Reliance upon informants in the venture capital industry

Abstract Can venture capital investors rely upon informants to be forthcoming with what they know? Or do they need to be concerned about self-serving conduct? These questions are investigated among two types of venture capital investors: business angels and venture capital firms. The results of the present study suggest that the more either type of investor is concerned with market or agency risk, the less likely he or she will be to use informal network informants (business associates and friends). Market risk is due to unforeseen competitive circumstances, whereas agency risk results from the separate and possibly divergent interests of investors and their informants. Investors with a higher concern for risk consult formal network informants (venture capital firm investors) for information about market risk, but concern with agency risk is not related to the frequency of use of venture capital firm sources. Agency risk deals with particular, self-interested individuals who are unlikely to be known to the formal informant network. Venture capital firm investors consult formal network sources more frequently than do business angels. Compared to business angels, they enjoy a much more efficient flow of information from their informants. As they gain more experience exchanging information, venture capital firm investors increase their reliance upon formal network informants. Because informal network informants have less experience exchanging information, it is possible that some informal sources could escape being detected if they decided to act in a devious, self-interested manner. Rather than relying upon informal informants, several investors indicated in face-to-face interviews that they prefer to perform their own due diligence. Business angels seem to distinguish between two types of informants: close associates with whom they have had extensive investment experience and mere acquaintances to whom they are only weakly tied by a referral from a close associate or someone else. It is quite likely that business angels rely upon informants who are close associates. However, the informants in this study were predominantly acquaintances, which may be fairly typical of most business angel informants. Because they were acquaintances and not close associates, they were not utilized much as informants. Venture capital firm investors rely heavily upon associates at other venture capital firms for market information. Because they do not trust other informants to the same extent, they may wish to de-emphasize their reliance upon them. Similarly, there are indications that business angels rely upon close associates to provide them with information about agency factors. Because angels do not trust others for this information and may in fact have limited access to other informants, they may wish to focus their search for information on business associates. This would enable them to avoid the expense of investigating the reliability of other informants. This research should be helpful to entrepreneurs who are searching for new venture funding. It suggests that certain types of informants may be more effective in championing the prospects of a deal to a venture capitalist. An entrepreneur with a technical or market advantage ought to approach a venture capital firm. Because the informant network for venture capital firms is highly interconnected with other venture capital firms, it is likely that presenting a request for funding to one of them will quickly result in the sharing of it among their informant associates. If entrepreneurs possess a market advantage, they ought to concentrate on obtaining funding from the first venture capital firm investor who reviews the deal. Entrepreneurs who can argue that they are trustworthy or competent, even if they lack a technical or market advantage, ought to present their deals to a business angel using a close business associate as an intermediary. A mere acquaintance used as an intermediary would be much less effective. Although statistical testing indicated that such an approach would not generate significant success, interviews with business angels suggested that using a close associate as an intermediary would improve an entrepreneur's prospects, especially if the business angel were relatively unconcerned about a deal's risk. Moreover, using an informant intermediary to contact a business angel would avoid the need to do an initial background check on the entrepreneur.