First Look

November 21, 2006

When it comes to being an entrepreneur or venture capitalist, is it better to be lucky or good? According to a new working paper, "Skill vs. Luck in Entrepreneurship and Venture Capital: Evidence from Serial Entrepreneurs," skill carries the day most of the time. "We show that entrepreneurs with a track record of success are more likely to succeed than first-time entrepreneurs and those who have previously failed," the authors observe. "Similarly, more experienced venture capitalists are able to identify and invest in first-time entrepreneurs who are more likely to become serial entrepreneurs. The paper is available for a small fee from SSRN.

Other papers released in the last week look at the need to develop forward-looking customer metrics, the relationship between taxes and corporate cash holdings, and the role of the press in sniffing out accounting fraud. In a new case study, social networking company Friendster is discussed.

— Sean Silverthorne

Working Papers

The Performance of Reverse Leveraged Buyouts


Reverse leveraged buyouts (RLBOs) have received increased public scrutiny but attracted little systematic study. We collect a comprehensive sample of 496 RLBOs between 1980 and 2002 and examine three- and five-year stock performance of these offerings. RLBOs appear to consistently outperform other IPOs and the stock market as a whole, with economically and statistically meaningful positive returns. There is no evidence of a deterioration of returns over time, despite the growth of the buyout market: RLBOs performed strongly in the late 1980s, the mid-1990s, and the 2000s. Large RLBOs that are backed by private equity firms with more capital under management perform better. We also find the so-called quick flips—when private equity firms sell off an investment within a year after acquisition—underperform.

Working paper not available.

Crime and Punishment in the 'American Dream'


We observe that countries where belief in the "American dream" (i.e., effort pays) prevails also set harsher punishment for criminals. We know from previous work that beliefs are also correlated with several features of the economic system (taxation, social insurance, etc.). Our objective is to study the joint determination of these three features (beliefs, punitiveness and economic system) in a way that replicates the observed empirical patterns. We present a model where beliefs determine the types of contracts that firms offer and whether workers exert effort. Some workers become criminals, depending on their luck in the labor market, the expected punishment, and an individual shock that we call "meanness". It is this meanness level that a penal system based on "retribution" tries to detect when deciding the severity of the punishment. We find that when initial beliefs differ, two equilibria can emerge out of identical fundamentals. In the "American" (as opposed to the "French") equilibrium, belief in the "American dream" is commonplace, workers exert effort, there are high powered contracts (and income is unequally distributed) and punishments are harsh. Economists who believe that deterrence (rather than retribution) shapes punishment can interpret the meanness parameter as pessimism about future economic opportunities and verify that two similar equilibria emerge.

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Three Perspectives on Team Learning: Outcome Improvement, Task Mastery, and Group Process


The emergence of a research literature on team learning has been driven by at least two factors. First, longstanding interest in what makes organizational work teams effective leads naturally to questions of how members of newly formed teams learn to work together and how existing teams improve or adapt. Second, some have argued that teams play a crucial role in organizational learning. These interests have produced a growing and heterogeneous literature. Empirical studies of learning by small groups or teams present a variety of terms, concepts, and methods. This heterogeneity is both generative and occasionally confusing. We identify three distinct areas of research that provide insight into how teams learn to stimulate cross-area discussion and future research. We find that scholars have made progress in understanding how teams in general learn, and propose that future work should develop more precise and context-specific theories to help guide research and practice in disparate task and industry domains.

Working paper not available.

Why Do Firms Hold So Much Cash? A Tax-Based Explanation


U.S. corporations hold significant amounts of cash on their balance sheets, and these cash holdings have been justified in the existing empirical literature by transaction costs and precautionary motives. An additional explanation, considered in this study, is that U.S. multinational firms hold cash in their foreign subsidiaries because of the tax costs associated with repatriating foreign income. Consistent with this hypothesis, firms that face higher repatriation tax burdens hold higher levels of cash, hold this cash abroad, and hold this cash in affiliates that trigger high tax costs when repatriating earnings. Estimates indicate that a one standard deviation increase in the tax burden from repatriating foreign income is associated with a 7.9% increase in the ratio of cash to net assets. In addition, certain firms, specifically those that are less financially constrained domestically and those that are more technology intensive, exhibit a higher sensitivity of affiliate cash holdings to repatriation tax burdens.

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Skill vs. Luck in Entrepreneurship and Venture Capital: Evidence from Serial Entrepreneurs


This paper argues that a large component of success in entrepreneurship and venture capital can be attributed to skill. We show that entrepreneurs with a track record of success are more likely to succeed than first time entrepreneurs and those who have previously failed. Funding by more experienced venture capital firms enhances the chance of success, but only for entrepreneurs without a successful track record. Similarly, more experienced venture capitalists are able to identify and invest in first time entrepreneurs who are more likely to become serial entrepreneurs. Investments by venture capitalists in successful serial entrepreneurs generate higher returns for their venture capital investors. This finding provides further support for the role of skill in both entrepreneurship and venture capital.

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Cases & Course Materials

Friendster (A)

Harvard Business School Case 707-409

In January 2006, the president of Friendster needs to choose between two strategic options to revive the company. Friendster started the social networking industry in 2003, but has been overtaken by MySpace and Facebook. The two options are: 1) offer new features to help members enhance their offline lives, such as arranging events with their friends; and 2) offer features, such as the ability to import friends' blogs, pictures, recommendations, and feeds, to help members manage their experiences with their online friends. The two choices have very different value propositions and have very different competitive implications. Also describes the dynamics of relationships inside Friendster and discusses how these dynamics prevented Friendster from maintaining its leadership position. As such, allows for integration of organization and strategy in an entrepreneurial setting, and should be taught with LinkedIn (A) to facilitate cross-case comparisons.

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Istituto Clinico Humanitas (C): Pronto Soccorso

Harvard Business School Case 607-022

Follows on from the cases Istituto Clinico Humanitas (A) and (B). Describes the design and running of the new Humanitas Emergency Department. Istituto Clinico Humanitas has developed a very efficient operating system for dealing with elective (largely surgical) patients. By opening an emergency room, however, the institution is now called upon to care for complex and highly variable medical patients. Asks if the previous operating system is appropriate for this new patient population and in what ways might it require modification to meet these patients' unique needs. The concept of hospital-within-a-hospital is central to Humnitas' new design, and the case examines if this is feasible in this setting.

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Ricardo Software

Harvard Business School Case 607-019

Engineer John Harrison must determine why motorcycle racer Marco Presto does not feel that his motorcycle is providing enough power as it comes out of corners. Harrison uses engine simulation software to help him in his work. Includes color exhibits.

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Wendy Kopp and Teach for America (A)

Harvard Business School Case 406-125

In 1995, Wendy Kopp, founder and president of Teach for America, faces a worsening budget shortfall and sharpening challenges from education experts concerning her organization's mission and effectiveness. Provides information on the leadership development of the protagonist, tracing her youth and education and the process of launching Teach for America. Raises questions about social entrepreneurship, organizational and leadership development, and sustainability of leadership.

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Wintel: Cooperation and Conflict


We study the incentives of complementors (producers of complementary products) to cooperate vs. compete and how these interact. In a system of complements, like the PC, the value of the final product depends on how well the different components work together. This, in turn, depends on the firms' investment in complementary R&D. We ask whether profit maximizing complementors will fully cooperate to make the final product as valuable as possible. Contrary to the popular view that two tight complements will generally have well aligned incentives, we demonstrate that natural conflicts emerge over pricing, the timing of investments, and who captures the greatest value at different phases of product generations.

The Press as a Watchdog for Accounting Fraud


This paper investigates the press's role as a monitor or "watchdog" for accounting fraud. I find that the press fulfills this role by rebroadcasting information from other information intermediaries (analysts, auditors, and lawsuits) and by undertaking original investigation and analysis. Articles based on original analysis provide new information to the markets while those that rebroadcast allegations from other intermediaries do not. Consistent with a dual role for the press, I find that business-oriented press is more likely to undertake original analysis while nonbusiness periodicals focus primarily on rebroadcasting. I also investigate the determinates of press coverage, finding systematic biases in the types of firms and frauds for which articles are published. In general, the press covers firms and frauds that will be of interest to a broad set of readers and situations that are lower cost to identify and investigate.

The Effect of File Sharing on Record Sales: An Empirical Analysis


For industries ranging from software to pharmaceuticals and entertainment, there is an intense debate about the appropriate level of protection for intellectual property. The Internet provides a natural crucible to assess the implications of reduced protection because it drastically lowers the cost of copying information. In this paper, we analyze whether file sharing has reduced the legal sales of music. While this question is receiving considerable attention in academia, industry and in Congress, we are the first to study the phenomenon employing data on actual downloads of music files. We match an extensive sample of downloads to U.S. sales data for a large number of albums. To establish causality, we instrument for downloads using data on international school holidays. Downloads have an effect on sales which is statistically indistinguishable from zero. Our estimates are inconsistent with claims that file sharing is the primary reason for the decline in music sales during our study period.

Efficient Kidney Exchange: Coincidence of Wants in a Structured Market


Patients needing kidney transplants may have willing donors who cannot donate to them because of blood or tissue incompatibility. Incompatible patient-donor pairs can exchange donor kidneys with other such pairs. The situation facing such pairs resembles models of the "double coincidence of wants," and relatively few exchanges have been consummated by decentralized means. As the population of available patient-donor pairs grows, the frequency with which exchanges can be arranged will depend in part on how exchanges are organized. We study the potential frequency of exchanges as a function of the number of patient-donor pairs, and the size of the largest feasible exchange. Developing infrastructure to identify and perform 3-way as well as 2-way exchanges will have a substantial effect on the number of transplants, and will help the most vulnerable patients. Larger than 3-way exchanges have much smaller impact. Larger populations of patient-donor pairs increase the percentage of patients of all kinds who can find exchanges.

Forward-Looking Focus: Can Firms Have Adaptive Foresight?


Customer metrics are pivotal to assessing and monitoring how firms perform with customers and other publics. The authors contend that customer metrics used by firms today are predominantly rear-view mirrors reporting the past or dashboards reporting the present. They argue that companies need to and can develop "adaptive foresight" to be positioned to predict the future by exploiting changes in the business environment and anticipating customer behavior. They address the need for adaptive foresight by synthesizing and integrating literature on customer metrics, customer relationship management, customer asset management, and customer portfolio management. They begin by reviewing the metrics that have been and are currently being used to capture customer focus. Next, they discuss possible "headlight" or forward-looking customer metrics that would allow firms to anticipate changes and provide opportunities to increase the value of the customer base. They then identify the conditions under which the new metrics would be appropriate and offer a process for developing adaptive foresight. The authors close by discussing the implications of adaptive foresight for successful customer asset management that increases long-run business performance.