Ethnic Ties in US Venture Capital Stage Financing

• Published date: 01 April 2018
• Date: 01 April 2018
• DOI: http://doi.org/10.1111/ajfs.12212
• Author: Na Ding

Ethnic Ties in US Venture Capital Stage

Financing*

Na Ding**

PBC School of Finance, Tsinghua University, China

Received 23 June 2017; Accepted 16 December 2017

Abstract

This paper examines the effect of ethnic ties on venture capital (VC) stage financing in

the US market. After dealing with the endogeneity problem, the paper shows that VC

investors who share ethnicity with an entrepreneur tend to finance the company using a

smaller number of rounds, longer durations between successive rounds, and a larger

amount in each round. The effect is more pronounced when the startup company and

the VC firm are not located in the same city or the VCs lack industry-specific expertise.

My findings also suggest that such trust due to co-ethnicity leads to bad investment per-

formance.

Keywords Ethnic ties; Venture capitalist; Entrepreneur; Staging

JEL Classification: G24, L26

1. Introduction

Ethnic minority immigrant entrepreneurs make up a large number of all US com-

panies’ founders (Saxenian, 2000, 2007). There is also a large number of venture

capitalists who are minority immigrants (Bengtsson and Hsu, 2015). It is less likely

for a traditional venture capitalist to invest in companies owned by ethnic-minority

entrepreneurs than those owned by white entrepreneurs (Bates and Bradford, 1992).

The reasons for this include discrimination, a mismatch between the types of

minority-owned businesses and those the traditional venture capital (VC) industry

fund; and the fact that ethnic-minority entrepreneurs lack access to VC networks,

*I acknowledge financial support from the National Natural Science Foundation of China

(Grant No. 71790591) and Tsinghua University Research Grant (Grant No. 20151080451). I

remain responsible for any remaining errors or omissions.

**Corresponding author: PBC School of Finance, Tsinghua University, 43 Chengfu Road,

Beijing, 100083, China. Tel: +86-188-1091-5594, Fax: +86-10-6279-8655, email: dingn.13@

pbcsf.tsinghua.edu.cn.

Asia-Pacific Journal of Financial Studies (2018) 47, 306–328 doi:10.1111/ajfs.12212

306 ©2018 Korean Securities Association

which are populated mainly by white people (Rubin, 2004). Ethnic ties

1

between

entrepreneurs and venture capitalists increase the likelihood of a venture capitalist

investing in an entrepreneur (Bengtsson and Hsu, 2015).

Stage financing refers to the stepwise infusion of funds from VC firms to ventures.

Instead of investing a lump sum, VC investors split finance into multiple rounds,

where the next round disbursement depends on whether the startup company meets

the current round’s performance target set by the VC. By allowing VC investors to

retain the option to abandon the entrepreneur’s project if it fails to meet stage goals,

staging mitigates the problem of agency costs and information asymmetry (Sahlman,

1990; Admati and Pfleiderer, 1994; Gompers, 1995). Moreover, staging mitigates the

hold-up problem because it reduces the amount the VC firm invests in the startup

company at any given time, and therefore, increases the founder’s human capital in

the company’s physical capital, which reduces the founder’s incentives to leave the

company (Neher, 1999; Da Rin et al., 2011; Tian, 2011).

However, as Tian (2011) argues, stage financing is costly. Potential costs arising

from VC staging include negotiation and contracting costs in each round of financ-

ing, forgone economies of scale due to divided capital infusions, induced short-ter-

mist behavior on the part of an entrepreneur, and underinvestment in early-stage

ventures. Hence, if it is possible to reduce agency costs and mitigate the risk of

information asymmetry due to less information uncertainty in a startup company’s

future development, the venture capitalist may use less staging. For example, when

public market prices are more informative, such that VC fund managers can more

effectively learn to guide their investment decisions, they will stage less to save the

cost of staging (Liu and Tian, 2016).

The effect of ethnic ties on stage financing is not clear. On the one hand, indi-

viduals from the same ethnic minority may have frequent exchanges and corpora-

tions on account of having the same language and culture; thus, the existence of

ethnic ties makes the venture capitalist trust the entrepreneur more and understand

the value of the project much better. As a result, VCs can expect to work better

with co-ethnic startups (Hegde and Tumlinson, 2014). Thus, there is less uncer-

tainty about the company’s future performance in this situation, which leads to

fewer rounds of investment. On the other hand, in response to the limitations of

the traditional VC industry, some minority-focused venture capitalists primarily

make investments in businesses owned by ethnic-minority entrepreneurs (Rubin,

2004). Bengtsson and Hsu (2015) find that co-ethnicity increases the likelihood of a

VC firm investing in a company. Hegde and Tumlinson (2014) also argue that ven-

ture capitalists select co-ethnic startups even when they appear to be of lower

1

Ethnic ties, co-ethnicity, and same ethnicity refer to the same dummy variable. The variable

equals to one only if the venture capitalist and entrepreneur are of the same minority. There

are two situations in which the variable equals zero: one where both the venture capitalist

and the entrepreneur are of the same ethnicity but not the minority (e.g., two Caucasians);

the other where they are from different ethnicities.

Ethnic Ties and Stage Financing

©2018 Korean Securities Association 307