That VCs’ screening and selection of startups is subject to biased decision-making is well-documented. Their subsequent funding decisions have, by contrast, always been assumed rational. A new study, available as open access article in the journal Industry and Innovation, questions this taken-for-granted assumption. The study’s results, which are based on data from 231 European IT-startups, suggest that a startup entrepreneur’s physical attractiveness and ethnic background significantly shape a VC’s funding approach. This finding is noteworthy, because a VC’s funding approach strongly influences a startup’s chances of survival and success.
A VC’s funding approach strongly influences a startup’s chances of survival and success.
Why a VC’s funding approach matters
Once selected, the startup entrepreneur and VC collaborate to make the startup a success. While an exciting phase for all parties involved, a VC is confronted with many questions that reflect the inherently uncertain nature of this phase: Will the startup live up to its promise? Is the entrepreneur as capable, trustworthy and ambitious as it appears to be? How will the market develop? Et cetera. The capital required to make the startup a success will, in view of these uncertainties, not be provided all at once but gradually disbursed as the startup develops (known as the staging of capital). This enables the VC to fund the startup while keeping the option to abandon the investment and minimize potential losses.
Previous research has shown that the way a VC stages the capital indicates the amount of trust and confidence he/she has in the respective startup. In case of great confidence and trust, granted funding disbursements on average tend to be of a higher amount and take place with longer time intervals in between. In case of doubts, however, the VC will seek more control over the startup, reflected by lower funding amounts and shorter time intervals between investment rounds. This enables the VC to keep the entrepreneur on a tight leash. To date, VCs have been assumed to determine their funding approach on rational grounds, weighing the costs of staging versus the costs of monitoring the venture, and benefiting from the information that comes available once the cooperation with the startup entrepreneur commences. Following this assumption, VCs’ funding decisions should be devoid of any biases.
To date, VCs have been assumed to determine their funding approach on rational grounds
There are nevertheless good reasons to question this rationality-assumption. Even though more information comes available after the screening and selection-phase, VCs still need to make up their minds in view of many known and unknown unknowns. Each investment round inherently introduces new uncertainties and risks, which effectively means VCs needs to make projections of an uncertain future. Moreover, as the investment unfolds, sunk costs are incurred, which affects VCs’ risk assessments. Also, VCs continue to face severe time-pressure and information discrepancies. All these factors combined increase the likelihood of biased decision-making.
How physical attractiveness and same ethnicity matter
To explore the potential for biased decision-making in VCs’ funding approaches, two factors were selected known to bias VCs’ selection decisions, namely entrepreneurs’ physical attractiveness and ethnic background. Physical attractiveness was selected to test for the presence of the halo-effect. The attractiveness-halo is known to bias peoples’ judgments of others during first encounters, but its relevancy beyond the initial encounter has hardly been researched before. Ethnicity was selected to capture potential similarity effects. People are known to have more positive attitudes towards others whom they perceive to be similar to themselves.
The findings show that, on average, physically attractive entrepreneurs enjoy longer time-periods between funding rounds, suggesting a more lenient stance of the VC toward startups led by handsome entrepreneurs. The same goes for startups led by entrepreneurs who share ethnic backgrounds with their VCs.
Attractiveness becomes a more relevant cue for VCs with ethnic backgrounds different from the entrepreneurs they fund.
The findings become a bit more intricate when we consider the effects of physical attractiveness and ethnicity jointly. The figure below shows the effect of physical attractiveness on VCs’ funding approach for pairs of entrepreneurs and VCs who share ethnic backgrounds (co-ethnicity = 1), and for those who don’t (co-ethnicity = 0). The effect of physical attractiveness is steeper for the second group, which indicates that attractiveness becomes a more relevant cue for VCs with ethnic backgrounds different from the entrepreneurs they fund. The figure also shows that, overall, co-ethnic entrepreneurs enjoy more favorable and lenient funding conditions.
Overall, co-ethnic entrepreneurs enjoy more favorable and lenient funding conditions.
Entrepreneurs with ethnic backgrounds different from their VCs may need to consider other ways to signal trustworthiness and potential
What does this mean for VCs and entrepreneurs?
The results put into question VCs’ assumedly rational funding approaches. From an entrepreneurial perspective, entrepreneurs’ attempts to benefit from biased decision-making may prove fruitful during the early funding stages. Entrepreneurs may particularly consider how to benefit from such biases during funding negotiations, but can also consider how to prevent adverse effects. For instance, entrepreneurs with ethnic backgrounds different from their VCs may need to consider other ways to signal trustworthiness and potential to secure more favorable funding conditions. From a VC-perspective, attempts to debias selection decisions may need to be transferred to the funding stage as well. Particularly, VCs should consider their stance toward entrepreneurs with different ethnic backgrounds or low physical attractiveness, for their ventures may suffer from the closer scrutiny they are subject to.
To conclude, venture capital investors stand for the challenging task of predicting a startup’s true potential in view of profound uncertainty. Given the large stakes involved, systematic, conscious, and effortful decision-making is much preferred. By uncovering factors that may bias VCs’ funding decisions, this study sought to create awareness and hopefully contributes to their improvement.
Given the large stakes involved, systematic, conscious, and effortful decision-making is much preferred.