Getting Tired of Your Friends: The Dynamics of Venture Capital Relationships

Qianqian Du is Assistant Professor at the Hong Kong Polytechnic University and Thomas Hellmann is DP World Professor of Entrepreneurship and Innovation at the University of Oxford. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups (discussed on the Forum here) and Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley (discussed on the Forum here), both by Jesse Fried and Brian Broughman.

The received wisdom is that stronger relationships reinforce over time and lead to better deals. Examining investor relationships in the venture capital (VC) industry we challenge this received wisdom by identifying circumstances where relationships weaken over time, and can even lead to lower performance.

Our central research question is how investor relationships evolve over time under a variety of conditions. For this we examine the investment history of the fifty most active U.S. venture capital firms between 1985 and 2012, constructing a sample of approximately 1.4 million real and hypothetical coinvestment opportunities. Our empirical analysis proceeds in three main steps. We first test whether the past strength of networks affects the likelihood of future coinvestments. After we introduce VC-pair fixed effects to the regression analysis, they absorb all cross-sectional variation across VC-pairs, which enables us to focus on the relationship dynamics within a pair of VCs. We find that, within a pair of VCs, the more they coinvested in the past, the less likely they will coinvest in the future. This may come as a surprise as the prior literature might leave the impression that deep relationships should lead to further coinvestments. The fact that we find the opposite suggests that there are countervailing forces that over time weaken stronger (and strengthen weaker) relationships. Hence the paper’s title is about “getting tired of your friends”.

The second step examines whether past coinvestments matter for future performance. Given the absence of any precise measure of the return to venture capital, we follow prior literature and use the proxy that captures the likelihood of having an IPO or getting acquired of the coinvested company. We find that stronger prior relationships are negatively correlated with exit rates. However, our findings may be caused by the selection effects that VCs with stronger prior relationships invest in the less promising entrepreneurial companies. After we use the Heckman two-step procedure to address this concern, we continue to find the negative impact of past coinvestments on exit rates.

Lastly, we explore three mechanisms through which past coinvestments cause fewer future coinvestments and success. We first distinguish the past into the recent past (the last 2 years) versus the more distant past (the last 3 to 5 years). Interestingly, we find that the recent past has a positive impact on new coinvestment, but the more distant past has a (stronger) negative impact, consistent with the notion of “getting tired of your friends”. We then examine whether market cyclicality plays any role in our findings. Indeed, we find that the negative effect of prior relationships on future coinvestment stems from relationships made in hot market. The analogy of this in interpersonal relationships would be that friendships forged in hard times (e.g., “wartime friends”) are stronger than those forged in easy times (e.g., “party friends”). We also investigate the trade-off between relationship depth (based on the past coinvestments) and network position (based on the number of connections). While adding the network position measures to the analysis does not change the prediction of the relationship depth variable, it does moderate the negative impact of past coinvestments on future coinvestments, i.e., the negative impact is weaker for VCs that are well connected in the venture capital industry.

Overall this paper challenges the received wisdom that deeper relationships are always beneficial. Instead we find that deeper relationships tend to reduce the likelihood of future coinvestments and entrepreneurial success. We also document the variation of VC relationships, i.e. relationships made in the more distant past, in markets with more investment opportunities, and by VCs lack of connections in the industry are less likely to sustain in the long term.

The complete paper is available for download here.

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