Does high-quality venture financing increase the success of funded ventures? My co-authors, Josh Lerner of HBS and Antoinette Schoar of MIT, and I define venture finance here to include professional investors in high-growth ventures like venture capitalists and angel investment groups. Other forms of entrepreneurial finance include credit cards, banks, friends and family, personal savings, and so on.
At first glance, this seems obvious — of course. A large fraction of companies that go public receive venture funding early in their life cycle. Moreover, within the venture capital industry, the odds of success improve with the quality of the investor. So, it would seem to follow that obtaining the backing of a top-tier financier is an important stepping stone for high-growth entrepreneurs.
Many entrepreneurs, however, would beg to disagree. Venture funding comes with a high price tag, and many start-ups want to avoid it or at least delay as long as possible. While Google, Facebook and Genentech took on venture funding early in their lifecycles, Dell, Microsoft and Honest Tea made amazing progress through bootstrapping and early non-professional investors.
A Tricky Problem
Evaluating the importance of venture investors for start-up success is a tricky problem. Most importantly, there is a great deal of assortative matching in these markets — that is, great business plans get paired with great investors, and not-so-great with not-so-great. How successful would these high-potential start-ups be absent these investors? At the very least, we should not attribute all of venture's success to the investors.
We study start-up companies that approached prominent angel investment groups to identify the extent to which backing by prominent investors is important for venture success. Angel investors are a central source of start-up funding, greater in deal counts and dollar volumes than venture capital. These investors are increasingly organizing into groups to make their investments. Banding together offers many gains: better deal flow, larger investment size potential, shared due diligence, and similar.
These groups also offer a rare research laboratory for evaluating the impact of high-growth, professional investors. Entrepreneurs make investment presentations to the full angel group. Each angel records his or her interest in the venture individually. The polling and record keeping involved in this process provide a wealth of information on the investment decision process — and its impact on the venture's success.
The Duds, the Homeruns, and the Ones We Study
Most potential deals receive no interest (the duds). A select few receive massive interest (the homeruns). These two groups are of limited use because the funding decisions and subsequent investment outcomes are so closely linked to observable venture quality.
In between these extremes, however, are a group of investment opportunities that carry tremendous information. The funding choices of angel groups display discontinuities or breaking points, where a small change in the collective interest levels of the angels can lead to a discrete jump in the probability of funding for otherwise comparable ventures.
As an example, 90% of the 2000+ ventures that approached Tech Coast Angels (TCA) between 2000-2006 garnered the interest of fewer than 10 angels. The probability of receiving funding in this group was basically zero. On the other hand, 2% of ventures received interest from more than 35 angels, with a maximum of 191 angels expressing interest. The funding probability is in this group was over 40%.
In between these extremes, the funding probability consistently grows, but it is non-linear. TCA was twice as likely to fund a venture if 20-24 angels are interested (38% probability) compared to if 15-19 angels are interested (17% probability). This breaking point is not due to a specific investment rule imposed by investors. Instead, it is an outcome of the their decision-making processes and the collection of sufficient interest around a deal.
Critically, however, one cannot find any statistical difference between the start-ups in the 15-19 group and those in the 20-24 groups in terms of venture sector, amount of funding sought, number of employees, and so on. Thus, the start-up companies in the 15-19 and 20-24 groups are initially comparable in quality but, due to idiosyncratic factors, have very different funding probabilities.
What Happens Next?
What happens to these two groups next says a lot about whether venture financing helps high-growth start-ups succeed or not. Comparing the groups just above the funding border with those just below, we find venture financing increases the probability of venture survival. It also increases venture performance and growth as measured through growth in web site traffic and web site rankings. The improvement gains typically range between 30% and 50%.
Interestingly, we do not find consistent evidence for venture financing leading to better access to follow-on financing by other investor groups, which is often cited as a benefit. Access to capital per se may not be the most important value-added that angel investment groups bring. Some of the "softer" features, such as angels' mentoring or business contacts, may help new ventures the most.
The Fine Print
Two caveats are important to note. First, angel investment groups are very heterogeneous, and our data come from groups that are professionally managed. These performance gains thus may not extend to everyone. More importantly, we are unable to consider the costs to entrepreneurs in terms of equity granted. The deal terms can't be too onerous or taking the money won't be worth it for the entrepreneurs no matter how successful the venture ultimately is.
William Kerr is an Assistant Professor at Harvard Business School, where he teaches the Entrepreneurial Manager course in the first year of the MBA program.
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