The structure of the investment networks of venture capital firms

Abstract Venture capital firms are linked together in a network by their joint investments in portfolio companies. Through connections in that network, they exchange resources with one another. The most important of those resources are the opportunity to invest in a portfolio company (good investment prospects are always scarce), the spreading of financial risk, and the sharing of knowledge. All venture capitalists operate in very uncertain environments, none more so than the one confronting high innovative venture capitalists, HIVCs, 1 that specialize in investing in high innovative technology companies. The most uncertain of all their investments is a high-technology start-up with nothing more than a product in the head of the founder. There is uncertainty about the talent of the entrepreneur, the market need for the product, the development of a saleable product, the raising of second-round financing for working capital and expansion; the manufacturing of the product, competitors' responses, and government policies such as capital gains tax and ERISA rules, to name some of the major components. It is a formidable list. Indeed, it is hard to name a segment of any other industry that bears more uncertainty than HIVCs. A venture capital firm copes with uncertainty by gathering information. This research shows that the amount of coinvesting by a firm depends on the degree of uncertainty it faces. The greater the uncertainty, the greater the degree of coinvesting. By examining how venture capital firms were connected by their joint investments, it was found that the top 21 HIVCs comprise a tightly coupled network. And of that group, none is more tightly bound than the nine HIVCs located in California. In contrast, the group of top 21 firms that invest mainly in low innovative technology companies, LIVCs, is more loosely bound. HIVCs are more tightly bound together because they shoulder more uncertainty and therefore have a greater need to share information with one another. The practical implications of this study are as follows: Venture Capitalists. It is vital to be well-connected to other venture capital firms. They are important sources of information and investment opportunities. For HIVCs, the California group is central in the network, so links to them are valuable. Communications in a tightly coupled system are swift, so it is likely that information is disseminated very quickly among members of the group. It probably facilitates the setting of a market rate for venture capital. A disadvantage of a tightly bound system is that information flowing among the members has a redundancy and sameness about it, so to ensure a supply of fresh information, members should have as many links as possible to other organizations and individuals besides venture capitalists. Entrepreneurs. When entrepreneurs submit a proposal for funding to venture capital firms, they can assume that news will spread fast to other firms. Thus, they should not use a bird-shot approach; rather, they should select their targets with rifle precision. The proposal should be submitted to a few firms that are known to specialize in the type of product or service that the entrepreneur is planning to make. Entrepreneurs should be concerned about more than the price of the deal. When the top 61 firms invest in a portfolio company, they bring information, contacts, and “deep pockets” to the companies in which they invest. Those factors are significant in nurturing a growing company. Policy Makers. The networks of HIVCs and UVCs are quite different. The HIVCs cluster around oases of high-technology entrepreneurship in the northeast and California, whereas the LIVCs are more evenly spread throughout the U.S.A. HIVCs are located almost exclusively in the so-called “bi-coastal regions of prosperity.” This study found cliques among the venture capital firms. But it found no evidence that the top 61 firms exclude other venture capital firms from their coinvestments of first-rounds of capital. More research is needed before conclusions can be drawn about the power and influence of the top firms. Researchers. In a recent article, Granovetter (1985) suggests that if we are to explain economic behavior, we must understand the networks in which transactions are embedded. This research shows that the networks formed by the syndicated coinvestments of venture capital firms may help us to explain their behavior. A general model for coinvestment networks that is developed in this article is applicable to analysis of syndicated coinvestments not only of venture capital firms, but of investors and lenders in general.