
Attracting Early Stage Investors: Evidence from a Randomized Experiment (2015) - gghyslain
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2432044
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swalsh
I went to one of those "pitch nights" a few years ago. Honestly, because I
heard there was free pizza, and it seemed interesting. I think maybe 10
startups went up to practice their pitch. A few of them were really impressive
and had some traction already, I was personally impressed. Who was the only
one to get one of the investors business cards at the end of their pitch? The
MIT kids with the only idea that didn't have a business model. I left that
night feeling pretty bitter. I always felt like the great part of tech was the
possibility of upward mobility, but it seemed like an illusion that night.

~~~
mathattack
For better or worse, degree is a signal in a noisy world. Someone who went to
MIT is on average more likely to be useful to an investor than someone who
isn't. And perhaps this is true even if they have an awful demo or product. If
they have tech skills, the investor can find them work elsewhere.

But in reality, pitch nights are generally garbage anyway. Investors put a lot
of weight on "Who introduced the entrepreneur to me" and that carries more
elitism than MIT. Again this is to get through all the noise.

If you have a project with traction and a large addressable market, the
investors will follow the signal and stop worrying about pedigree.

~~~
codemac
> For better or worse, degree is a signal in a noisy world.

I think the contention is that it's not actually a signal, we just believe it
to be true, and it's a confirmation bias.

~~~
mathattack
Google recruiting would agree with you. They've de-emphasized school. :-)

My (limited) observation is it's one signal of many that is real, in a very
noisy world. And 2-3 years post-graduation it's much weaker than other work
related signals.

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SmellTheGlove
I'm not too surprised by the result - at the beginning of any new business,
all you really have are the initial people on board and the quality of their
abilities. What's going on now matters less than the ability of the founders
to react and shift as needed.

For the tl;dr crowd, what mattered most to investors is the quality of the
founding team. The paper finds that operational abilities and expertise of the
founders is important. Relevant paragraph:

"Given the importance of team information, what is the channel through which
human capital information is important for early stage investors? One
explanation is that the operational or technical capabilities of the founding
team raise the chance of success, especially in the earlier stages of a firm’s
lifecycle, when experimentation is important. An alternative explanation is
that high quality teams have attractive outside options, and can therefore
credibly signal the quality of the idea. We find evidence that human capital
is important at least in part due to the operational capabilities and
expertise of the founders."

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20yrs_no_equity
Measuring quality of a person is very difficult in a resume. I don't think
that investors are able to identify quality people really easily. So I'm
assuming they are making assumptions based on pedigree (eg: went to stanford,
worked at amazon therefore must have high ability!)

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gwbas1c
"We find evidence that human capital is important at least in part due to the
operational capabilities and expertise of the founders."

That's not a statement of pedigree.

"operational capabilities" basically means that investors have some way to
figure out that the founders can organize labor, manage money, define the
product, find customers, ect.

How is such a judgement made, though?

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mbesto
> How is such a judgement made, though?

That's exactly what the parent was saying, investors can only draw that
conclusion based on pedigree and experience. "Oh they ran the software at the
warehouses in Amazon, they must be experts in that, here's $5M for your
warehouse management software". Unfortunately this often gets conflated with
pattern matching that doesn't always correlate with a person's pedigree and
their ability to "organize labor, manage money, define the product, find
customers, ect.". In other words, you're both saying the same thing.

Investors telling the public that they can appropriately assess startup teams
in a 1-hour pitch is a glittering lure to increase deal flow, not something
that makes one investor necessarily smarter than an other.

~~~
gwbas1c
"Oh they ran the software at the warehouses in Amazon, they must be experts in
that, here's $5M for your warehouse management software"

That's only 1/3rd; the other 1/3rd is "Successfully founded xyzCorp that had
$xxxx / year revenue and sold for $x,xxx,xxx after 5 years."

Investing in a founding team where the founders have a solid history of
starting successful companies isn't relying on pedigree.

The final 1/3rd is looking at the team dynamic during a pitch. Is the team on
the same page? Are they happy with each other? Does one person do all the
talking?

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hanniabu
Is it seen as beneficial when one person does the talking?

~~~
mbesto
Yes. Regardless of equal equity, having a dominant player in the management
team is highly valuable.

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20yrs_no_equity
In my experience I've found little correlation between pedigree and quality.
This isn't a randomized study, but my experience for 30 years working for and
founding (sometimes random) startups. The school one goes to and the companies
one has on their resume do not mark a great employee or founder. Talent or
ability and willingness to work hard and take responsibility are important.

At the same time, there are a lot of companies that fail into success-- where
the market is right and the funding is sufficient that they can make mistake
after mistake and still end up being successful.

So I think the part of the abstract that claims that this is "rational" to
fund based on pedigree is confusing correlation for causation-- if people with
pedigree but no ability tend to get a lot more funding than people with the
same lack of ability but no pedigree, obviously more of them are going to be
more successful. And the people with ability whether they have pedigree or
not, may be more successful overall, but this study isn't controlling for
that. (and it's hard to identify ability, that's for sure.)

~~~
SmellTheGlove
I don't think it's as much about pedigree (school especially) as it is what
you're leaving on the table to do the startup. It's a strong signaling factor
if a Fortune 500 VP leaves to start something new, versus someone who was an
Analyst at a bunch of small companies. The VP is presumably leaving a lot of
money on the table for the idea - its skin in the game measurable in
opportunity cost.

>Talent or ability and willingness to work hard and take responsibility are
important.

In reading the paper, that seemed to be the other factor in the human capital
evaluation. Investors need to feel good about the abilities of the founders.

~~~
DenisM
Both VP and rank-and-file are leaving a lot on the table - their entire
income. If anything it's easier for a VP due to their savings stretching
farther and their passive investments.

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jacques_chester
We're humans.

So pedigree matters.

If I got a buck for every startup story of the form "When I was a freshman at
Stanford...", I could probably afford to go to Stanford.

On the upside, there's a juicy chance here for canny investors to try and find
underpriced opportunities of the form "When I was working at the video store
..."

~~~
mbesto
Yup. Investors will always conclude their assessments of founding teams based
on their chosen narrative.

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mpbm
Maybe it's much more of a social decision than a business decision.

Early stage investors are gambling even more than late stage investors. The
best they can hope for is to find 50 reasonable deals and let the math work
itself out.

So the better part of their decision could easily be based much more on what
their peer early stage investors think of them. Founders with pedigree are
easy to justify and obviously more socially valuable than founders without
pedigree (like buying IBM). So being the angel who keeps getting those
founders means other investors will look up to you.

And, if things go wrong, nobody can blame an investor for getting into bed
with pedigreed founders. It's an obvious decision, so it won't invite
ridicule. Since it's obvious, there will be more competition, and that's
something the angel doesn't have to rely on luck to win.

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gghyslain
I found this paper in the references of a previous similar paper discussed on
HN:
[http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2801385](http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2801385)
I am using it to write a chapter of my dissertation. Here are some relevant
quotes from the paper.

TLDR:

>> Introduction

Start-up firms are particularly difficult to finance because their prospects
are highly uncertain, they lack tangible assets that can be used as
collateral, and they face severe information problems (Hall and Lerner
(2010)). Given these problems, how do investors choose which start-ups to
fund? What factors drive their selection process? (…)

This paper provides, to the best of our knowledge, the first experimental
evidence of the causal impact of start-up characteristics on investor
decisions. (…)

Based on competing theories of the firm, we focus on three key characteristics
of start-ups: the founding team, the start-up’s traction (such as sales and
user base), and the identity of current investors. (…)

We sent approximately 17,000 emails to nearly 4,500 investors on the platform,
spanning 21 different start-ups, during the summer of 2013. The randomized
experiment reveals that the average investor is highly responsive to
information about the founding team, whereas information about traction and
current investors does not lead to a significantly higher response rate. This
suggests that information about the human capital of the firm is uniquely
important to potential investors, even after controlling for information about
the start-up’s idea. (…)

We find that the more experienced and successful investors react strongly only
to the team information, which provides indirect evidence of the viability of
an investment strategy based on selecting on team information.

>> Why do Investors React to Information on Founding Team?

We find evidence that human capital is important at least in part due to the
operational capabilities and expertise of the founders. (…)

>> Is it Rational to Invest Based on Founding Team?

It is challenging to answer this question directly, for several reasons (…) We
can, however, take an indirect approach by exploring how successful and
experienced investors react to various information (…)

The inexperienced investors with no prior investments, who make up 18% of the
sample, react not only to the team information, but also to the traction and
current investors.(…)

The experienced investors still only respond to information about the team,
while the significance of the response to the traction and current investors
categories among inexperienced investors weakens somewhat.(…)

>> Conclusion

Overall, the results in this paper present evidence for the causal importance
of human capital assets for the success of early stage firms, and contribute
to the debate around the importance of various key assets to organization
success. Our results, however, do not suggest that non-human assets are not
essential. Rather, the results are consistent with the model by Rajan (2012),
in which human capital is initially important for differentiation, but needs
to be replaceable in later stages so that outside investors can obtain control
rights, thus allowing the firm to raise large amounts of external funding

~~~
drewvolpe
What's your dissertation on?

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DelaneyM
I worry about survey-based studies with small sample sets which reinforce
conventional wisdom...

~~~
dirtyaura
With a quick glance, I got an impression that it wasn't a survey, but this was
an actual experiment. They sent 17000 randomized emails to 5000 early-stage
investors through AngelList. Emails highlighted either the team, traction,
existing investors or some combination of these. Researchers measured how many
investors responded with "View" or "Get an Intro" buttons.

I think that is pretty well designed experiment given the difficulty of
researching such topic.

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api
"Not to traction" is a wow for me.

I think a tl;dr would be that early stage investing is more of a social
decision about who and what you want to help than a rational decision ala the
mythical "homo economicus."

~~~
SmellTheGlove
I think that suggests that the initial concept and the product that eventually
follows will eventually diverge. More emphasis is put on the people steering
the ship when you need to change direction, and if I had to guess, investors
presume that a change of direction is very likely to happen.

~~~
api
Yeah, and I assume there are limits to the indifference to traction too. If
you stumble in reeking of pot and looking like you haven't bathed in a week
but you have 300% CMGR I imagine something might still happen.

~~~
SmellTheGlove
Definitely. The truth of the matter is that most early stage startups don't
have much traction, so trying to split those hairs isn't as important as
evaluating the founding team.

Take this for what it's worth from my experience working at various
organizations, but in some investment circles, the importance of the
management team matters even with large organizations. Berkshire Hathaway, for
instance, weighs the strength of management very highly when deciding where to
invest, because like an early stage investment model they are largely situated
to leave the businesses to manage themselves and provide support in an
advisory capacity. I started early in my career at one of Berkshire's best
bets (GEICO) not long after Buffett bought the rest of the company. Back then
at least, he was the kind of guy that visited and talked to the employees a
couple times a year, (even the peons like me), and he was very candid on
valuing strength of management very highly in investment decisions. Yes, it
was a contrarian bet to buy an insurance company that had almost gone out of
business, but he was confident in the ability of the management team. I've
been all over the insurance industry, and objectively speaking, that's the
best run company I've ever been at, and their growth and market position from
1996 to today would reflect that. And they're not my current employer, btw.

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rfrey
Sorry for adding noise to the signal, but I want to say what a pleasure it was
to click the link, read the abstract, then click "PDF in Browser" to read the
full article.

No "$40 for a day" overlays, no searching for the authors' websites to get a
preprint version. Just one person with his curiosity satisfied. Thank you to
whoever paid for it.

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arekkas
is there a tl;dr to this

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JumpCrisscross
You didn't even click the link...

The abstract:

"This paper uses a randomized field experiment to identify which start-up
characteristics are most important to investors in early stage firms. The
experiment randomizes investors’ information sets of fund-raising start-ups.
The average investor responds strongly to information about the founding team,
but not to firm traction or existing lead investors. We provide suggestive
evidence that team is not merely a signal of quality, and that investing based
on team information is a rational strategy. Altogether, our results indicate
that information about human assets is causally important for the funding of
early stage firms, and hence, for entrepreneurial success."

~~~
overcast
We must abstract further! Investors care mainly if you went to Stanford or
worked previously at Amazon/Facebook/Google.

