Thursday, October 28, 2021

Risk Taking in Venture Capital: Chasing Performance, using Networks, or Something Else?

Venture capital is all about risk. The firms find young ventures, or more often select from many ventures seeking funding. These ventures have in common that they are at such an early stage that their market and offerings are unproven, and they cannot succeed unless they receive the funding, and often also advice and instructions. In other words, they are all risky.

There are still ways of adjusting the risk. Some ventures are more risky than others, and even the same venture has different risk levels depending on whether the venture capital firm participates in the first round of funding or a later round of funding. But if venture capital is essentially about risk, and they need to take this risk to gain the high returns they want, what determines the risk level they take at each funding opportunity? This is what Songcui Hu, Qian (Cecilia) Gu, and Jun Xiac studied in research just published in Organization Science. The answer, or should I say answers, are very informative.

The first part is that venture capitalists chase performance: if their performance has been disappointing, they will take greater risk than if it has been good. This is not just how venture capitalists act – firms make more changes when their executives fall behind their goals, and often these changes are risky. Indeed, the most special thing about venture capitalists is that they control the risk very easily by choosing more first-stage investments when their performance is disappointing. Other firms also try to control risk, but sometimes their risk taking is unplanned.

The second part is that venture capital firms form networks with each other through participating in funding syndicates. These syndicates divide up investments and spread risk, but they also produce collaboration, information exchange, and friendship. They result in networks that look different for each venture capital firm. Some place themselves in the center of spider-web networks that spread out widely. Others find positions between different groups of venture capitalists, becoming brokers of information. And here is the main finding from their research. These networks not only determine the information available; they also influence how venture capitalists think about opportunities available. So, what is the result?

Broker venture capitalists see more investment opportunities, and greater variety of opportunities, giving them practice assessing and experimenting with risk. As a result, they can make big adjustments of risk taking according to performance. Spider-web venture capitalists also get many offers, but they are more similar to each other, and this compromises their ability to adjust risk. The result is clear: All venture capital firms try to adjust risk to reach their performance goals, but the firms that are brokers in their networks are much more able to do so.

So, risk taking is a result of chasing performance goals, and of having the right kind of networks. Some decision makers are half aware of these adjustments, but many do not know that these factors influence risk. If they were, would they more carefully consider how goals are constructed? Would they pay closer attention to how their networks are built? I think the answer to both questions is yes. Gaining and spreading this knowledge is why we do research and teach the results.

Hu S, Gu Q, Xia J. 2021. Problemistic Search of the Embedded Firm: The Joint Effects of Performance Feedback and Network Positions on Venture Capital Firms’ Risk Taking. Organization Science forthcoming.