NBER WORKING PAPER SERIES THE IMPORTANCE OF TRUST FOR INVESTMENT: EVIDENCE FROM VENTURE CAPITAL

We examine the effect of trust on financial investment and contracting decisions in a micro-economic environment where trust is exogenous. Using hand-collected data on European venture capital, we show that the Eurobarometer measure of trust among nations significantly affects investment decisions. This holds even after controlling for investor and company fixed effects, geographic distance, information and transaction costs. The national identity of venture capital firms' individual partners further contributes to the effect of trust. Education and work experience reduce the effect of trust but do not eliminate it. We also examine the relationship between trust and sophisticated contracts involving contingent control rights and find that, even after controlling for endogeneity, they are complements, not substitutes. Laura Bottazzi Department of Economics Bologna University StradaMaggiore 45 40126 BOLOGNA Italy and IGIERUniversità Bocconi l.bottazzi@unibo.it bottazzi@unibocconi.it Marco Da Rin Department of Finance-Office K 936 Tilburg University Warandelaan 2 P.O. Box 90153 5000 LE Tilburg The Netherlands and European Corporate Governance Network (ECGI) and IGIER marco.darin@uvt.nl Thomas F. Hellmann Sauder School of Business University of British Columbia 2053 Main Mall Vancouver, BC V6T 1Z2, CANADA and NBER hellmann@sauder.ubc. ca “There are countries in Europe [. ] where the most serious impediment to conducting business concerns on a large scale, is the rarity of persons who are supposed fit to be trusted with the receipt and expenditure of large sums of money. ” (John Stuart Mill) Many economists intuitively recognize the importance of trust for economic transactions. Since Arrow’s (1973) remark that “virtually every commercial transaction has within itself an element of trust” a small literature has analyzed the role of trust in economic decisions. For example, the work of Knack and Keefer (1997), Temple and Johnson (1998), and Zak and Knack (2001) establishes a positive relationship between trust and economic growth. More recently, Guiso, Sapienza and Zingales (2009) study the importance of trust for bilateral trade in goods, financial assets, and direct foreign investment, and Guiso, Sapienza and Zingales (2008) use Dutch and Italian data to establish an effect of trust on stock market participation. In this paper we ask whether trust among nations affects the decision to make an investment across different countries. We also ask whether trust affects financial contracting and test whether trust and sophisticated contracts are substitutes or complements. We use a unique hand-collected dataset of European venture capital investments that allows us to study the effect of trust on financial investments and contracts using a powerful fixed-effect identification strategy. Following the social capital literature, we define trust as a subjective belief about the likelihood that a potential trading partner will act honestly. It is important to distinguish two different types of trust. Generalized trust pertains to the preconceptions that people of one identifiable group have for people from another identifiable group. Personalized trust, instead, concerns the evolving relationship between two specific agents. In this paper we focus solely on generalized trust, so that we are concerned with what might be considered cursory beliefs, generalizations about others, even stereotypes. Our first question is whether generalized trust affects the likelihood that a venture capital firm will invest in a start-up company. Prior to investing, there is a search process where entrepreneurs vie for the attention of venture capitalists, which in turn, have to incur time and costs in screening potential deals. We hypothesize that higher trust facilitates this matching process. Moreover, we conjecture that in addition to the country location of the venture capital firm, the nationality and personal characteristics of individual venture capital partners also affect the trust relationship with entrepreneurs, and therefore the likelihood of investing. Our second question concerns the effect of trust on contracting. We identify two contrasting views. The ‘substitutes’ hypothesis argues that sophisticated contracts can be used to overcome low trust between investors and entrepreneurs. The ‘complements’ hypothesis argues that investors make use of sophisticated contracts only when there is sufficient trust. The difference between the two hypotheses concerns investors’ beliefs about contract enforceability. Under the substitutes hypothesis, enforcement is taken for granted, and investors trade-off the costs and benefits of using contractual sophistication: they make use of sophisticated contracts only in the absence of trust. By contrast, under the complements hypothesis, two parties do not find worthwhile to write a sophisticated contract if they have low trust in their counterparts’ nation. We examine these two questions in the context of venture capital investment and