Gender Diversity and Venture Capital Firm Performance

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HBS Professor Paul Gompers and his colleagues have conducted impactful research on the impact of gender diversity, or lack thereof, in the venture capital industry.  Not surpisingly, they found that venture capital firms tend to have homogenous management teams.   Most of the partners tend to be white men with liberal arts undergraduate degrees and MBAs.  A significant portion attended Harvard Business School.   The representation of women in the venture capital world has not increased much since 1990, according to Gompers' research. He notes, "“We really saw how powerful the force of ‘birds of a feather flocking together’ was. The more similar you are to someone, the more likely you are to work with them.”  The scholars discovered that, "Partners who came from the same school achieved an 11.5 percent lower success rate for acquisitions and IPOs; those who were ethnically homogenous saw a success rate 26 to 32 percent lower."  

To disentangle correlation from causation, Paul Gompers and Sophie Wang conducted another fascinating study.  They reviewed alumni data from universities that accounted for most of the venture capital partners in their sample. They discovered that partners with daughters tended to hire more women as partners in their firms. Then they examined venture capital fund performance, and they found a substantial advantage for funds with at least one woman serving as a partner. According to HBS Working Knowledge, "While the median venture capital fund return is around 14 to 15 percent, funds with a female partner returned 16 to 17 percent. Moreover, having women as partners increased the percentage of successful startups supported by those firms—that either went public or sold for more than their total capital investment—from about 28 percent to about 31 percent." 

Should States Stop the Strict Enforcement of Non-Compete Agreements?

Over the past few years, Massachusetts has witnessed a vibrant debate about whether the state should stop the strict enforcement of non-compete agreements that employers require many employees to sign.   Many entrepreneurs and venture capitalists have argued that Massachusetts is at a substantial disadvantage to California, a state that does not typically enforce non-compete agreements.  A new article from Yale Insights (a publication of Yale's School of Management) examines the research on this topic.  Scholars Olav Sorenson and Matthew Marx write about their work on this subject.  They argue that non-compete agreements inhibit entrepreneurship and slow economic growth.  Here's an excerpt:  

States that enforce non-compete agreements and those that enforce them more strictly have fewer startups. Entrepreneurs usually have prior experience in the industry they enter, or in a closely related one; non-compete agreements can thus prevent them from striking out on their own. Even if they can found their own firms, these agreements hamper their ability to hire early employees. As a result, a dollar of venture capital goes further—in terms of creating more jobs and more economic growth—in states that restrict the enforcement of non-compete agreements. Some of our research indicates that venture capital creates two to three times as much economic growth in regions that do not enforce these agreements as it does in regions that do.

States that enforce non-compete agreements also suffer from a brain drain, with sought-after employees leaving states like Massachusetts, which enforce non-competes strictly, for states like California, which do not. Many of the students we teach at MIT and Yale to move to California for this very reason. The enforcement of non-compete agreements therefore imposes an economic cost on all of us. We support these reforms not so much because they might help to right some of the wrongs associated with non-competes—though they should help to do that as well—but because they would promote economic growth.

Venture Capital Investments that Suppress Innovation?

Rory McDonald, Emily Cox Pahnke, Benjamin Hallen, and Dan Wang have written a new paper titled, "Exposed: Venture Capital, Competitor Ties, and Entrepreneurial Innovation."  In this article, the scholars examine the impact on startups when venture capital firms invest in multiple firms in the same industry.   The researchers argue that startups seek out venture capital investments for a variety of reasons, not simply access to funds.  They also want the expertise, skills, and advice that venture capitalists have to offer, as well as access to a network of potential partners and customers that the VC firm can tap into for them.  What happens though when venture capital firms invest in more than one firm in the same industry?  Will their divided attention hurt the startups in which they invest?  Will conflicts of interest damage innovation at the startups?    In other words, might the venture capitalist end up picking favorites among the startups in which they have invested?  

To study these questions, the scholars examined roughly 200 firms working on medical devices related to minimally invasive surgery over a twenty year period.   They identified which firms were working in the same market spaces, and they examined the venture capitalists investing in each of these firms.   Ultimately, they tracked the new product introduction rate for each firm.  What did they find?  According to Harvard Business School's Working Knowledge website, "The data showed that companies tied to a competitor by at least one VC firm in common were indeed less innovative than those unencumbered by such ties; in fact, they were 30 percent less likely to introduce a new product in any given year."  

The scholars found some other impacts.  According to HBS Working Knowledge, "The first was the level of “commitment” a VC had to a particular company, judged by the amount and frequency of funding. The same way a teacher may lavish more attention on a favorite student, the researchers found that VC firms also tended to pick favorites, which did better overall; their competitors were 55 percent less likely to introduce a product."  

Individual vs. Group Decision Making in the Venture Capital World

Wharton doctoral candidate Andy Wu has conducted some interesting research about decision making in the venture capital world.    He explains his research to Knowledge@Wharton:

My current work focuses on the role of partners of venture capital firms who make angel investments on the side. What that allows us to do is compare organizational decision-making to individual decision-making. In this work, we find that individuals acting alone are able to process private information that they have that their organization doesn’t have, and allows them to make investments in firms with observably weaker characteristics, such as younger founding teams, less educated founding teams. Nevertheless, these individual investors are able to generate the same financial return as their employing firms.

What does Wu mean by private information?  Well, he's really referring to tacit knowledge... expertise that cannot be easily transmitted to others.  Your intuition may tell you that a certain investment is attractive or not.   The data do not justify your conclusions.  How do you persuade your partners in the firm?  Wu argues that you often do not persuade them.   You can't make a strong, rational, explicit case to them.  However, tacit knowledge leads you to conclude that it's a good investment.  Groups, Wu argues, focus on explicit information and often fail to incorporate crucial tacit knowledge.  

Can Experts Predict the Next Great Startup Success Story?

Scholars Erin Scott, Pian Shu, and Roman Lubynsky have written a fascinating new paper about startups.  They examined a dataset of 652 ventures from MIT's Venture Mentoring Service (VMS).   The service attempts to match startups with mentors.  The mentors receive data about a variety of startup ideas.  They must decide what they think about the ideas without having an opportunity to review information about the founders or to meet the team in person.   The researchers then examined how many of these startups went on to have their products commercialized successfully.  

Overall, the more highly rated ideas did have a better chance of being commercialized.  However, that was not the case for all types of startups.  They grouped the ventures in terms of high R&D intensity industries (i.e. life sciences, energy) and low R&D intensity industries (i.e. software, consumer products).  Highly evaluated ideas tended to be more likely to be commercialized successfully in the high R&D intensity group, but no such relationship was found in the low R&D intensity group.  HBR's Walter Frick explains this finding: 

Think of it this way: if the venture “idea” includes patent-protected technology in an industry with high entry costs, it’s going to be easier to determine that the venture has commercial potential. For web and mobile ventures, which are less likely to have intellectual property, and where entry costs are lower, it’s harder to know up front whether a venture will have a real, sustainable competitive advantage.

Finally, the researchers examined whether experts were better at predicting success.   Frick writes, "The researchers checked to see if “expert” mentors were any better at picking ideas than the group overall. They looked at mentors with experience in the venture’s industry, as well as mentors with a PhD. Neither group was any better at predicting which ideas would succeed."  

Truth vs. Faith in Decision Making

In this week's New York Times Corner Office column, Adam Bryant interviewed Tae Hea Nahm, Managing Director of Storm Ventures - a venture capital firm based in Menlo Park, California.  Nahm described a fundamental tension that exists between truth and faith when it comes to decision making.  I have never quite heard leadership described in this way, and I thought it was worth sharing here.  Here's an excerpt: 

The other thing I learned as C.E.O. is that it’s very lonely. If you share all the doubts and fears with people, then people sort of freak out, whether they’re other investors or employees or executives. You have to provide a path to success. So what I found as C.E.O. is that you almost need a split personality.  On the one hand, you have to appear like Moses, so that people believe that you’re going to take them to the Promised Land. And you have to present a very simple, clear path to success. On the other hand, if you just believe all of that, you can easily run the company off a cliff. Being a C.E.O. requires a lot of faith and passion, but for making decisions, sometimes truth and faith are different.  So you also have to be a skeptic, almost like Galileo. You can have beliefs, but you have to really search for the truth, which is often tied to bad news. 

Step back and consider your leadership style for a moment.  Are you terrific at the passion element described by Nahm, but perhaps blindly devoted to the path on which you have set out?   Or, are you appropriately open to alternative views, but perhaps not effective enough in selling the vision to your employees?  Have you struck the appropriate balance? 

Beware of How Venture Capital Firms Team Up

Drew Graham, Managing Partner of Ballast Point Ventures, pointed me in the direction of a great new study by Paul Gompers, Yuhai Xuan and Vladimir Mukharlyamov.  The scholars examined over 3,500 venture capitalists and their investments in over 12,000 start-ups over a thirty-year period.  They discovered, not surprisingly, that venture capitalists tend to invest in deals alongside other venture capitalists who were quite similar to them (in terms of ethnic background, education, employment experience).   What was the effect on performance?  Here's a summary from HBS Working Knowledge:

They found that the probability of success decreased by 17 percent if two co-investors had previously worked at the same company—even if they hadn't worked there at the same time. In cases where investors had attended the same undergraduate school, the success rate dropped by 19 percent. And, overall, investors who were members of the same ethnic minority were 20 percent less successful than investors with different ethnic backgrounds.

Two major factors might be driving this drop in performance.   The venture capitalists might be picking bad deals (perhaps one is convincing the other to invest in a deal that has concerns).   Alternatively, the venture capitalists might be making poor decisions after the deal, in terms of how they influence the firm's strategy and management.  The scholars argue that "groupthink" leads to inefficient decisions after the deals, when venture capitalists are co-investing with folks with whom they share many similar characteristics.  We shouldn't be surprised by this finding, but it certainly offers a warning sign not only for investors, but also for start-ups as they seek funding. 

Handsome Males More Likely to Achieve Success in Entrepreneurial Pitches

HBS Professor Alison Wood Brooks, Wharton Professor Laura Huang, MIT scholar Sarah Wood Kearney, and MIT Associate Dean Fiona Murray have conducted three intriguing new studies about the effect of gender in entrepreneurial pitches.  They found that investors are more likely to favor male entrepreneurs rather than female entrepreneurs.  Attractive men do better than unattractive males. 

In the first study, angel investors watched videos of real pitches and rated the attractiveness of the entrepreneurs.  According to HBS Working Knowledge, "Male entrepreneurs were 60 percent likelier to receive a funding prize than were female entrepreneurs. Among those male entrepreneurs, investor-deemed attractiveness led to a 36 percent increase in pitch success. But for female entrepreneurs, their looks had no apparent effect on the success of their pitches."  

In the second study, each participant watched two pitch videos, one of which was successful while the other was not.  50% of the participants were women.  Roughly 2/3 of the participants preferred the pitches from males.  Interestingly, the preference for male entrepreneurs existed both for the male and female participants who were judging the pitches.

In the final study, 194 participants watched a pitch video.  The voices on the video could be either male or female.   The voice-overs were accompanied by a photo, some of which had been independently rated as highly attractive and others that had been evaluated as less attractive.  According to HBS Working Knowledge, "As with the previous studies, participants awarded higher ratings to pitches with male voices—deeming the male pitches more "persuasive," "fact-based," and "logical" than otherwise identical female pitches. Additionally, the participants preferred pitches from the "high-attractiveness" male entrepreneurs over those from "low-attractiveness" men. But looks had no significant effect on whether female-voiced entrepreneurs fared well." 

Cooperation & Competition in the Venture Capital Market

Yael Hochberg, Michael J. Mazzeo and Ryan McDevitt have conducted some interesting new research on competition and cooperation in the venture capital market.   They found that competition has a different impact in the VC market as compared to most other industries.   Mazzeo explains in a write-up on the Kellogg Insight website:

"In other industries what you see is that the first competitor that is similar to you to enter the market hurts you a lot, and the second competitor hurts you a little less, and the third even less.  But that flips around in the venture capital industry, where the first competitor that is similar to you to enter the market doesn't hurt you very much, but the second competitor hurts you a little more and the third hurts you even more.  This makes sense because there is a beneficial element to the first competitor in the market if you are working together and sharing resources. But that benefit begins to go away with the second competitor, and it's even less with the third."

Cooperation is key in the VC market because some firms may be very adept at providng the expertise required to help a particular start-up grow, but may want to spread the risk by bringing in a partner to provide some of the needed capital.  In certain cases, a start-up may need different types of expertise, access to networks, etc.  One VC firm may provide some of that assistance, while another VC firm may provide other forms of support and guidance.   Once firms work together on one deal, they may learn that they can work together effectively, and that each has important capabilities to contribute.  That makes them likely to want work together again.   Thus, cooperation becomes crucial to success in the VC market. 

On the other hand, VC firms still compete to find the best deals, get the most favorable terms, identify the next hidden gem so that they can get in early, etc.   What that means is that a feeding frenzy can eventually take place, where too much money is chasing too few deals... as a result, diminishing returns eventually can kick in, and returns on investment can fall.   Cooperation doesn't mean that rivalry won't harm returns.  That still happens, as it would in any industry.