04 Dec 2006  Research & Ideas

The Money Connection—Understanding VC Networks

Venture capital firms often consider investments in companies located far away or in unfamiliar industries. How do they spot these opportunities and also reduce risk? It's the power of networks, says Harvard Business School professor Toby Stuart—and understanding how they work in VC is just now starting to be understood. Key concepts include:

  • Networks are important in all industries, but especially so in VC where investment opportunities can be located far away from the centers of venture capital.
  • "Spanning ties" enable investors with fixed locations and industry expertise to learn of opportunities outside their geographic and industry domains, while also reducing risk.
  • Ties are more likely to form between VC firms in the context of bandwagons, such as a "hot" IPO market, that create a rush of excitement around particular types of companies.

 

Most of us have experienced the power of networks. There's the job found through a friend's sister's boyfriend, or the lifelong partner met through a neighbor's cousin.

But how do networks play into business—particularly the relationship-rich industry of venture capital?

New this year to the HBS faculty, Toby Stuart studies networks and how they enable or impede certain organizational and entrepreneurial behaviors. In a working paper, "The Evolution of Venture Capital Investment Networks," he and coauthor Olav Sorenson of University of Toronto's Rotman School of Management examine the effects of geographic distance and a "hot" IPO market on the formation of networks in the venture capital industry.

The fact that the world is connected through spanning ties has huge effects on the spread of all manner of things.

"The origin of that paper goes back to when I was on the faculty at the University of Chicago's Graduate School of Business," Stuart says. "I was part of a committee examining why there wasn't a more vibrant life sciences industry in the Chicago area when all of the requisite ingredients were in place. I became very interested in the role of geographic space in establishing networks."

The vital network

Venture capital shares some of the same qualities as the life sciences industry in terms of the crucial role played by networks, Stuart says.

"Networks are important to all businesses, obviously, but they're absolutely essential to the functioning of VC and the technology-based industries in which VCs often invest. And in addition to person-to-person social networks, firm-to-firm networks are vital in both contexts.

"For example, about two-thirds of venture capital financing rounds involve syndicates of investors rather than single firms. And most young companies are very narrow in scope in terms of the scope of their internal activities, which means that they need to extensively partner with other companies to bring their product to market. These syndicated and partnerships weave together firm-to-firm networks."

There's a general understanding of the role played by proximity and likeness in establishing local network clusters—but how to account for the appearance in a network of a distant player with no immediate connection or similarity to others in its group?

Look at your own life, says Stuart. "To put it in social terms, you probably know a lot of people who know one another. For many of us, most of our time is spent within small clusters of people—at the office, in our neighborhoods. But you also have connections to people who are distant from the small set of cliques in which you live your daily life.

"We have better theories about how you formed a group with your immediate coworkers, friends, and neighbors than we do for those connections that are outside the circle."

Spanning ties

Yet those "spanning ties," as Stuart calls them, have important implications in a variety of contexts.

"The fact that the world is connected through spanning ties has huge effects on the spread of all manner of things ranging from information about positions among job searchers to the potentially rapid spread of communicable diseases," he says.

A market bubble can effectively rewire some of the links in the network.

In the case of venture capital, spanning ties enable investors with fixed locations and industry expertise to learn of opportunities outside their geographic and industry domains.

"They're instrumental in the movement of capital from money centers like New York to entrepreneurial centers like Silicon Valley and Boston," he explains. "In addition to providing access to information about investments and invitations to join syndicates, firms with broad, far-reaching networks are often more comfortable investing in a start-up from a distance because they have reliable, local partners to advise and monitor the new venture."

In their paper, Stuart and Sorenson posit that these ties are more likely to form between VC firms in the context of certain events, such as a "hot" IPO market. "A market bubble can effectively rewire some of the links in the network," says Stuart. "That sort of heated environment creates a rush of investment activity that increases the number of participants hoping to quickly take a company public. It results in some unlikely bedfellows in the syndicate network."

Another factor that can reconfigure a network is risk, Stuart adds. "The general reluctance in doing business with strangers revolves around trust," he says. "You don't know how to assess their competence and don't have a sense of how to 'read' them."

However, spanning ties are more likely to form between the lead venture capital firm and distant investors as the size of the syndicate grows, thus decreasing the risk associated with each organization's investment. The lead VC also perceives less risk in forming a relationship with a distant syndicate partner when they are seeking investment at a later stage of a company's financing, when they enjoy geographic proximity to the start-up in question, and when they are a specialist in the start-up's industry.

Under these low-risk circumstances, a firm starts small by engaging partners they believe will be useful to work with in the future. "The next time around, that entity is part of their working set," Stuart says.

Career networks

Taken more broadly, spanning ties weave together the fabric of the network and contribute to the diffusion of information across the investing community—a dynamic Stuart will study further in Networks in Technology and Entrepreneurship, a work-in-progress that will combine data analysis with insights culled from interviews with HBS alumni working in the high-tech and entrepreneurial arenas.

"The book will examine the role of networks in career development—from recognizing entrepreneurial opportunities to raising capital to growing a business," he says. "It will also look at how the very same networks that enable some individuals to become entrepreneurs can constrain others—some women, for example—because they are outside the core social networks in their areas."

Stuart, the Charles Edward Wilson Professor of Business Administration, was recently awarded the 2007 Ewing Marion Kauffman Prize Medal for Distinguished Research in Entrepreneurship, an award given every two years to one scholar under the age of forty whose research has made a significant contribution to entrepreneurship.

About the author

Julia Hanna is the Associate Editor of the HBS Alumni Bulletin.