Hypotheses on the General Importance of the Contact Network and of Other

Other Venture Capital Firms as Source of Deal Flow

Based on social capital theories explained, previous empirical research, and the logics to measure deal flow quantity and quality, several hypotheses on the general importance of the contact network and of other VCs as source of deal flow for the generation of deal flow can be derived. In the hypotheses, the letters A, B, C, A', B', and C' relate to those used in figure 3.7.

In social capital theories, it has been explained that, in general, for the exchange of information, trusted norms and reciprocity serve as the basic underlying mechanisms.548 Especially in environments characterized by high uncertainty, such as in the venture capital industry, these mechanisms imply that the contact network of VCs can be expected to play an important role with respect to deal flow generation.549 That is, the level of social capital in the form of values and norms, can be seen as the lubricant that makes the exchange of resources possible. In the context of this study, resources are information on potential investment opportunities.

548 _{See the explanations in section 3.3.3 and 3.3.4.} 549 _{See Bygrave (1988), p. 137.}

The first hypothesis refers to the question, whether VCs in the German market receive more investment opportunities from their network contacts or whether they receive more unsolicited. For the US market it could be shown that more than half of the investment opportunities received, come by referral.550 For the German market it was found that approximately 50% of the investment opportunities received, come by referral.551 While there already is data for the German market on the question, which is also addressed by the first hypothesis, the latter will still be set up in order to be able to draw a consistent picture for the VCs under consideration in the present study. The first hypothesis consequently refers to deal flow quantity and the argumentation is as follows.

Based on the fact, that VCs spend the largest amount of time on the identification and on the evaluation of investment opportunities,552 it can be assumed that they also intend to optimize the output of that process.553 In terms of deal flow quantity, the output of that process is a sufficiently large number of investment opportunities the VC can select from. At the same time, the VCs try to optimize the quality of their deal flow, which means, that they try to identify as many investment opportunities as possible that meet their investment criteria. Because VCs assume that investment opportunities, which come by referral, potentially meet these criteria better, the VCs can be assumed to put a larger amount of time into the establishment and maintaining of their general contact network than they put into marketing activities, which might increase the number of investment opportunities received unsolicited. The reasons why a VC can be assumed to spend more time on its network than on other activities are therefore two-fold: One aspect is certainly, that the referrers potentially better know the investment criteria of the VC. However, the second aspect is that referrers cannot afford to refer bad deals to the VC, which is due to the fact that such behavior will be punished by the VC by, for example, excluding the referrer from future business. This mechanism can be understood as social capital inherent in the relationship network. Now, if a VC knows that this mechanism is

550 _{Wells found that 61% of the investment opportunities came from referrals, Tyebjee/Bruno found a} value of 65%. See Wells (1974), p. 57; Tyebjee/Bruno (1984), p. 1055.

551 _{Jugel found a value of 46%, Vater an equivalent value of 54%. See Jugel (2001), p. 39; Vater (2002),} p. 144.

552 _{See Vater (2002), p. 99.}

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in place, and if the VC therefore expects to receive high-quality deals from its referrers, then it can be assumed that VCs spend more time on establishing and maintaining its network than it spends on other activities (such as marketing) to generate deal flow quantity. If one can also assume that the sources (either contact network or unsolicited) yield a number of investment opportunities as output that corresponds to the effort that the VC spends on that source, then the number of investment opportunities received from network contacts can be expected to be higher than the number received unsolicited.554 A verification of HI 1 would lead to the conclusion that the contact network of VCs is important because it delivers many investment opportunities. It follows:

HI 1: Of all investment opportunities received (irrespective of their quality), the percentage of investment opportunities received from a network contact (A) is higher than the percentage received unsolicited (B), so that A>B.

The second hypothesis refers to the same question as the first, this time though relating to deal flow quality, i.e., to those investment opportunities that actually get funded by the VCs. For the US, it has been found that most deals that are funded, came by referral.555 For the German market, there is no such data. The argumentation is similar to the one developed for HI 1: Based on social capital theory, that trust in norms of behavior is the basic underlying mechanism that makes collaboration possible,556 it should follow for VCs and their general contact network, that only those deals get referred, which probably meet the quality criteria of the VC. This is due to the fact, that, if a source out of the contact network frequently refers bad quality deals to a VC, the VC will probably lose interest in the relationship it has to that specific referrer and sanction him by exclusion from future transactions.557 Therefore, two assumptions can be made: The VC has trust in

554 _{If HI 1 will be confirmed, this would be in line with the findings for the US market, however, it would} go against the findings for the German market.

555 _{However, the study was based on a fairly small sample size of 18 VCs. See Fried/Hisrich (1994), pp. 31 f.} 556 _{Refer back to section 3.3.3.5.}

557 _{Although, for example, referrers such as lawyers or consultants do not directly invest with VCs, it} would still be negative for their reputation if they were known for frequently referring bad deals. If they frequently did so, the VC could sanction them by not collaborating with them in the future.

the norms of behavior, i.e., trust in the referrers' judgment and trust in that no bad deals are referred.558 And, the referrers can be assumed to know well the investment criteria of the VCs.

If confirmed, the result would be in line with the empirical finding of Fried and Hisrich (1994) for the US market, and would lead to the conclusion that the contact network of VCs in Germany is important because it delivers high-quality investment opportunities. It follows:

HI 2: Of those investment opportunities that get funded, the percentage of investment opportunities received from a network contact (A') is higher than the percentage received unsolicited (B'), so that A'>B'.

Hypothesis HI 3 is set up to evaluate, whether the contact network is more important for the generation of deal flow quantity, or for the generation of deal flow quality. It will therefore be examined, whether the percentage of referrals is higher for those investment opportunities that get funded (deal flow quality) compared to all investment opportunities received (deal flow quantity). The argumentation is analog to the one for HI 2: Since the referrers probably know the investment criteria of the VC and since underlying norms of behavior prevents the VCs' contacts to refer bad deals, the 'referred' portion of those investment opportunities that get funded should be higher than the 'referred' portion of all investment opportunities. If confirmed, the conclusion would be, that the contact network of VCs in Germany is important because, above all, it delivers high-quality investment opportunities. Therefore, it can be hypothesized:

HI 3: The percentage of funded investment opportunities received from a network contact (A') is higher compared to the percentage of all investment opportunities received from a network contact (A), so that A'>A.

Hypotheses HI 4 - HI 6 address the importance of other VCs as a source of deal flow. That is, the importance of the source 'Other VCs' within the contact network is compared to the importance of the other sources within the network (universities/research centers,

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banks/investment banks, private contacts, other). Wells (1974) and Tyebjee and Bruno (1984) could show for the US that approximately 30% of the investment opportunities received, stemmed from other VCs or other professional sources.559 _{For the German}

market, Vater (2002) found a value of approximately 7%,560 while, at the same time, the respondents regarded the source 'Other VCs' as very important.561 Since these results are contradictory, hypothesis HI 4 relates to the question, how important the source 'Other VCs' is with respect to all investment opportunities received (deal flow quantity). HI 5 is analog to HI 4 but refers to deal flow quality, i.e., the funded investment opportunities. HI 6 then, again, compares deal flow quantity with deal flow quality by examining, whether the percentage referred by other VCs is higher for deals that get funded compared to all deals received.

As derived above, most of the effort that a VC spends on generating deal flow, he will put into that source from which it expects to receive the highest quality of deals. If it can be assumed, based on the norms of behavior among VCs, that other VCs only refer those deals that meet the investment criteria of the VC the deal is referred to, then the highest quality of deals can be expected to come from the source 'Other VCs'. This, in turn, implies that VCs, on average, put most of their effort for deal flow generation into contacts to other VCs. If one can assume that the 'output' of a network source (investment opportunities received) depends on the effort spent on that source, then the source 'Other VCs' should not only deliver the most investment opportunities compared to the other sources, but it should also deliver deals with the highest quality.

Note that a central aspect underlying this argumentation is based on the norms of behavior, i.e., that a VC only refers those deals that meet the investment criteria of the VC the deal is referred to. That is, the amount of social capital (prevalence of norms and trust) in the network VCs have among each other, enables the exchange of information on investment opportunities.

559 _{See Wells (1974), p. 57; Tyebjee/Bruno (1984), p. 1055.}

560 _{In his study, Vater differentiates between several types of VCs. The one that is relevant for the present} study ('Venture-Capital-Gesellschaften'), showed a value of approximately 13%. However, in the relevant group, only 7 firms are included (in addition, the other groups even show lower values). Therefore, it is questionable, whether the result can be used as reliable comparison for the results of the present study. See Vater (2002), p. 144.

It can therefore be derived that, not only for deal flow quantity but also for deal flow quality, the source 'Other VCs' should account for the largest portion. A confirmation of HI 4 would lead to the conclusion, that 'Other VCs' as source of deal flow is important because it delivers many investment opportunities. A confirmation of HI 5 would imply that 'Other VCs' as source of deal flow is important because it delivers high-quality investment opportunities. It therefore follows:

HI 4: Based on deal flow quantity and based on the deal flow sources within the contact network, other VCs (C) represent the largest single source, so that C > any other single source.

HI 5: Based on deal flow quality and based on the deal flow sources within the contact network, other VCs (C') represent the largest single source, so that C' > any other single source.

The final hypothesis HI 6 is set up to examine, whether the benefit of 'Other VCs' as source of deal flow is larger for the generation of deal flow quantity, or, for the generation of deal flow quality. Therefore, the percentages C' and C have to be compared. If C' is higher than C, consequently, above all the high-quality investment opportunities come from other VCs. Again, the theoretical reasoning why this can be expected is that the amount of social capital in the form of norms of behavior allows VCs to trust the referrers' judgment. This is the case because the referrer knows that if he refers bad deals, he will be sanctioned by being excluded from future transactions. In addition, other VCs probably know best the investment criteria of their peers A confirmation of HI 6 would lead to the conclusion that 'Other VCs' as source of deal flow is important because, above

all, it delivers high-quality investment opportunities. Therefore, it follows:

HI 6: The percentage of investment opportunities referred to by other VCs is higher based on deal flow quality (C') than it is based on deal flow quantity (C), so that C'>C.

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