Effects of venture capital social advice networks on escalation of commitment.

Abstract

Characteristics of focal VC firms and the various advice network indices attached to their position in the network were used to predict escalation of commitment in new start-ups where the first round of funding was between 1990 and 1995. Data for the study came from Thompson Financial's VentureXpert database. The 294 VC firms in this study funded 498 new start-ups. When the focal VC firm worked with another VC firm prior to 1990, that VC firm was part of the focal firm's advice network. Two different advice networks were identified. The first consisted of every VC firm that funded at least one round of a particular start-up company. The second was the advice network consisting only of the VC firms which funded Rounds 1 or 2. These were the VC firms which made the initial decision to continue funding a company that eventually failed and, as a result, escalated commitment to a failing course of action.

Three major findings emerged from the study. First, the network of VC firms that invest in new high technology start-up companies has become far more interconnected and dense over the last 15 or so years. It was not possible to identify regional hubs based on VC firm funding ties. Second, the dense interconnections between VC firms allowed information to flow freely throughout the network. Some of the network variables and characteristics of the VC firms in the advice network were significant predictors of escalation of commitment. Third, determining the boundaries of a network and defining that network's membership affected the underlying network structure and thus the results.

This study examined the advice networks of venture capital (VC) firms that funded new start-up entrepreneurial companies in the high technology sector. Three outcomes were associated with VC firms' funding of start-up companies. Two were classified as successful decisions making. These were funding a company until it went public with an IPO, was acquired, or merged with an established company and deciding to terminate funding a faltering company that would eventually fail after no more than two round of funding. The third outcome, which was classified as unsuccessful decision making, was funding a faltering company that eventually failed beyond two funding rounds. This unsuccessful investment represents the escalation of commitment case.