Digital start-up access to venture capital financing: What signals quality?
Introduction
Entrepreneurial startups play a fundamental role in the promotion of innovation and economic growth (Acs and Audretsch, 1988; Acs et al., 2008; Audretsch, 2007a and Audretsch, 2007b; Audretsch et al., 2009; Baumol, 1996; Chavis et al., 2009; Cumming and Johan, 2014; Cumming et al., 2014; Fairlie and Chatterji, 2013; Klapper and Love, 2011; Marcotte, 2012; McMullen, 2011; Naude, 2010; Stam and Wennberg, 2009; Thurik et al., 2008). The creation of new entrepreneurial and innovative ventures requires capital financing and, as such, there is a large body of research looking into access to entrepreneurial finance for entrepreneurs and startups (Bhide, 1992; Bonini et al., 2012; Fossen, 2014; Nahata, 2008; Wang and Wang, 2012; Li et al., 2016). We know that sustained financing can ensure high levels of growth and survival of new ventures (Cosh et al., 2009; Smallbone et al., 2003; Storey, 2016; Van Auken and Carter, 1989) while lack of financing can result in low levels of growth and an increased likelihood of failure (Alsos et al., 2006; Basu and Parker, 2001). As financing is crucial for startups not only at the initial stages but also at the later stages for continued growth and survival, extant research has sought to determine the factors that play a significant role in access to finance, such as the human capital of the founders (Almus and Nerlinger, 1999; Colombo and Grilli, 2005; Cressy, 1996; Cumming and Johan, 2008a; Stuart and Abetti, 1990; Westhead and Cowling, 1995) and founders’ social networks (Goh et al., 2013; Hochberg et al., 2007; Luo et al., 2013).
Human capital plays a significant role in entrepreneurial endeavors. Researchers have divided human capital into two broad categories: formal and informal. Formal signifies individual educational qualifications, skills, and abilities, whereas informal signifies human capital developed through work and familial experiences. We know that educational investments and work experience can translate into economic advantages (Becker, 1993; Killeen et al., 1999; Langelett, 2002) and, if applied towards an entrepreneurial activity, can result in improved entrepreneurial judgment (Baron and Ensley, 2006; Corbett, 2005; McGrath and MacMillan, 2000; Parker, 2006; Ronstadt, 1988; Shane, 2000; Wiklund and Shepherd, 2003) and forecasting ability (Clement, 1999; Mikhail et al., 1997). It is clear that the impact of human capital on entrepreneurial activity and judgment has been previously widely studied in more developed economies. There is however limited empirical evidence on the role of human capital in startup financing for firms in developing or emerging markets where institutions are arguably weaker, and informal quality signals are much more important to mitigate information asymmetry. In this paper we analyze Indian tech startups to determine the extent formal and informal human capital signals serve as positive signals to mitigate information asymmetries and potentially impact access to venture capital (VC) for Indian entrepreneurs. Our formal and informal measures include total years of experience, the type of work experience (technical, founder, or consultant), the degree to which an elite educational institute provides access to a network of resources, and the breadth of the entrepreneurial team.
In India, technology has been a major driver of innovation for the last 25 years. Major business opportunities have surfaced in the technological front; consequently, there has been exponential growth in the number of startups, which has attracted investments from a large number of venture capitalists (VCs). From 2012–2017, reports show a significant increase in investments by VCs in Indian startups. The transaction value has increased over 13.5 times (from $94 million in 2011 to $1.275 billion in 2016)1. In 2017, investments by VCs in the country reached record levels at $26.5 billion.
With such rapid growth, policymakers face considerable challenges. One challenge is mitigating the inefficiency of the matching process between investors and new technological startups, especially in a financial market which still largely remains imperfect (e.g. Colombo and Grilli, 2005, Colombo and Grilli, 2009). In India, graduates from top engineering colleges are no longer restricted to only joining the corporate world; thus, those with engineering, mathematical, and analytical skills are increasingly incentivized to create their own entrepreneurial firms. A report published by NASSCOM2 states that 50% of the founders of new firms have engineering backgrounds, 25% of them have management backgrounds, and 25% have other educational qualifications. In 2018, nearly half of the startups in India had one or more founders who studied in one or more of the country’s top four engineering and management colleges: the IITs3, IIMs4, BITS5, or the Indian School of Business6. In the United States, we observe the same trend in relation to Harvard, Stanford, and MIT7 according to Pitchbook8 and Crunchbase statistics. These considerations raise our initial question of whether the traditional human capital signal of previous work experience continues to signal quality to investors, as suggested by extant research. Our follow-up question is whether a degree from an elite institute, which may signal quality and increased social capital due to a higher probability of access to a network of high quality and successful alumni and other social connections, results in greater ease of obtaining startup financing from VCs.
We believe another key factor in gaining startup financing is digital network signaling, or using social networks to amass numbers of followers on multiple sites such as Twitter, LinkedIn, and Facebook. Prior research has already linked social capital to the propensity for investors to invest in the Australian crowdfunding context, and we seek to extend this research to our analysis of Indian technology startups (Ahlers et al., 2015). Startups and founders who successfully network and build relationships digitally with their consumers build a successful brand image, which serves as a positive signal to VCs. Previous studies have shown the effectiveness of social media in promoting word-of-mouth information diffusion (Aral et al., 2013; Chevalier and Mayzlin, 2006; Dellarocas et al., 2007; Forman et al., 2008; Zhu and Zhang, 2010) in marketing goods and services (Aral et al., 2013; Bharadwaj et al., 2013) and by serving as a platform for greater consumer engagement and participation (Chen et al., 2015; Ghose and Han, 2011; Goes et al., 2014; Li and Wu, 2018; Miller and Tucker, 2013). In this study, we hand collect information from various social media networks (LinkedIn, Twitter, and Facebook) to determine the strength of the startup’s digital network and how it impacts a startup’s access to financing.
By extending Crane and Hartwell (2019), we link signaling theory with human capital theory and social capital theory to test our developed hypotheses. We collected data from 102 startups that obtained funding between the years 2014–2017. To address potential survivorship bias, we included both failed and active startups. Our results are not only illuminating but also counter-intuitive. We find that the networking and digital signals evidenced by a degree from an elite educational institute (India or abroad), the breadth of the entrepreneurial team (number of founders), and the higher the social media fan following positively impacts access to finance. Founders’ years of experience, as well as their prior industry experience as a founder, more specifically their prior experience as technical engineers and consultants, do not show any impact on financing. These findings, related to traditional human capital signals, are rather unexpected as extant research (Baum and Silverman, 2004; Beckman et al., 2007; Burton et al., 2002; Gompers and Lerner, 2001; Hsu, 2007) using data from developed countries (mainly the US and Europe) show contrasting results. These finding can have several implications for digital entrepreneurs, policymakers, and for VCs, especially in developing countries other than India.
We believe that this study makes important contributions to the existing literature on VC financing (Audretsch et al., 2012; Baum and Silverman, 2004; Cao and Hsu, 2011; Conti et al., 2013; Cumming and Johan, 2014; Greenberg, 2013; Häussler et al., 2012; Hoenen et al., 2014; Hsu and Ziedonis, 2013; Mann and Sager, 2007; Cumming and Zhang, 2016), as this study is the first empirical study, to the best of our knowledge, which links human capital theory, social capital theory, and signaling theory to show the impact of human capital and social capital on obtaining VC financing in the developing market context.
The remaining sections of this paper are organized as follows. We begin by reviewing the relevant literature on signaling; the problems of asymmetry, human capital, and social networking; and then we use this research to develop our hypotheses and theoretical framework in Section 2. We describe the research method, data collection, and variables used to test the hypotheses in Section 3. We present our results of multivariate logistic regressions and our robustness tests in Section 4. We conclude and discuss the limitations of our research in Section 5.
Section snippets
Theoretical background and hypotheses
Evans and Bahrami (1995) suggest that technological startups9
Data collection
We collected data comprising 47 active startups and 55 failed startups from 2014–2017 through several online sources and random searches (Crunchbase11
Results
Table 1, Table 2 reports the bivariate correlations and descriptive statistics, respectively, for the variables in the analysis. Significant correlations were found between the dependent variable and the explanatory variables “Educational Institute,” “Number of Founders,” and “Social Network.” Correlation analysis results indicate weak levels (<.3) of correlations between all independent variables except “Educational Institute” and “Prior founder experience,” where we observe strong significant
Conclusion and limitation of research
VCs confronted with information asymmetry are likely to look for certain signals to reduce informational gaps in the exercise of their judgement. This leads to the question, if information asymmetry is potentially heightened due to the continuously evolving nature of digital startups or the higher institutional burdens in certain countries, how would this affect the signals? We believe our research contributes to extant literature as we link signaling theory to traditional human capital,
CRediT authorship contribution statement
Nirjhar Nigam: Conceptualization, Methodology, Writing - original draft. Cristiane Benetti: Data curation, Formal analysis. Sofia A. Johan: Writing - review & editing, Supervision.
Declaration of Competing Interest
None.
Acknowledgements
We are grateful to anonymous reviewers and editors for their comments, suggestions that helped us to improve the quality of paper immensely. Thanks to University of Lorraine and Prof. Jean-Noel Ory and Prof. Vincent Braun for financing this project with University grant. We are also thankful to ICN Artem Business School for allowing us to present the paper in International conferences. We are also thankful to participants of internal and external seminars for their useful comments and
References (148)
- et al.
Initial resources' influence on new venture survival: a longitudinal study of new technology-based firms
Technovation
(2005) - et al.
Financial signaling by innovativenascent ventures: the relevance of patents and prototypes
Res. Policy
(2012) The base rate fallacy controversy
Adv. Psychol.
(1983)- et al.
Picking winners or building them? Alliance, intellectual, and human capital as selection criteria in venture financing and performance of biotechnology startups
J. Bus. Ventur.
(2004) Entrepreneurship: productive, unproductive, and destructive
J. Bus. Ventur.
(1996)- et al.
Early teams: the impact of team demography on VC financing and going public
J. Bus. Ventur.
(2007) - et al.
An investigation of hindsight bias in nascent venture activity
J. Bus. Ventur.
(2009) - et al.
An examination of the substitutability of founders’ human and financial capital in emerging business ventures
J. Bus. Ventur.
(1998) Analyst forecast accuracy: do ability, resources, and portfolio complexity matter?
J. Account. Econ.
(1999)- et al.
Founders’ human capital and the growth of new technology-based firms: a competence-based view
Res. Policy
(2005)
Global talent management: a life cycle view of the interaction between human and social capital
J. World Bus.
Preplanned exit strategies in venture capital
Eur. Econ. Rev.
Alternative investments in emerging markets: a review and new trends
Emerg. Mark. Rev.
The moderating effect of institutional context on the relationship between associational activity and new business activity in emerging economies
Int. Bus. Rev.
Exploring the value of online product reviews in forecasting sales: the case of motion pictures
J. Interact. Mark.
Contracting, signalling, and moral hazard: a model of entrepreneurs, ‘angels,’ and venture capitalists
J. Bus. Ventur.
Firm-level implications of early stage venture capital investment – an empirical investigation
J. Empir. Financ.
Venture capital-financed innovation and technological change in the USA
Res. Policy
Founder’s human capital, external investment, and the survival of new high-technology ventures
Res. Policy
Determinants of venture capital investments in emerging markets
Emerg. Mark. Rev.
Venture capitalists’ decision criteria in new venture evaluation
J. Bus. Ventur.
The diminishing signalling value of patents between early rounds of venture capital financing
Res. Policy
Experienced entrepreneurial founders, organizational capital, and venture capital funding
Res. Policy
Innovation in large and small firms: an empirical analysis
Am. Econ. Rev.
Entrepreneurship, economic development and institutions
Small Bus. Econ.
Social capital: prospects for a new concept
Acad. Manag. Rev.
Signaling in equity crowdfunding
Entrepr. Theory Pract.
Fools rush in? The institutional context of industry creation
Acad. Manag. Rev.
Testing “Gibrat’s Law” for young firms: empirical results for West Germany
Small Bus. Econ.
New venture finaning and subsequent business growth in men- and women-led businesses
Enterp. Theory Pract.
Introduction to the special issue-social media and business transformation: a framework for research
Inf. Syst. Res.
The Entrepreneurial Society
Entrepreneurship capital and economic growth
Oxf. Rev. Econ. Policy
Financing high-tech growth: the role of banks and venture capitalists
Schmalenbach Business Rev.
Entrepreneurship, Growth and Public Policy
Opportunity recognition as the detection of meaningful patterns: evidence from comparisons of novice and experienced entrepreneurs
Manag. Sci.
Family finance and new business start-ups
Oxf. Bull. Econ. Stat.
Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education
The stock market reaction to the hiring of management consultants: a signalling theory approach
J. Manag. Stud.
Digital business strategy: toward a next generation of insights
MIS Q.
Bootstrap finance: the art of start-ups
Harv. Bus. Rev.
Inequality and Heterogeneity: A Primitive Theory of Social Structure
The effects of venture capitalists on the governance of firms
Corp. Govern. Int. Rev.
Determinants of auditor expertise
J. Account. Res.
From initial idea to unique advantage: the entrepreneurial challenge of constructing a resource base
Acad. Manag. Exec.
The contingent value of social capital
Adm. Sci. Q.
Coming from good stock: career histories and new venture formation
Overconfidence and excess entry: an experimental approach
Am. Econ. Rev.
The Informational Role of Patents in Venture Capital Financing
Bootstrap financing and owner’s perceptions of their business constraints and opportunities
Entrepr. Reg. Dev.
Cited by (30)
FinTech entrepreneurial ecosystem in India: Role of incubators and accelerators
2024, Global Finance JournalImpact of digital finance on the asset allocation of small- and medium-sized enterprises in China: Mediating role of financing constraints
2023, Journal of Innovation and KnowledgeFortune favors the experienced: entrepreneurs’ Internet-Era Imprint, digital entrepreneurship and venture capital
2023, Information Processing and ManagementMachine-learning forecasting of successful ICOs
2022, Journal of Economics and BusinessCitation Excerpt :This is particularly relevant if we consider the limited incentives for small investors to perform due diligence in the context of digital finance (Allen et al., 2021; Block et al., 2021; Rossi et al., 2021). Previous studies on fundraising prediction usually applied traditional statistical methods such as linear regression and logistic regression (Nigam et al., 2020; Signori & Vismara, 2018), assuming that the input variables were also independent. Consequently, the regression method may produce a larger prediction error when the input variables are correlated (Yeh & Chen, 2020).
From the theories of financial resource acquisition to a theory for acquiring financial resources - how should digital ventures raise equity capital beyond seed funding
2021, Journal of Business Venturing InsightsCitation Excerpt :The key question, therefore, is what is this logically consistent set of (design) principles? The left column of Table 1 covers research on 1) how entrepreneurs approach financial resource acquisition based on their internal motivations and their perceptions of environmental factors (Mason and Kwok, 2010; Mason and Harrison, 2003; Murzacheva and Levie, 2020; Weigand, 2019); 2) the factors that influence the fundraising ability and investability of innovative new ventures (Douglas and Shepherd, 2002; Prohorovs et al., 2019; Talaia et al., 2016); and 3) how entrepreneurs organize their networks to establish legitimacy and engage the funding sources (e.g., Becker-Blease and Sohl, 2015; Clarke, 2011; Hoang and Yi, 2015; Ko and McKelvie, 2018; Kuratko et al., 2017; Nigam, Benetti and Johan, 2020a; Shane and Cable, 2002; Shepherd et al., 2019). These three themes also emerged from an analysis of practice-based works in the right-hand column of Table 1 (Harris and Tam, 2020; Ockenfels, 2016; Iskold, 2020).
The influence of local economic conditions on start-ups and local open innovation system
2021, Journal of Open Innovation: Technology, Market, and Complexity