Attracting Early Stage Investors: Evidence from a Randomized Experiment (2015)

I went to one of those "pitch nights" a few years ago. Honestly, because I heard there was free pizza, and it seemed interesting. I think maybe 10 startups went up to practice their pitch. A few of them were really impressive and had some traction already, I was personally impressed. Who was the only one to get one of the investors business cards at the end of their pitch? The MIT kids with the only idea that didn't have a business model. I left that night feeling pretty bitter. I always felt like the great part of tech was the possibility of upward mobility, but it seemed like an illusion that night.

I'm not too surprised by the result - at the beginning of any new business, all you really have are the initial people on board and the quality of their abilities. What's going on now matters less than the ability of the founders to react and shift as needed.

For the tl;dr crowd, what mattered most to investors is the quality of the founding team. The paper finds that operational abilities and expertise of the founders is important. Relevant paragraph:

"Given the importance of team information, what is the channel through which human capital information is important for early stage investors? One explanation is that the operational or technical capabilities of the founding team raise the chance of success, especially in the earlier stages of a firm’s lifecycle, when experimentation is important. An alternative explanation is that high quality teams have attractive outside options, and can therefore credibly signal the quality of the idea. We find evidence that human capital is important at least in part due to the operational capabilities and expertise of the founders."

In my experience I've found little correlation between pedigree and quality. This isn't a randomized study, but my experience for 30 years working for and founding (sometimes random) startups. The school one goes to and the companies one has on their resume do not mark a great employee or founder. Talent or ability and willingness to work hard and take responsibility are important.

At the same time, there are a lot of companies that fail into success-- where the market is right and the funding is sufficient that they can make mistake after mistake and still end up being successful.

So I think the part of the abstract that claims that this is "rational" to fund based on pedigree is confusing correlation for causation-- if people with pedigree but no ability tend to get a lot more funding than people with the same lack of ability but no pedigree, obviously more of them are going to be more successful. And the people with ability whether they have pedigree or not, may be more successful overall, but this study isn't controlling for that. (and it's hard to identify ability, that's for sure.)

We're humans.

So pedigree matters.

If I got a buck for every startup story of the form "When I was a freshman at Stanford...", I could probably afford to go to Stanford.

On the upside, there's a juicy chance here for canny investors to try and find underpriced opportunities of the form "When I was working at the video store ..."

Maybe it's much more of a social decision than a business decision.

Early stage investors are gambling even more than late stage investors. The best they can hope for is to find 50 reasonable deals and let the math work itself out.

So the better part of their decision could easily be based much more on what their peer early stage investors think of them. Founders with pedigree are easy to justify and obviously more socially valuable than founders without pedigree (like buying IBM). So being the angel who keeps getting those founders means other investors will look up to you.

And, if things go wrong, nobody can blame an investor for getting into bed with pedigreed founders. It's an obvious decision, so it won't invite ridicule. Since it's obvious, there will be more competition, and that's something the angel doesn't have to rely on luck to win.

I found this paper in the references of a previous similar paper discussed on HN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2801385 I am using it to write a chapter of my dissertation. Here are some relevant quotes from the paper.

TLDR:

>> Introduction

Start-up firms are particularly difficult to finance because their prospects are highly uncertain, they lack tangible assets that can be used as collateral, and they face severe information problems (Hall and Lerner (2010)). Given these problems, how do investors choose which start-ups to fund? What factors drive their selection process? (…)

This paper provides, to the best of our knowledge, the first experimental evidence of the causal impact of start-up characteristics on investor decisions. (…)

Based on competing theories of the firm, we focus on three key characteristics of start-ups: the founding team, the start-up’s traction (such as sales and user base), and the identity of current investors. (…)

We sent approximately 17,000 emails to nearly 4,500 investors on the platform, spanning 21 different start-ups, during the summer of 2013. The randomized experiment reveals that the average investor is highly responsive to information about the founding team, whereas information about traction and current investors does not lead to a significantly higher response rate. This suggests that information about the human capital of the firm is uniquely important to potential investors, even after controlling for information about the start-up’s idea. (…)

We find that the more experienced and successful investors react strongly only to the team information, which provides indirect evidence of the viability of an investment strategy based on selecting on team information.

>> Why do Investors React to Information on Founding Team?

We find evidence that human capital is important at least in part due to the operational capabilities and expertise of the founders. (…)

>> Is it Rational to Invest Based on Founding Team?

It is challenging to answer this question directly, for several reasons (…) We can, however, take an indirect approach by exploring how successful and experienced investors react to various information (…)

The inexperienced investors with no prior investments, who make up 18% of the sample, react not only to the team information, but also to the traction and current investors.(…)

The experienced investors still only respond to information about the team, while the significance of the response to the traction and current investors categories among inexperienced investors weakens somewhat.(…)

>> Conclusion

Overall, the results in this paper present evidence for the causal importance of human capital assets for the success of early stage firms, and contribute to the debate around the importance of various key assets to organization success. Our results, however, do not suggest that non-human assets are not essential. Rather, the results are consistent with the model by Rajan (2012), in which human capital is initially important for differentiation, but needs to be replaceable in later stages so that outside investors can obtain control rights, thus allowing the firm to raise large amounts of external funding

I worry about survey-based studies with small sample sets which reinforce conventional wisdom...

"Not to traction" is a wow for me.

I think a tl;dr would be that early stage investing is more of a social decision about who and what you want to help than a rational decision ala the mythical "homo economicus."

Sorry for adding noise to the signal, but I want to say what a pleasure it was to click the link, read the abstract, then click "PDF in Browser" to read the full article.

No "$40 for a day" overlays, no searching for the authors' websites to get a preprint version. Just one person with his curiosity satisfied. Thank you to whoever paid for it.

is there a tl;dr to this