Getting To Know You

Based on research by Alexander W. Butler and Sinan Goktan

• Startups can profit from partnering with newer venture capital firms.
• Younger venture capital firms have an advantage when analyzing startup companies: They gather information through relationship building and intense study.
• Inexperienced venture capitalists build on their strengths rather than resting on their reputations.

In the high-risk world of venture capital investing, successful firms don’t always start big. For venture capital firms that are young and inexperienced, wealth can flow from backing a similarly young company, and patiently building client confidence with financial records and persuasive information.

According to a study coauthored by Alexander W. Butler, a finance professor at the business school, and Sinan Goktan of California State University East Bay, a number of startups have partnered successfully with inexperienced venture capitalists. These newer venture capitalists, Butler and Goktan found, were highly motivated to build the financial backing and advice needed to showcase their startup partner’s potential.

Investors are aware that some well-known companies are nearly guaranteed to deliver profits. But newer companies also have the potential for huge returns if they can escape their lackluster credibility. And newer venture capitalists can be their ticket out. These equally hungry partners are willing use their own resources to build financial profiles that reassure bigger investors. When the heavy hitters join in, it can prompt an initial public offering.

It’s obvious why a startup would welcome that kind of support. But why do young venture capitalists take the risk? It’s because the collaboration benefits them as well, Butler and Goktan explain. The startups provide an important niche for younger venture capitalist firms, which gravitate toward companies that outside investors find hard to evaluate, then roll up their sleeves to build credibility for them.

While experienced venture capitalists judge an investment based on existing financial data, the young venture capitalists tend to be ground-breakers. Their goal is to offer bigger investors–with whom they have often already have relationships–a detailed view of what is going on inside a new company, and to show why those investors should be part of its future.

Younger venture capitalists don’t shrink from new firms that lack hard financial information. For them, a promising startup is an opportunity to be seized. Later involvement from more established venture capitalist firms is part of the plan. When these heavy hitters invest, word spreads that a company has major support and may be the next big thing.

To generate hard information for investors, the newer venture capitalists hustle. They talk with a company’s key people, and they learn what’s going on day to day. When they see fit, they give advice. Because their insights are built on relationships, the closer the venture capitalists are to a company geographically the more efficient the process tends to be.

These findings, Butler and Gotkan note, explain a puzzle. When startups pair with younger venture capitalist firms, the latter often do something that seems uncomfortably self-serving: They rush their startup partners into initial public offerings, a tactic known as “grandstanding.”

These collaborations continue, the researchers say, because the startups and the investment firms know their mutual inexperience has unique benefits for both. While young venture capitalists have incentive to grandstand, they also have a comparative advantage at gleaning crucial financial information. Both investor and investment in these arrangements, in other words, benefit from similar traits. They’re intensely motivated, they take the long view and they’re willing push an idea from dream to blue chip reality.

Alexander W. Butler is a professor of finance at Jones Graduate School of Business at Rice University.

To learn more, please see: Butler, A. W. & Gotkan, M. S. (2013).  On the role of inexperienced venture capitalists in taking companies public. Journal of Corporate Finance, 22, 299-319.