Beware the Potential Downside of Venture Capital Relationships

Opinion

Conventional wisdom has it that entrepreneurs benefit from wide networks and strong ties with other organizations. Venture capital (VC) firms, in particular, are seen as a valuable source of funding, social status, technical knowledge, and expert advice for fledgling new businesses. But what if these same relationships can also create new liabilities for entrepreneurs? As entrepreneurial firms share their innovations and ideas with VC partners, how can they be sure that the investors’ interests are aligned with their own?

Recent research indicates, in fact, that these early relationships should be approached with caution. My coauthors, Rory McDonald, Dan Wang, Benjamin Hallen, and I took a close look at the impact of new businesses’ relationships with VC firms in the medical device sector and found that ties to some investors inhibited firms’ innovation. VC firms, we found, often invest in competing entrepreneurial companies, and they occasionally share valuable information they learn from one firm with its competitors. While the VC firms gain useful knowledge by working with multiple companies in the same industry and from the opportunity to channel this information, more vulnerable startup companies may suffer from the indirect conduit to a competitor.

Our advice to entrepreneurs, then, is first and foremost to consider these relationships and the value they bring carefully before engaging a VC firm. While many entrepreneurs are advised not to “go it alone,” partnerships with VCs are not always positive. Firms in our study with many indirect ties to competitors through a VC were significantly less innovative (i.e. less likely to receive FDA approval for a new device) than those with no ties.

If entrepreneurs choose to enter into relationships with VCs, they must scrutinize potential investment partners thoroughly and seek VCs that will result in fewer indirect ties. Tools like Crunchbase make it easier than ever for new firms to learn about VC companies’ existing investments. We found several common characteristics of VC firms that influenced their opportunities, motivation, and ability to leak information. These conclusions from our research (funded by the Kauffman Foundation and the National Science Foundation) may help entrepreneurs select VC partners and navigate early investment relationships:

1. Investors that simultaneously invest in direct competitors are signaling their priorities. Entrepreneurs should be cautious about engaging firms that have already invested in competitors.

2. Sequence matters. Information is most likely to flow from the earliest investment to firms with later-formed ties. Later firms are more guarded, as they are aware of the competing firm’s relationship. Furthermore, the VC firm has a stronger background in the field when they choose their later investments.

3. The VC firm’s level of commitment is an important indicator. Entrepreneurial firms with greater commitments and more resources from a shared VC are less vulnerable to information leakage than those that receive fewer resources. VC firms are more likely to channel information to the firms in which they are most invested.

4. Proximity strengthens relationships. VC partners are more likely to share information from entrepreneurial firms that are more geographically distant with those that are more proximate. Local relationships allow for more communication, oversight, and familiarity, and VCs may be more concerned about remaining well-regarded within their own regions.

5. High-status VCs are especially able and willing to leak competitor information that harms entrepreneurs and boosts their own returns. These VCs have greater power relative to the entrepreneurial firms and may see fewer consequences of leaking information.

If entrepreneurs choose to work with investors who back competitors, they can protect themselves by pursuing later-formed, more committed, and more geographically proximate relationships.

Whether a new firm is a VC’s first investment in the industry or one of several, all entrepreneurs must be mindful of the potential for information leakage and be guarded in the information they share. Awareness of the potential for information exposure will help young firms decide what they tell their investors.

Of course, this information leakage benefits the favored firm as much as it hurts the others involved. The possibility of receiving this competitive information from a VC firm could be yet another benefit to an entrepreneurial firm from a VC partnership. Entrepreneurs should keep in mind, however, that more indirect ties to competitors through a shared VC mean a more remote possibility that their firm will be preferred. And the same criteria presented above will influence this prospect: the favored firm is likely to be one of the later-formed, more committed, and more geographically proximate relationships.

Emily Cox Pahnke is an Assistant Professor of Management and Organization at the University of Washington’s Foster School of Business. Her research focuses on innovation and resource assembly in entrepreneurial ventures. Follow @

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