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Six Degrees of Separation

According to an old adage, six degrees separate each person from the next. It’s not surprising that a similar principle works for business.

Research by Toby E. Stuart

Social scientists have long known that geography plays an important role in determining who your friends are. Common sense mandates that proximity greatly increases the chance that two individual will meet, and thus it improves the probability that they will form a relationship.

A recent research report titled "Syndication Networks and the Spatial Distribution of Venture Capital Investments" by Toby Stuart, a professor of organizations and strategy at the University of Chicago Graduate School of Business, and Olav Sorenson of UCLA's Anderson School of Management, begins with a related premise: Geographical and industry proximity are crucial determinants of the likelihood that venture capital (VC) firms invest in emerging companies, or investment "targets."

Stuart's research affirms that VC firms typically invest in target companies that are close to their geographic and industry "neighborhoods."

"The data show that VCs invest in companies 10 miles from their offices twice as often as those 100 miles away," says Stuart. "And those with experience entirely within the same industry as the target are six times more likely to invest than VC firms with no prior experience in that industry."

One implication of this pattern is that new ventures in regions lacking venture capital communities may have difficulty accessing capital. But Stuart's research quickly moves beyond this basic finding to examine what catalysts spur venture capitalists to fund fledgling commercial enterprises beyond their geographical area and outside the domains of their industry experience. In searching for these factors, Stuart focuses on VC firms' positions in the industry's co-investment networks.

Less is More

One would think that VC firms would benefit from an evaluation of the broadest possible array of investment targets. The reason is simple: The top five investments drawn from a pool of 10,000 candidates would almost certainly outperform the top five from a set of 10 candidates. But venture capitalists generally don't search for targets in distant geographic areas or in industry segments in which they lack investment experience. Instead, they tend to concentrate on evaluating target candidates in their geographic areas and in industries familiar to them.

Reasons for this tendency lie in both the pre-investment and post-investment roles of VC firms. Prior to investment, VC firms need to gather information about the existence and characteristics of investment opportunities, and they need to assess the quality of those opportunities. Following investment, they must monitor their portfolio companies and provide advice
and expertise to management teams. Both their pre-investment and post-investment roles are more effectively performed when targets are close in physical space, and when targets are in industries already familiar to the VC firm.

What then are the factors that lead venture capitalists to reach out and fund targets beyond their geographic and industry "neighborhoods?"

Casting a Wider Net

According to Stuart, there is significant variance across VC firms in their inclination to invest in geographically distant targets or those in industries in which they have little previous experience. The primary goal of his paper is to understand the sources of this variation.

One obvious factor is the target company's development stage. Says Stuart, "The data show that older and more developed target companies receive investments from geographically and industry distant VC firms more often than do seed-stage ventures." One reason is that older target companies typically are more visible than seed stage companies. This means that distant investors are more likely to be aware of their existence. But it is also because early-stage investors in a target company may deploy their networks to bring in distant VC firms as investors.

Extensive networks exist in the VC community in part because investor syndicates often fund targets. Relationships between VC firms are created when they finance new ventures in syndicates, and these connections increase the distance information travels within the VC community. Syndicated investing also engenders trust between VC firms, which is built up when firms engage in repeated transactions with the same syndicate partners. As relations between a VC firm and other venture investors are strengthened and broadened, chances are that the VC firm
will be invited to join future syndicates, and this increases a VC's access to geographically and industry distant deals.

Stuart hypothesizes that VC firms will be more likely to fund a geographically distant target if they have previously co-invested with another VC firm that invested in the target.

Similarly, he predicts that VC firms will more likely fund geographically distant targets in situations where previous investment partners belong to the syndicates for the targets and are in the same geographic or industry "neighborhood" as the target. In this situation, the distant VC firm can rely on a local, trusted firm to perform due diligence, monitor and advise the start-up. Outsourcing these tasks to a trusted partner enables VC firms to invest over greater distances.

Stuart also anticipates that VC firms centrally positioned in the venture capital community's co-investment network will more likely fund geographically distant targets. VC firms such as Kleiner Perkins, Menlo Ventures, and Greylock have been at the center of the industry's deal flow in the past and have helped create many successful companies. Because of the past successes and extensive networks of firms like these, they receive significant information about investment opportunities and this boosts the chances that they will hear about geographically distant opportunities. A central position also suggests high status, likely resulting in invitations to join investment syndicates.

Putting Predictions to the Test

To explore these ideas, Stuart compiled a data set of venture capital investments from 1986 to 1998, recording all VC firm investments in domestic, private companies. Using these data, Stuart developed a number of statistical models to determine whether his predictions would prove correct.

The data analysis strongly supported his key predictions. One of the most interesting findings from the analysis was that the effects of industry and spatial distance in determining the likelihood of an investment were identical. According to Stuart, "People are more likely to know others who live in their vicinity, but professionals are also more likely to know others who work in their profession. That is why geographic distance and industry distance have similar effects on the likelihood of an investment - VCs have richer networks and greater knowledge of opportunities in nearby geographic areas and in industry spaces where they have previously invested. VC firms with numerous and widely dispersed relationships with other VC firms tend to invest across geographic and industry boundaries more often than those lacking such relationships. Networks appear to break down the barriers that prevent the diffusion of information."

It's Who You Know

In an industry noted for high uncertainty and imbalances in information between market participants, close and dense relationships are essential in identifying and investing in the most promising young companies. These relational assets are also necessary to overcome transactional and incentive problems that can prevent economic agents from closing a deal. Such insights are important because VC firms continue to play an increasingly critical role in the U.S. economy. In the first half of 1999 alone, these firms invested more than $12.5 billion in early-stage companies.

As the capital VC firms have available to invest has increased, so has their influence in the development of companies and industries, and the macroeconomic health of regions and nations. Understanding what factors affect the spatial patterns of investment is the critical first step in helping regions to devise targeted policies that promote the growth of local, VC-backed companies. Ultimately, Stuart hopes that this line of research will contribute to our understanding of spatial patterns in the formation of entrepreneurial ventures. Again, it's not so much what you know but who you know. - J.S.

Toby E. Stuart is Fred G. Steingraber - A. T. Kearney Professor of Organizations and Strategy at the University of Chicago Graduate School of Business.

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