How the social capital of your investor affects business success


 

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A headset that offers a virtual reality experience as a support for meditation exercises, doesn’t that sound like an exciting idea? In fact, there are various small tech start-ups that are exactly trying to develop something of the sort: a simulated environment that help people focus on the here and now, on their current state of being.

Yet, developing virtual reality systems certain does not come cheap. And is there really a market for this? Doesn’t it clash with the very idea of meditation, to try and bring you back to the actual here and now, and not to an imagined one…? Companies in the process of developing VR meditation would certainly benefit from venture capital investment. Not only may venture capitalists provide the required funding to set up beta-batch production and market testing, their advice on what may be viable business models may be equally if not more important.

If you were a young entrepreneur in this space and had the luxury of being able to choose between two investment offers, which offer would you choose? The two offers are exactly alike but for the network of past co-investment partners that they each investor has and that it may draw on in advising your business.

Investor A’s past investment partners are all highly experienced investors in the virtual reality domain. Because these partners often co-invested together they have an extensive joint history, forming a dense, closed network where the investors place great trust in each other.

Investor B has the same level of experience and success in virtual reality investments, but has previously co-invested with investors that have deep experience from investments in a range of other domains of information technology, but little in virtual reality. These partners have never invested together and thus form a sparse network that is only kept together by investor B. Graphically depicted, the networks of investors A and B looks as follows:

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Which investor would you prefer? The deep level of experience in the virtual reality domain of investor A’s partners and the trusted relationships with them would seem appealing at first. However, network scholars would have you believe investor B is the better bet.

If you want your investor to propose a course of action that differentiates your firm from similar businesses that have received investment before, investor A – embedded in a closed network of deeply specialized partners – may not be quite as a wise choice as it may seem at first glance. Members of a closed-specialized network may offer you a too limited view of how your business may develop due to problems of “group-think”. Due to their extensive shared experience and a lack of engagement with outsiders who may offer a diverse perspective, investors in closed-specialized networks are likely to think too much alike, at the risk of being oblivious to developments and trends outside their group of like-minded friends.

In a recent study, published in the Administrative Science Quarterly, I show that entrepreneurs indeed do not fare very well if they have investors like investor A. Surprisingly having investor B appeared to be equally problematic!

The classic brokerage story would teach you that an investor who operates as the “sole intermediary” between other investors is in a unique position to gain access to different types of input from the mutually unconnected investors in their network. They – and they alone – can combine such inputs to define a novel course of action for your business. For example, it may obtain insights on successful business models from the investors with diverse sectoral experience it brokers between and bring these insights together in a high-quality advice to your firm.

So why is having an investor of type B – with an open-diverse network – also leading to limited business success? The answer lies in the difficulty for the brokering investor to interpret the sheer diversity of inputs it accesses from its network. Not only is the information diverse because of the brokering position, the information also relates to a broad variety of IT domains. Without the possibility to rely on trusted partners, it may simply be too difficult to assess how insights from one domain may transfer and apply to the context of virtual reality, to the context of your business.

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With neither investors A and B working out particularly well for the businesses in which they invest, the question arises what kind of networks may offer better prospects. Our research finds there are two investor network configurations that offer “the best of both worlds”: (1) access to diverse information that allows learning from the experience of others and (2) the ability of the investor to interpret how obtained insights may apply to the specific businesses it is investing in.

Investors like investor C that have closed networks among diverse partners get access to diversity because their partners’ past profiles span a variety of sectors. But, at the same time, the group of investors have sufficient history of shared investments to form a trusted circle of ‘friends’ that can help with interpreting how insights from one domain may apply in another. Collectively investors in a closed but diverse network stand a better chance in making sense of new information, whilst the diverse profiles of the members prevent them from thinking too much alike.

An investor specialized in virtual reality firms may call on partners specialized in, for example, sports app firms and video games firms, to assess how a business model it learned about from investors in digital platform companies may apply to its portfolio of virtual reality firms. In our research we found that firms with first-round investors with such closed-diverse networks were more successful in attracting further funding than those who had investors with open-diverse or closed-specialized networks.

The second type of investor networks associated with positive outcomes for the invested businesses are open-specialized networks. Investors like investor D that have open-specialized networks can easily interpret the information they get from their network connections. These ties are mostly to investors that specialize in the same domain and thus investors are unlikely to need much help in understanding how the information they obtain applies to the firms they are investing in. At the same time, the information they get from their partners is diverse. Here a virtual reality-specialized investor has connections mostly to other investors in that same domain. These, however, do not form a closed group of investors with uniform views, but instead a collection of investors who rarely worked together, which makes it likely that each of them will provide that investor with different views, for example, on effective business models in their domain.

The bottom line is that an investor will be able to provide high-quality advice if it combines access to diverse information with the ability, either alone or with trusted friends, to make sense how that information may apply to the context of a specific firm. It may be difficult for start-up businesses to understand their investors’ network, but, given the evidence, it may be well worth a try.

To access the Open Access article on which this blog post is based, click here.

 

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