Does Social Similarity Pay Off? Homophily and Venture Capitalists’ Deal Valuation, Downside Risk Protection, and Financial Returns in India

Abstract

We ask how social similarity between start-up founders and venture capitalists (VCs) influences VCs’ pricing decisions and returns on investments. We conceptualize how regional and caste similarity, two salient aspects of social similarity in India, affect two distinct aspects of deal pricing: premoney valuation and investors’ downside risk protection in the Indian venture capital market. We theorize that VCs reflect the benefits and costs of social similarity by setting higher premoney valuation when investing in companies led by socially similar founders while also minimizing their downside risks in these investments. We expect that social similarity’s impact on pricing is amplified when VCs face greater subjective uncertainty, such as for early-stage deals or if the VCs lack expertise in the start-up company’s product market. Finally, we claim that VCs achieve superior returns on investments when their deal pricing accurately reflects the impact of social similarity. We tested our conceptual model using both parametric and nonparametric methods on a hand-collected data set of all deals that occurred during 2005–2012, and we supplemented our analyses with in-depth, qualitative interviews that contextualize our findings. The pattern of findings on regional similarity are consistent with our model, but the effects of caste in our data are theoretically anomalous. Post hoc analyses to resolve the anomaly suggest an “intrinsic quality” mechanism, whereby higher-caste VCs set higher valuations when matching with lower-caste founders that signal high quality. Overall, our findings offer evidence that VCs incorporate social attributes into deal pricing in nuanced yet boundedly rational ways.

Signaling Theory in Entrepreneurship Research: A Systematic Review and Research Agenda

“…Similarities tend to be favorable and yield more positive interpretations. In particular, receivers perceive signals sent by similar others as more credible, because they regard members of the same group more favorably and as more trustworthy (Claes & Vissa, 2020). Thus, business angels tend to regard signals from other angels as more useful and informative than signals from crowd investors (Wang, Mahmood et al, 2019); venture capitalists perceive signals as more credible if they come from venture capitalists with whom they have conducted joint deals before (Hopp & Lukas, 2014).…”

“…Thus, business angels tend to regard signals from other angels as more useful and informative than signals from crowd investors (Wang, Mahmood et al, 2019); venture capitalists perceive signals as more credible if they come from venture capitalists with whom they have conducted joint deals before (Hopp & Lukas, 2014). Moreover, receivers might actively look for signalers who seem similar, to accelerate trust formation and a productive working relationship (Claes & Vissa, 2020). A prestigious board looks for prestigious new directors (Acharya & Pollock, 2013), and prestigious investors in turn look for firms with prestigious boards (Certo, 2003).…”

Gender Diversity, Role Congruity and the Success of VC Investments

“…Colombo & Murtinu, 2017; Croce et al, 2013; Lee & Wahal, 2004) and on similarity/diversity (e.g. Claes & Vissa, 2020; Hegde & Tumlinson, 2014). The industry, country and year of investment fixed effects of the venture are included to capture any differences in investment patterns across different sectors, countries and over time.…”

“…We accounted for this endogeneity by combining multiple empirical methods. Following a choice-based, sampling approach (Claes & Vissa, 2020;Sorenson & Stuart, 2001), we constructed a plausible set of counterfactual pairs for each VC manager-entrepreneur dyads. Specifically, we focused on the first co-investment between an individual manager of a VC fund and a founder, since the decision to collaborate for the first time is not influenced by other confounding factors, such as the experience of past collaborations 2 .…”

“…A similar mismatch approach (i.e. instrument defined at the geographical/industrial aggregated level and analysis at the individual level) has been used in other studies on the VC industry (see e.g., Colombo and Murtinu, 2017;Croce, Martì, Murtinu, 2013;Lee and Wahal, 2004) and on similarity/diversity (e.g., Claes andVissa, 2020: Hegde andTumlinson 2014).…”