quite differently than in other industries.
to your inbox.
to your inbox.
We’ll send you one email a week with content you actually want to read, curated by the Insight team.
Yael Hochberg, an assistant professor of finance at the Kellogg School who has previously researched cooperation strategies between venture capital firms, was intrigued by the challenge of measuring competition between VC firms in markets where cooperation was common versus markets where cooperation was uncommon. She collaborated with Michael Mazzeo, an associate professor of management and strategy at the Kellogg School, who has researched competition in other industries.
Cooperative Ties and Networking
Venture capital funds receive money from investors to nurture start-up companies in need of capital. These start-up companies are typically in the types of industries where there is initially plenty of growth but not necessarily much profit, which makes borrowing money from a bank difficult or impossible. The VC funds essentially buy pieces of the company, and investors from the VC firm often serve on the start-up company’s board of directors, or they help to direct and advise the company.
Mazzeo says there are two ways that venture capital funds can be successful. The first is to identify potentially successful companies at a very early stage, because this allows them to buy pieces of the company while they are still relatively inexpensive. The second way is to provide the industry experience or insider knowledge to help make strategic decisions within the start-up after making an equity investment. “This is one of the reasons that the industry is geographically segmented, because there is an important informational component associated with getting the right deals up front,” Mazzeo says. “Also, the VC wants to be involved after the investment is made, and that requires co-location.”
Here is where the cooperation kicks in. “There is an element where sharing information and resources between firms proves to be useful, both in finding the good deals that are out there, and in managing them successfully to the point where they grow into good, independent companies,” Hochberg says. If a firm finds a deal that is a good fit for its expertise, but does not quite have the capital to cover a particular investment, or vice-versa, cooperation can be beneficial. Alternatively, firms may want to share the risk of an investment to diffuse potential losses. “This type of cooperation between firms also operates largely on a quid pro quo basis because the expectation is that if I invite you to come invest with me when I find eBay, then you’ll invite me to come invest with you when you find Google. Which is why we tend to see the same groups of investors co-investing on many different deals together.”
Hochberg and Mazzeo used a standard database of U.S. venture capital firms to trace the cooperative ties between firms via their co-investments. From these ties, they created a map of networks within each geographically based market. They then broke their sample into two halves: networked markets and non-networked markets. Next, they developed a model that allowed them to measure competition in both samples.
“The more demand that is needed to support an additional firm, the more competition exists in that market, because the price effect.” — Michael J. Mazzeo
“We used a method that allowed us to understand how competitive different firms are … based solely on how many firms are in the market and how many firms are operating relative to the market size,” Mazzeo says. Essentially, the researchers used the amount of additional demand needed to support one more firm in the market as a proxy for competition. Says Mazzeo, “The more demand that is needed to support an additional firm, the more competition exists in that market, because the price effect”—the downward pressure that increased competition imposes on prices—“from the additional firm requires more quantity to generate the same amount of revenue.” Mazzeo and Hochberg looked at whether competition would be affected by how many VC firms operated in the market, as well as the extent to which each firm specialized in a particular industry (though the effects of specialization are beyond the scope of this article.)
A Pattern Reversal
Mazzeo and Hochberg found that the pattern of competition in networked VC markets looked very different from what was observed in other industries. “In other industries what you see is that the first competitor that is similar to you to enter the market hurts you a lot, and the second competitor hurts you a little less, and the third even less,” Mazzeo says. “But that flips around in the venture capital industry, where the first competitor that is similar to you to enter the market doesn’t hurt you very much, but the second competitor hurts you a little more and the third hurts you even more.”
The reversed pattern is entirely consistent with the existence of cooperative networks, Hochberg says. “This makes sense because there is a beneficial element to the first competitor in the market if you are working together and sharing resources. But that benefit begins to go away with the second competitor, and it’s even less with the third.” Interestingly, other research by Hochberg finds that VC firms sometimes penalize other firms for letting additional competitors into what had been a tightly networked market. “Sometimes they were shut out for a very lengthy period of time,” Hochberg says. The networks also work to effectively exclude new competitors from markets, as start-up companies in need of capital and expertise are rapidly serviced by the existing network.
The weakening of competition seen in networked VC markets goes to show that it is not just whom you know that matters in this business, it is whom you choose to build bridges with.
About the Writer
T. DeLene Beeland is a science writer based in Asheville, NC.
About the Research
Hochberg, Yael V., Michael J. Mazzeo and Ryan C. McDevitt. 2011. “Specialization and Competition in the Venture Capital Industry.” Working Paper.
Suggested For You
A study of professional sports teams suggests that one factor is clearly more important, but the best teams combine them both.
Organizations would be wise to help employees avoid compartmentalizing their personal and professional identities.
It’s never too late to forge your own path. Here are four steps.
Plus, ideas for designing spaces that encourage employees to team up in unique ways.
Most Popular Podcasts
Coworkers can make us crazy. Here’s how to handle tough situations.
Plus: Four questions to consider before becoming a social-impact entrepreneur.
Finding and nurturing high performers isn’t easy, but it pays off.
A Broadway songwriter and a marketing professor discuss the connection between our favorite tunes and how they make us feel.
More in Economics