Bringing the Stages Back in: Social Network Ties and Start‐up firms’ Access to Venture Capital in China

• Date: 01 September 2016
• Author: Yanbo Wang
• Published date: 01 September 2016
• DOI: http://doi.org/10.1002/sej.1229

BRINGING THE STAGES BACK IN: SOCIAL NETWORK

TIES AND START-UP FIRMS’ACCESS TO VENTURE

CAPITAL IN CHINA

YANBO WANG*

Cheung Kong Graduate School of Business, Beijing, China

Research summary: Social networks are believed to help start-ups access venture capital (VC).

However, the causal mechanisms remain unclear because social ties probably influence both a

start-up’s likelihood of being screened forevaluation and its likelihood of being funded.Whereas

prior studies conceptualize venture financing as a single-moment event, in this article, it is

theorized as a dynamic multistage process in which a screening decision precedes a funding

decision. Failure to address the selection effects at each stage could lead to biased

findings regarding how social ties confer advantage in venture financing. This study uses a

hand-collected dataset from China to empirically examine these arguments.

Managerial summary: Social networks are believed to help start-ups access venture capital.

However, it is unclear whether this is because social ties help venture capitalists (VCs) and

start-ups overcome the problems of information asymmetry and behavioral opportunism in

early-stage financing or whether VCs are more likely to become aware of investment

opportunities embedded within social networks. This study divides VC decision making into

two stages:awareness generationand venture evaluation.This study finds that sociallyconnected

start-ups have cumulative advantages in the access to venture capital, butthis advantage mainly

arises in the earlystage where informationembedded in social ties helps reduce investors’search

costs in deal screening. In contrast, social ties are a secondary consideration in the subsequent

stage of VC funding d ecisions Copyright © 2016 Strategic Management Society.

INTRODUCTION

Social ties matter in venture finance (Stuart and

Sorenson, 2005). Entrepreneurs, endowed with little

legitimacy and few resources for survival and growth,

often use theirsocial capital to access financial capital.

In a study of 134 U.S. high-tech firms, Shane and

Stuart (2002) find that new ventures are most likely

to be funded when their founders are socially

connected with the venture capital (VC) community.

Similar results have been replicated in many settings

(e.g., Shane and Cable, 2002; Hallen, 2008),

including transition economies (e.g., Bruton and

Ahlstrom, 2003). Batjargal and Liu (2004) find that

Chinese venture capitalists not only prefer to invest

in firms owned by theirfriends, but also approve more

funding for them. The prevalence of social ties in the

quest for financial capital seems to confirm the old

saying—‘It’snot what you know; it’s who you know.’

Why do VCs favor socially connected

entrepreneurs? The existent literature focuses on

venture evaluation and examines the role of socialties

in overcoming the problems of information

asymmetry and behavioral opportunism in early-stage

financing.On the one hand, social ties could serve as a

pipeline to transfer trustworthy information between

investor and entrepreneur (Podolny, 2001). Such

collaborative communication creates opportunities

for the two parties to combinetheir resources to create

Keywords: venture capital; social network; high-tech firms;

entrepreneurship; China

*Correspondence to: Yanbo Wang, Cheung Kong Graduate

School of Business, 1 East Chang An Avenue, Beijing 100738,

P.R. China. E-mail: yanbo.wang@ckgsb.edu.cn

Strategic Entrepreneurs hip Journal

Strat. Entrepreneurship J., 10:300–317 (2016)

Published onlinein Wiley Online Library (wileyonlinelibrary.com).DOI: 10.1002/sej

Copyright © 2016 Strategic Management Society

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new value (Uzzi and Lancaster, 2003). On the other

hand, socialties could serve as a stick to help mobilize

the collective force of the community connecting the

two parties to sanction either one should it conduct

malfeasance against the other (Coleman, 1988;

DiMaggio and Louch, 1998). When social

embeddedness breeds the pros of value creation

while weeding the cons of opportunism, a given

entrepreneur would be evaluated more positively by

exchange partners with whom she has prior ties than

by those with whom she does not. The entrepreneur’s

start-up will, in turn, be more likely to secure funding

from the former than from the latter.

While these arguments seem compelling, the

causal mechanisms by which social ties affectventure

financing are unclear (Stuart and Sorenson, 2007). A

key shortcoming in the literature is that it has ignored

the dynamic nature of venture financing. Given the

large number of funding requests VCs receive and

the complexity of evaluating them, VC firms

generally divide the funding decision into relatively

simple, yet structured, stages (Newell and Simon,

1972; Eckhardt,Shane, and Delmar, 2006). Although

it is common for VCs to reject up to 90 percent of the

business plans they receive before reviewing the rest

for funding decisions (Tyebjee and Bruno, 1984), past

studies have focused on the final outcome of start-

up-VC interactions while ignoring the intermediary

steps leading to the VC’s final decision. When

decision making takes place in a sequence of actions

and deliberations, we are obliged to take a process-

oriented view if we want to reveal the causal

mechanisms hidden in the black box (e.g., Coleman,

Katz, and Menzel, 1966; Fernandez, Castilla, and

Moore, 2000). As Eckhardt et al. (2006: 221) have

warned concerning venture financing research, ‘[F]

ailure to appropriately address the potential effects of

selection at eachstage fails to capture key relationship

and leads to biased findings.’

To better understand the role of social ties in

venture financing, I build on the long tradition

established by Simon (1955) and Coleman et al.

(1966) and argue that VC firms, like most

organizations, are constrained by limited cognitive

capability and that the best way to conceptualize

venture financing is with a dynamic, multistage model

of decision making. In particular, I distinguish

between two stages in the VC decision process: the

stage of awareness generation, in which funding

applicantsaresortedintogroupstobefurther

considered for evaluation, and a subsequent stage of

venture evaluation in which the firms in the

consideration set are evaluated and those with the

highest expected return on investment are chosen for

funding. This distinction is analytically useful for

disentangling the role of social contacts: given that

VC firms have qualitatively different needs at

different stages, it becomes possible to develop

predictions about which specific aspects of the

fund-seeking entrepreneurs’social contacts will be

more helpful at each stage.

To explain the varying roles of social ties across

these two stages, I look at the VC decision

environment and the content and structural features

of networks connecting VCs and entrepreneurs. I

argue that socialties have a powerful effect on venture

financing: information embedded in social ties helps

reduce investors’search costs in deal screening, but

it is a secondary consideration in the subsequent stage

of funding decision. Since a start-up cannot get to the

second stage without succeeding in the first, those

with social ties to investors could have a cumulative

advantage over their unconnected peers in acc essing

capital even if social ties do not help in the final

decision to fund. Without conceptualizing venture

financing as a multistage process, one could

mistakenly attribute the effect of social ties at the

earlier stage to the later stage and, thus, exaggerate

their role in venture evaluation.

The current study uses a hand-collected dataset

to illustrate how venture financing could be

modeled as a two-stage selection process. The data

come from 85 technology-based start-up firms in

two Chinese university science parks (USPs). Even

though USP-based start-ups are not representative

of firms seeking venture capital, this dataset offers

a number of empirical advantages. First, I have

details on start-ups’fund-raising outcomes at eac h

stage in the process of raising capital, including

the contacts through which they approached VC

firms and whether they received interviews and

offers from each VC firm they approached. This

allows for a clean assessment of success at different

stages in the capital-raising process. Second,

because the dataset contains multiple start-up-VC

pairs for each start-up, I can address important

empirical concerns that have been levied against

studies of social contacts in venture financing—

namely, endogeneity and individual heterogeneity

(Stuart and Sorenson, 2007). Third, this dataset

was collected in China, an emerging economy with

the world’s third-largest VC market. While much

research has been done on VCs in developed

economies, much less is known about VC practices

Social Ties and Start-ups’Access to VC in China 301

Copyright© 2016 Strategic Management Society Strat. Entrepreneurship J., 10:300–317 (2016)

DOI: 10.1002/sej