By Constance Gamache (Research Lead) and Madison Hofert (Undergraduate Researcher)
Wuebker, Hampl, and Wustenhagen. , 2017
Summary:
Common sense suggests that personal networks and perceived prestige are both key factors in how venture capitalists make investment decisions; if an investment is recommended by someone that a given investor holds close both personally and professionally, then the investor ascribes high value to the recommendation based on a history of trust. Similarly, if others who are making the same investment have high perceived status or prestige, then that investor is also much more likely to trust their decision. Literature shows that these intuitions derive from both organizational and social network theory, which explain the mechanisms behind decision making heuristics.
The interaction between organizational and social network theory is less intuitive. The Strength of Strong Ties takes an experimental approach to finding a relationship between status hierarchies and personal social networks. The experiment involved a three-step series of decision making tasks meant to simulate real-world investment selection processes. Three clear patterns emerged in the data.
- In the context of high market uncertainty, the trust behind personal ties is much more important than the signaling effects of high-profile investors. This result is particularly salient to startups operating in areas like new and emerging technology, implying that those working on products with little-to-no market history should prioritize personal connections rather than status when seeking investments.
- The extent to which personal ties are prioritized is mediated by the density of personal networks: using geography as a partial proxy for understanding network density, Wuebker et al. compared investors from the densely-connected San Francisco Bay area, as well as the much more sparsely-networked Europe. Personal ties were substantially more significant in San Francisco than in Europe.
- As investors gain experience, the role of strong personal ties in investment heuristics follow a U-shaped path. Wuebker et al. find statistically significant evidence that the most inexperienced investors rely on strong social ties for choosing deals. As investors gain experience, the strength of personal networks declines in importance, perhaps as investors develop their own decision making heuristics, which could include the relative prestige of the lead investor. For very experienced investors, however, there is a return to prioritization of personal ties. Wuebker et al. explain this phenomenon — extremely experienced investors may expect to be aware of “high quality deals” based on their close connections who are also likely to be highly experienced; in another vein, extremely experienced investors may begin to over-rely on their heuristics. Additionally, at this part of the scale, “prestigiousness” may also correlate strongly with personal networks.
Takeaways:
- Personal relationships are relatively more important: This highlights the compounding difficulties that under-represented entrepreneurs and investors face in the VC space.
- Consider the ease of your personal networks: Given that this study is premised on the importance of personal networks as well as perceived prestige, it’s clear that founders (and aspiring investors) who aren’t white, male, or alumni of certain schools are at a disadvantage, as they are more likely to lack the “ins” to those networks and to be picked up by “prestigious” investors.
- Opportunity for a diversity of new communities to form: The development of social and professional communities for and by marginalized communities in VC could overcome structural, compounded disadvantages facing minority groups, leveling the playing field of social connections.
Additional Reading:
*Denotes key source