You don’t know what you don’t know—and almost by definition new entrepreneurial ventures need a helping hand from established partners if they hope to succeed. “Startups suffer from what researchers call ‘liability of newness,’” says Harvard Business School Assistant Professor Rory M. McDonald, “which is a fancy way of referring to all of the things you don’t have as a new company—products, knowledge, connections, resources.”
The most common and effective way to make up for that lack is to find someone who can help you overcome it—most often a venture capital firm that can infuse not only much-needed cash but also expertise and advice.
In a perfect world, everyone benefits. The VC firm takes an equity stake and makes money when the company succeeds, rewarding limited partners who have invested in the VC firm.
But what happens when the interests of the VC and the startup don’t exactly align? For example, when the VC hedges its bet by investing in multiple startups that may be competitors?
McDonald explores that question in the paper Exposed: Venture Capital, Competitor Ties, and Entrepreneurial Innovation, published in the October 2015 Academy of Management Journal and co-written with Emily Cox Pahnke and Benjamin Hallen of the University of Washington and Dan Wang of Columbia University.
The paper finds that far from being a supporting hand for startups, some partnerships can be a hand holding a company down, making it less productive than it otherwise would have been.
TIES THAT BIND
Investing in multiple companies in the same sector and product category may not seem so nefarious from the standpoint of the VC. “Venture capital is a hit-driven business,” says McDonald. VC firms spread their wealth around to dozens of startups, hoping to hit that one jackpot that might be the next Facebook or Google.
The problem comes when they have to choose between supporting one company over another.
Such a case caught McDonald’s attention in 2009 when VC firm Mohr Davidow made an investment in Navigenics, a direct competitor to personal genomics company 23andMe, a startup it had invested in previously. A year later, a similar case occurred when Andreesen Horowitz cut its investments in photo-sharing company Instagram after doubling down on competitor Picplz (a poor bet, as was proven by history).
In both these cases, the startups stood to benefit not only from the monetary investment, but also from the knowledge the VCs obtained in advising their direct competitor.
As it happened, McDonald and his co-authors had firsthand experience of that kind of “information leakage” in a different venue: As doctoral students at Stanford, they had the same advisor.
“Each of us knew what the others were working on before we ever talked to each other about our projects,” he says. While that indirect information sharing may be benign in the case of students, the researchers surmised it may dampen innovation among competitive companies.
To test that hypothesis, McDonald, Pahnke, Hallen and Wang looked at close to 200 medical device startups that developed products for minimally invasive surgery from 1986 to 2007. Using regulatory codes developed by the Food and Drug Administration (FDA), they were able to tell which companies were competitors in the same patient application areas (such as cardiology, oncology, or urology) and product classes.
Then, using commercial investor databases, they determined which companies were funded by the same VCs. Finally, they determined how “innovative” each company was, based on the number of new products they introduced that were approved by the FDA (averaging one product every two years).
The data showed that companies tied to a competitor by at least one VC firm in common were indeed less innovative than those unencumbered by such ties; in fact, they were 30 percent less likely to introduce a new product in any given year.
The magnitude of the effect took the researchers by surprise. “We thought it might happen, but we didn’t expect the size to be as big as it was,” McDonald says.
LAST IS FIRST
Drilling down further into the data, they analyzed which factors determine which companies were most likely to be helped or hurt by such ties. First off, McDonald and his co-authors hypothesized that the biggest beneficiary would be the most recent company to be funded, since it would be able to benefit from the experience of earlier competitors, while those that were first to be funded would pay the price. In the case of Mohr Davidow, for example, “it’s pretty clear Navigenics is going to be the one that benefits, perhaps at the expense of 23andMe,” says McDonald. In fact, they found exactly that: Companies that were first among their competitors to be funded were even less innovative, being 34 percent less likely to introduce a product in any given year.
Two additional factors proved to be even more crucial. The first was the level of “commitment” a VC had to a particular company, judged by the amount and frequency of funding. The same way a teacher may lavish more attention on a favorite student, the researchers found that VC firms also tended to pick favorites, which did better overall; their competitors were 55 percent less likely to introduce a product.
Equally important was a hometown advantage. Companies based closer to funders tended to do better overall; those that were farther away from a shared investor were 56 percent less likely to introduce a new product.
Finally, McDonald, Pahnke, Hallen and Wang looked at firm reputation, surmising that more respected VC firms would be less likely to redirect information between competing startups. They found just the opposite.
Companies tied to VCs in the top 25 percent of reputation indexes were significantly less likely to introduce new products in any given year. Reputable VCs weren’t more likely to invest in competing startups, but when they did, innovation outcomes were greatly diminished. In an effort to explain such a surprising finding, the researchers speculate that perhaps some of these higher-reputation firms may be using their golden image as cover to get away with more flagrant breaches of information sharing.
“We thought there might be a subset of these higher-reputation firms that are taking advantage of their prior successes to do this occasionally and perhaps opportunistically,” McDonald says.
AVOIDING VC CONFLICT OF INTEREST
What should startups to do to inoculate themselves from the effects of these competitive ties?
For starters, companies might benefit from looking beyond the traditional VC world to consider the wide range of funding options available—including super angel investors, micro VCs, accelerators, and incubators.
In cases where a startup does decide to go with a VC, it pays to do homework. Through social media and publicly available sources, there is more information than ever on what firms are investing in which companies, making the reputational risks for VCs investing in multiple competitors higher than it once was, and startups better able to find funders without such conflicts of interest.
At the same time, it’s not just about whether to sign with a venture capital firm or not. Says McDonald, “It’s also about what kind of VC I’m going to get—someone with a history of backing these competing firms, or someone who is going to be more focused on me.”
[This article was provided with permission from Harvard Business School Working Knowledge.]