Venture Capital Networks

Cristiano Bellavitis

• Publisher: Business Expert Press
• Year: 2017
• Print ISBN: 9781631579844
• eBook ISBN: 9781631579851
• Topic: Business
• Subtopic: Finance
• Index: Business

In the venture capital (VC) industry, firms often co-invest with other peers in syndicated deals. The process of syndication is a form of investment alliance that generates networks of VC firms and start-up companies. Despite the prominent role played by syndicates, extant entrepreneurship literature found contradicting evidence on the relationship between the practice of syndication and the performance of both the start-up and the investors. In fact, our understanding of the circumstances under which syndicates have the potential to boost performance, rather than hamper them, is still limited. This book intends to fill this gap and explore the performance dynamics surrounding networks in the venture capital industry. The text also provides introductory knowledge to those interested in network studies and methods.

CHAPTER 1

The Effects of Intra- and Extra-Industry Networks on Performance of Venture Capital Portfolio Firms

This study examines the influence of intra- and extra-industry networks on firm performance by using data on 1,264 UK venture capital (VC)–backed start-up companies. The ventures’ network was operationalized by connecting together the various portfolio companies sharing the same investor. Regression results show that the venture’s network has a strong impact on firm’s success. Yet, whereas extra-industry ties are directly and positively linked to the likelihood of the venture to reach a successful exit, intra-industry ties exert a negative impact on companies’ performances. However, interaction effects show that once a firm establishes a sufficient number of extra-industry ties, it is able to profit from the network in its industry of operation. Overall, these findings show that an optimal balance of ties is achieved through a diverse set of connections incorporating both intra- and extra-industry ties.

1.1 Introduction

Although a venture’s network may facilitate the pursuit of new opportunities, provide access to innovative knowledge, and hence enhance performance, it is increasingly recognized as not only an asset but also a potential liability that constrains the firms’ operations and is costly to maintain (e.g., Baden-Fuller et al. 2011; Brass et al. 2004; Gargiulo and Benassi 2000; Stam and Elfring 2008). A better understanding of the conditions under which a venture’s network enhances a firm’s performance may thus require a contingency perspective in which the categorization of the networks is based on tie attributes rather than structural measures (Lorrain and White 1971). As pointed out by various scholars (e.g., Dahlander and Frederiksen 2011: 1002; Gulati 1995: 645; Lavie 2006; Maurer and Ebers 2006), while much work has focused on the structural attributes of the firm’s networks, surprisingly few studies have examined how heterogeneous ties, in particular intra- and extra-industry connections, impact the firms’ success. The limited empirical evidence that exists suggests that, although networks may enhance performance of entrepreneurial firms, not all ties do so equally (Peng and Luo 2000). Thus, identifying the contingency conditions under which particular networks enhance or constrain venture’s success represents an important research agenda (Lee et al. 2001).

In this study, we aim to contribute to previous network literature by studying how network capital that is embedded in the intra- and extra-industry ties of entrepreneurial ventures impacts the firm’s success. In the economics and entrepreneurship literature, a network is seen as invaluable for the entrepreneur because it provides access to resources, contacts, and opportunities (Ahuja 2000; Aldrich and Martinez 2001; Batjargal 2003; Baum and Oliver 1991; Birley 1985; Bruderl and Preisendorfer 1998; Combes et al. 2005; Dimov and De Clercq 2006; Knack and Keefer 1997; McEvily and Zaheer 1999; Podolny and Baron 1997; Stuart et al. 1999). Networks also play a pivotal role in enabling actors to discover opportunities (Burt 1992), perceive, and exploit them (Companys and Mullen 2007). However, some researchers highlight the cost of managing networks and propose a cost–benefit trade-off associated with networks. Gargiulo and Benassi (2000), for example, conclude that “like the tightrope walker who maintains balance by constant movements of his balancing pole, the successful individual or organization in today’s business environment may have to continuously balance the trade-off between safe (e.g., intra-industry) and flexible networks (e.g., extra-industry).” Contributing to recent efforts to integrate this apparently opposing views, we try to reconcile these perspectives (e.g., Oh et al. 2004; Stam and Elfring 2008) building on the premise that network capital has contingent value (Ahuja 2000).¹

Therefore, we propose that optimal firm performance results from a specific balance of intra- and extra-industry ties. Since simultaneously establishing these two sets of ties may involve significant trade-offs, it is relevant to understand whether they are complementary or duplicative (Stam and Elfring 2008). We argue that both types of networks provide ventures with access to distinct resources (Geletkanycz and Hambrick 1997), and we show that the value of such access is maximized when a firm combines the two types of ties in a certain proportion. Once the venture departs from this optimal combination of intra- and extra-industry ties, its chances of being successful drop. However, if we consider the ties separately, it appears that extra-industry ties are more beneficial to a firm’s success than intra-industry connections.² We argue that the positive effect of extra-industry ties is predominantly related to the knowledge and resource diversity to which these ties give access to. On the other hand, intra-industry ties offer resources that the venture may already possess, and with a lack of extra-industry ties, the venture will not be able to take advantage of a brokerage position between the two “worlds.”

Using a combination of secondary data, hand-collected firm-level variables, and primary sources on networks of VC-backed ventures in the UK, this research specifically examines how a firm’s intra- and extra-industry VC portfolio network centrality contributes to the success of the firm. Addressing recent calls for “more complex, multidimensional models that investigate the interactions between different types of social capital conduits” (Oh et al. 2004: 870), in particular differentiating between intra- and extra-industry ties (Gulati 1995a: 645), we aim to identify the configuration of network ties that maximizes the contribution of networks to ventures’ success.

1.2 Theory and Hypotheses

Networks can be defined both as an entrepreneur’s attempt to mobilize personal contacts in order to profit from entrepreneurial opportunities (Granovetter 1985) and as a firm’s effort to cooperate with others in order to obtain and sustain a competitive advantage (Peng and Luo 2000). Brass et al. (2004) define a network as a set of nodes and the ties representing some relationships, or lack of relationships, between the nodes (individuals, work units, or organizations). Network structure relates to the pattern of relationships that exist among a set of actors, while network composition refers to the types of actors defined by their stable traits, features, or resource endowments (Phelps 2010; Wasserman and Faust 1994). The content of the relationships represented by the ties can vary widely, and it is limited only by a researcher’s imagination (Brass et al. 2004). Specifically, we define the network as the actual and potential resources available to a firm through its network of relationships (Nahapiet and Ghoshal 1998) established by VC-backed ventures within the portfolio of each VC investing in the firm.

Building on recent research (e.g., Dahlander and Frederiksen 2011; Geletkanycz and Hambrick 1997), we focus our attention on the ties’ attributes rather than structural measures. Our focus on network attributes is based on a premise that, although prior work has examined the core discussion related to networks of entrepreneurs (e.g., McEvily and Zaheer 1999) and the structural differences of ties (e.g., Stam and Elfring 2008), this literature lacks systematic research differentiating the resources accessible through different types of ties, therefore acknowledging the heterogeneity of the connections. This study specifically examines two important dimensions of a firm’s network: (1) intra-industry network ties and (2) extra-industry ties. Following the differentiation between “internal” and “external” social capital (Adler and Kwon 2002), our approach builds on the notion that intra- and extra-industry ties provide a focal firm with access to distinct social capital resources, in line with Geletkanycz and Hambrick (1997) and Stam and Elfring (2008).

However, our study departs from Geletkanycz and Hambrick (1997) and Stam and Elfring (2008) on various important dimensions. First, these authors study the impact of ties at the executives’ level, rather than at the firms’ level; second, their sample is related to publicly traded firms while our sample is composed of young firms operating in rapidly changing environments. Third, methodologically they assume the existence of external ties while we adopt specific and longitudinal measures that allow us to precisely identify the amount of external connections and their nature. Hence, to the best of our knowledge, this study is the first which specifically studies the impact of intra- and extra-industry ties on entrepreneurial ventures’ success.

1.2.1 Entrepreneurial Ventures’ Success

In this study, we look at the effect of two types of ties, intra- and extra-industry, on firm’s success. In this section, we explain how we define success. Entrepreneurial ventures, especially in their early years, are usually cash flow negative or have very limited profits. Many VCs argue that valuing a start-up is more an art than a science but the industry agrees that the exit is the ultimate acknowledgment of the start-up market value and therefore its success. Therefore, considering that the main successful [exit] routes considered in the literature are Initial Public Offerings (IPO) and trade sales (Manigart and Wright 2013: 56), in this study, we consider the company exit as our measure of success.

1.2.2 The Role of Intra- and Extra-industry Ties

Previous studies suggest that ventures with central network positions enjoy several advantages that contribute to higher performances (Brass et al. 2004). Being highly connected allows a firm to learn about new market conditions, strategies of competitors, and partnership opportunities (Powell et al. 1996) and have access to alternative providers of valuable resources (Tsai 2001). However, different ties offer different benefits and each tie has a particular trade-off between costs and benefits (Baden-Fuller et al. 2011).

In rapidly changing environments, such as the one in which entrepreneurial ventures are embedded in, firms increase their performances by focusing on ties that offer nonduplicative resources in order to gain new information and knowledge (Christensen and Raynor 2003; Duysters 1996). For instance, biotechnology start-ups with networks providing access to diverse information have higher revenue growth (Baum et al. 2000). Cosmopolitans—entities that are connected with different networks or industries—are more likely to innovate, and are therefore potentially more successful (Dahlander and Frederiksen 2011). Furthermore, resource heterogeneity accessed through connections is an important source of success (Hagedoorn and Schakenraad 1994; Penrose 1959; Prahalad and Hamel 1990; Ring and Van de Ven 1994).

In this light, we posit that extra-industry ties, connections that span outside the main industry of operations of the focal firm, lead entrepreneurial ventures to succeed not only because they offer access to a diverse knowledge base and heterogeneous resources, but also because they help the firm to gain power and potential for brokerage opportunities. Considering that ventures should develop new routines, competencies, and technologies and that extra-industry ties facilitate access to complementary resources that are not available within the industry boundaries (Stam and Elgring 2008), and therefore stimulate exposure to a diversity of approaches, perspectives, and ideas that are not well established in the focal industry (Hargadon 2002), allowing the focal firm to “bring together new combinations of productive factors” (Low and Abrahamson 1997: 443), extra-industry ties are very valuable for new ventures. In sum, extra-industry ties are more likely to lead the firm to success by functioning as a scanning device that allow entrepreneurial firms to detect new trends and asymmetries in a market faster than firms lacking such connections.

In addition, extra-industry ties provide power, allowing a firm to diversify its ties across different industries and therefore avoid the control by few others who control critical resource exchanges (Pfeffer and Salancik 1978:131). Similarly, diversifying ties offers the possibility to broker contacts in different industries that would probably otherwise be disconnected. Therefore a firm that spans contacts across industries is less likely to be dependent on each of these contacts, but rather other firms are dependent on the firm itself (Kotter 1979).

The advantages provided by extra-industry ties are not without costs. In fact, this type of ties involves higher risks and coordination costs (Burt 1992). However, we argue that these two disadvantages are mitigated by the presence of a common investor that helps to reduce transaction and coordination costs through its intermediation (Hsu 2006).

Symmetrically, the main advantage of intra-industry ties is that they offer a cohesive environment with a common ground of behavioral rules (Coleman 1988) and therefore low risk and coordination costs. Furthermore, intra-industry ties provide industry legitimacy, and reduce uncertainty regarding the firm’s quality. However, VCs already play a strong role providing legitimacy (Stuart et al. 1999), information about the quality of the firm (Sapienza et al. 1996), and an environment where failure to comply with the network rules is coupled with severe punishment (Burt and Knez 1995).³

In addition, being dependent on one main industry for connections and resources is likely to increase the firm’s competition over the resources; in fact competition tends to arise in organizations that are functionally equivalent, in that they are attempting to produce similar products and services for similar markets (Pfeffer and Nowak 1976).

Therefore, from the previous discussion we hypothesize that starting from the assumption that entrepreneurial ventures should favor nonduplicative connections, extra-industry connections will be more beneficial to the firm’s success.

H1: The VC-backed venture’s success will be positively (...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright Page
• Contents
• Introduction
• Chapter 1 The Effects of Intra- and Extra-Industry Networks on Performance of Venture Capital Portfolio Firms
• Chapter 2 The Impact of Investment Networks on Venture Capital Firm Performance
• Chapter 3 Does Familiarity among Venture Capital Co-Investors Lead to Higher Performance?
• Chapter 4 Conclusion
• Bibliography
• Index