The Right Connections

In attracting funding for a new venture, report HBS Professor Monica Higgins and her colleague Ranjay Gulati of Northwestern University, professional ties and company connections are even more important than a good product in inspiring the trust and loosening the wallets of potential investors.
by Judith A. Ross

From genome research to e-commerce, new ventures are popping up everywhere, competing for the cash needed to turn them into successful enterprises. But when vying against others in industries where high uncertainty, long development cycles, crowded markets, and technological complexity are all part of the picture, a young company must clear many hurdles before convincing potential investors that its future prosperity is a good bet.

New research by HBS associate professor Monica Higgins and Associate Professor Ranjay Gulati of the Kellogg Graduate School of Management presents strong evidence that whom you know can be just as important as what you know when trying to offset the uncertainty inherent in backing a high-risk startup in an initial public offering (IPO). "Our work suggests that the functional backgrounds or experience levels of the top management team — the CEO, CFO, and chief scientific officer, in particular — aren't really the deciding factors for investment bankers," Higgins explains. "It's these executives' professional ties and company connections, their access to information and resources — what we call social capital-that matter most when they are trying to raise money."

Organizational behaviorists have known for years that third-party endorsements are critical to a young firm's success. Higgins and Gulati wanted to understand the origins and nature of these important relationships. The result is an HBS working paper, "The Effects of IPO Team Ties on Investment Bank Affiliation and IPO Success," which examines how individuals' affiliations can affect the formation of alliances at the firm level.

To that end, the researchers pinpointed the biotechnology industry as a venue for studying the effects of top executives' social capital on their ability to secure resources. "In biotech it can take eight to ten years to develop a product and cost hundreds of millions of dollars to bring it to market," says Higgins. "Therefore, funding is particularly crucial; yet it is also difficult for external parties to assess the quality of the young firm."

It was while following a friend's small biotech firm as it went public that Higgins first noticed that pre-IPO discussions consistently homed in on one question: "What company did you work for before?" "A name with marquee value seemed to indicate competence at the young firm — and the potential for firm-level success," she says. On a hunch that she might be witnessing an important phenomenon, Higgins began interviewing top managers from local biotech companies about their careers. When a trend supporting her hypothesis emerged, she gathered additional data by examining the prospectuses of all public biotech firms over a twenty-year period. The 295 companies and more than 3,000 executives whose career histories she and Gulati analyzed formed the core of their study.

The results showed that top managers' ties to notable pharmaceutical companies — what the authors call downstream social capital — had a direct impact on the size of the startup's IPO. "Downstream social capital was essential in attracting the interest of a top investment bank and getting a high valuation for the IPO," Higgins says. Such connections can be a source of information about the FDA approval process and offer insights as to how to market and sell the young firm's products. They can also provide resources and contacts to facilitate these tasks. Another significant factor was identified in the study as intra-industry social capital— that is, top management's connections to major biotech firms. In contrast, upstream social capital-team members' ties to important research institutions-had no impact at all on the new organization's success. "In this industry," Higgins theorizes, "these sorts of connections may indicate that the enterprise is only in the early stages of product development."

Each kind of social capital, Higgins contends, helps mitigate three categories of investor uncertainty: technological, firm-based, and market-based. "A young company has no track record, no reputation, no finished or test product," she says. "Investment bankers want to know if it has technological sophistication and competence, if it can manage its internal resources effectively, and if it can bring its product to market."

Given these concerns, the researchers expected to find that IPO team social capital was particularly helpful in times of great uncertainty. A look at the evidence proved that assumption correct: when a firm's product was in its early (that is, pre-clinical) stages, substantial downstream or intra-industry social capital, or a combination of the two, was particularly helpful in securing the backing of a prominent investment bank. Furthermore, the less centrally located the firm, the more beneficial was its downstream capital with respect to the size of the IPO.

According to Higgins, startups in every industry face this trio of investor doubts, but the significance of each may vary from sector to sector. Technological uncertainty is a major issue for young Internet companies, for instance, but it's not much of a factor in the cement industry.

To Higgins's surprise, the data also showed that it's not just one team member's social capital that carries clout with a prestigious investment bank but the combined affiliations of the whole group. "I thought having a well-connected head of research from a renowned institution might have the greatest impact," she says. "But no matter how I cut the data, it was the social capital brought by the entire team that enabled a firm to move toward profitability." In addition, Higgins and Gulati found that top management teams whose members' collective connections were wide ranging and complementary were most effective at mitigating investor uncertainty and thus had the best chance of attracting notable investors.

Higgins contends that an IPO team's connections are a crucial component of any startup's portfolio. "There's no question that the new company must show promise that it has a good product and that it can bring favorable returns to investors," she says. "But that's just part of the package. It must also assemble a management team that brings a combination of influential and complementary affiliations to the table." Social capital, it turns out, is truly worth its weight in gold.