VENTURE CAPITAL INVESTING: ARE WOMEN ENTREPRENEURS PERCEIVED AS RISKIER INVESTMENTS?

Frontiers of Entrepreneurship Research Volume 35 Issue 7 CHAPTER VII. WOMEN ENTREPRENEURSHIP Article 1 6-13-2015 VENTURE CAPITAL INVESTING: ARE WOMEN ENTREPRENEURS PERCEIVED AS RISKIER INVESTMENTS? Candida G. Brush Lakshmi Balachandra Amy Davis Patti Greene Recommended Citation Brush, Candida G.; Balachandra, Lakshmi; Davis, Amy; and Greene, Patti (2015) "VENTURE CAPITAL INVESTING: ARE WOMEN ENTREPRENEURS PERCEIVED AS RISKIER INVESTMENTS?," Frontiers of Entrepreneurship Research: Vol. 35 : Iss. 7, Article 1. Available at: http://digitalknowledge.babson.edu/fer/vol35/iss7/1 This Paper is brought to you for free and open access by the Entrepreneurship at Babson at Digital Knowledge at Babson. It has been accepted for inclusion in Frontiers of Entrepreneurship Research by an authorized editor of Digital Knowledge at Babson. For more information, please contact digitalknowledge@babson.edu.

Brush et al.: VENTURE CAPITAL INVESTING WOMEN ENTREPRENEURSHIP 177 VENTURE CAPITAL INVESTING: ARE WOMEN ENTREPRENEURS PERCEIVED AS RISKIER INVESTMENTS? Candida G. Brush, Lakshmi Balachandra, Amy Davis, Patti Greene, Abstract We study whether venture capital firms with higher status and reputation are more risk tolerant due to their position in the field as opposed to lower status venture firms which might be more risk averse, due to less proven capabilities. We explore this possibility by considering whether or not role incongruity and gender stereotyping by venture capital firms lead to perceptions of women entrepreneurs as more risky investments. Results show that VC firm status produces a difference in risk tolerance and risk aversion in terms of investments in companies with women entrepreneurs, with higher status firms more likely to invest in women entrepreneurs. In addition, we find that companies with women CEOs are likely to be older and bigger and receive lower valuations than companies with men CEOs. Introduction Venture capital investing is decision-making under uncertainty. Venture capitalists may never know specific outcomes emerging from their decisions, and because of the high failure rate, the risk of incurring a financial loss is high (Rhunka & Young, 1991). As a result, cognition plays an important role in this decision-making process (whether to invest or not) in that perceptions often guide the decision process (Baron, 1998). In the process of deciding whether to invest in a venture or not, venture capitalists will take steps to evaluate the riskiness of an investment, through the due diligence process. The venture capitalists perceptions of risk are based in information asymmetry and their sense of their ability to acquire risk reducing information about the venture in their investment decision-making process. Venture capitalists risk perceptions influence their risk- taking (Busenitz & Barney, 1997). Perceptions of risk derive from ambiguities about future events that might lead to negative performance outcomes (Das & Teng, 2001). Because of the strong possibility for financial loss, venture capitalists naturally seek to mitigate their risks, by making choices they feel have greater certainty to increase in value, and they practice a portfolio strategy that fits the desired risk-return mix they are seeking (Rhunka & Young, 1991). Often the perceptions of investment risk are based on observable factors and signals, such as the characteristics of the venture, the management team, the business plan, market potential, technology development, industry structure relative to the size of the investment (MacMillan & Narasimha, 1982: Shepherd, 1999). Therefore, information about the entrepreneur him/herself (e.g. intentions, character, integrity, etc.) can become important considerations in the venture capitalist s decision-making process and become subsumed as assumptions based on the characteristics of the firm (MacMillan, et al, 1986; Steier & Greenwood, 1995; Zacharakis & Shepherd, 2001). In other Frontiers of Entrepreneurship Research 2015 1

Frontiers of Entrepreneurship Research, Vol. 35 [2015], Iss. 7, Art. 1 178 FRONTIERS OF ENTREPRENEURSHIP RESEARCH 2015 words, these assumptions about the entrepreneur may not be cognitively explicit for the venture capitalist in his/her decision-making, thus, VCs instead use many firm or individual characteristics as substitutes for risk mitigating qualities in their investment decision-making. Research thus far has considered how human capital factors make a difference in the investment decision, in particular, education, track record of experience, diversity of functional backgrounds and management skills (Zacharakis & Meyer, 2000; Baum & Silverman, 2004). However, to date no studies have explicitly examined the gender composition of the entrepreneurial venture team in this decision. Because women entrepreneurs do not conform to the role of the entrepreneur in the high growth venture, role incongruity may lead to greater perceived risk on the part of venture capital investors (Orser, Riding & Manley, 2006; Brush, et al, 2002). In essence, venture capital firms may have differing cognitive biases that inherently affect their risk perspective in evaluating entrepreneurial ventures with women on the team versus those with all male teams (Kahneman, 2003; Kahneman & Lovallo, 1993; Bazerman, 1990; Busenitz & Lau, 1996). For this analysis, we draw from status theory of investment firms (Sorenson & Stuart, 2001; Stuart, Hoang & Hybels, 1999; Washington & Zajac, 2005) to parse out venture firms and their related investment outcomes in firms with women on the team and those without. We investigate the extent to which higher or lower status and reputation influences risk perceptions in the investment decision (Dimov, Shepherd & Sutcliffe 2007). We develop hypotheses that test the risk aversion and risk tolerance of venture capital firms investing in companies with women entrepreneurs depending on the venture firm s status and reputation. Hypothesis Development Research shows that venture capital investment decisions are influenced by the status and reputation of the VC firm (Dimov, et al, 2007). Reputation is a signal of future performance based on past performance (Podony, 1994; Fombrun & Shanley, 1990). Reputation is rooted in the success of previous investments of the VC firm based which affects the firm s ability to raise and invest new funds. VC firms that have made more successful investments in the past are more desirable syndication partners who have greater visibility and possibilities for raising more money (Lerner, 1994). These firms with high reputation may be interested in protecting the quality of their reputation by continuing to have high performance. One way to protect reputation is to reduce overall riskiness of the portfolio by making investments in safer projects (Diamond, 1989). On the other hand, high reputation firms may wish to use their market advantage as leverage and preempt competition. These firms may actually be less concerned with risk mitigation and thus be more risk tolerant of certain technologies or innovations because of experience with successfully exploiting technological innovations (Stuart, et al, 1999). Further, high reputation firms may look to expand their portfolios and thus have more financial slack due to a proven ability to raise funds. Such firms may be able to take greater risks in their investments (Gompers, 1996). Because reputation is linked to past performance which leads to inflows of investments, lower reputation firms work to build their reputations (Ippolito, 1992). Low reputation firms are interested in developing performance track records and so might be willing to make more risky investments to create legitimacy, and so are more concerned about risk mitigation (Piskorski, 2006). Entrepreneurial firms with women on the team are anomalies in the venture capital funding environment and do not necessarily fit the model for venture capital fundable businesses (Brush, Greene, Balachandra & Davis, 2014). There is evidence that gender role stereotypes for successful Posted at Digital Knowledge at Babson http://digitalknowledge.babson.edu/fer/vol35/iss7/1 2

Brush et al.: VENTURE CAPITAL INVESTING WOMEN ENTREPRENEURSHIP 179 entrepreneurs may create the perception that women entrepreneurs are less qualified for venture capital investment. More specifically, a successful entrepreneur has been typically stereotyped as a highly masculine role, frequently described as someone who is a bold, aggressive risk-taker, descriptions typically associated with men (Ahl, 2004; Bird & Brush, 2003; Gupta, Turban, Wasti & Sikdar, 2009). Perceptions of risk can be formed based on the VC investment team s assessment of demographic characteristics of a venture s management team, so it is therefore likely that entrepreneurial ventures with women on the team will be perceived as more risky investments. And, as high reputation VC firms are less likely to take investment risks that may be rooted in the capabilities of the management team, we therefore propose that: H1A- High reputation venture capital firms will be less likely to invest in companies with women on the entrepreneurial team. H1B- High reputation venture capital firms will be less likely to invest in companies with a woman CEO. Research shows that high reputation venture firms also prefer to invest in safer, later stage projects that are similar to companies meeting their previous profiles for investment rather ventures with greater uncertainties (Diamond, 1989). Later stage investments have better defined product/market characteristics which allows for a better estimation of the future payoffs; this allows venture firms greater ease in managing potential future risks (Amit, Brander & Zott, 1998). It may also be that firms believe there is less control over earlier stage deals due to the increased uncertainty about possible outcomes of these young, undeveloped companies (March & Shapira 1987). Companies with women CEOs or women on the management team may be perceived similarly, as uncertain investments which may undermine the relative status of the firm from the venture firm s perspective (Washington & Sajac, 2005). Therefore, we hypothesize that when a high status venture capital firm invests in a company with women on the team or a woman CEO, they mitigate this perceived uncertainty investing in later stage deals. H2A When investing in companies with women on the entrepreneurial team, high reputation venture capital firms will be less likely to invest in seed stage deals than low reputation firms. H2B When investing in companies with women CEOs, high reputation venture capital firms will be less likely to invest in seed stage deals than low reputation firms. Method To examine our research question, we obtained three years of recent venture capital funding data (2011-2013) from a private company, Pitchbook, that provides systematic and comprehensively reviewed public data on all companies that were funded by private equity and venture capital over the past decade. We limited our analysis to firms that received their first and only venture capital funding between the years of 2011-2013; this included over 6,000 unique VC funded companies and 1,562 VC firms. To be included in our data for this study, funded companies had to have valid values for industry and venture founding date as well as complete information on at least one of their investors as well as for our variables of interest: state, year founded, and number of investment professionals. Our final dataset included 691 venture capital firms and 1,455 firms receiving venture capital funding. For our analysis, our independent variable was venture capital firm reputation measured by VC firm size (employees, age), location (California, Massachusetts, or New York, noted for established venture capital communities) and average number of investments (Sorenson & Stuart, Frontiers of Entrepreneurship Research 2015 3

Frontiers of Entrepreneurship Research, Vol. 35 [2015], Iss. 7, Art. 1 180 FRONTIERS OF ENTREPRENEURSHIP RESEARCH 2015 2001) and our dependent variables were investment in companies with a woman on the team and stage of investment. Our control variables were age of entrepreneurial venture and industry of the venture. Results A descriptive analysis of the firms receiving venture capital shows that nearly 90 percent of firms have no female leadership, and only five percent have a woman CEO. In this sample of firms receiving their first and only funding between 2011 and 2013, there are no statistically significant differences in the age of the firms or their likelihood of being a software firm. However, firms with female leadership, especially those with women CEOs, have significantly more investors participating in their first and only financing deal compared to firms with no female leadership. The average number of VCs investing in a firm without female leadership is 2.33, compared to 2.89 for firms with female leadership (p<.001) and 3.22 for firms with a woman CEO (p<.001). In addition, while almost half (45 percent) of firms without female leadership received investment from only one VC firm, only 32.45 percent of firms with female leadership (p<.01) and 23.29 percent of firms with a woman CEO (p<.001) received investment from only one VC firm. A descriptive analysis of the 691 venture capital firms in our sample shows that fifty percent of all venture capital firms in the sample are headquartered in California (35.89 percent), Massachusetts (11.14 percent), and New York (12.74 percent). The average year VC firms in our sample were founded is 1999. They have an average of nearly 10 investment professionals. Twenty-three percent of VCs have invested in a firm with female leadership, with nearly 10 percent investing in a firm with a woman CEO. To examine our two hypotheses, we ran logistic regressions (see Table 1) to determine whether or not high status venture capital firms (older, larger and located in MA, NY or CA. compared to other states and the District of Columbia) were less likely to invest in companies with female leadership or women CEOs. We found that VC firms located in MA or CA that were larger were much more likely to invest in companies with a woman on the team or with a woman CEO. Age was not significant in the analysis, and VC firms located in NY were no more or less likely to invest in these companies from other states. Based on these results, we do not find support for hypothesis 1a or 1b: higher status VCs are in fact more likely to invest in companies with female leadership and female CEOs. To test our second hypothesis, we conducted another regression to determine whether or not high status venture capital firms investing in companies with women on the team or with women CEOs were less likely to invest in seed stage businesses. We organized our data to establish VC firm-vc funded venture pairs. (If a venture s financing deal involved one VC, then it was represented by one observation. If it involved 15 VCs (the maximum value in these data) then it would be represented by 15 observations. Similarly, each VC firm has an observation for every one of its funded ventures. Regressions include 3,179 pairs of VCs and VC backed companies (where data is complete for each member of the pair). This resulted in 1,445 unique VC-backed companies and 691 unique VCs. We used generalized estimating equations to account for potential correlations among the different investments a single VC firm may make. In this analysis, we controlled for both the status of the VC firm as well as characteristics of the venture receiving investment. In predicting if VC firms provided seed funding to ventures, VCs in NY and CA were more likely than VCs in the rest of the country to offer seed funding with another regression, presented in Table 2. Larger VCs were less likely to offer seed funding. Older VCs were more likely to offer Posted at Digital Knowledge at Babson http://digitalknowledge.babson.edu/fer/vol35/iss7/1 4

Brush et al.: VENTURE CAPITAL INVESTING WOMEN ENTREPRENEURSHIP 181 seed funding. VCs more often offered seed VC funding to firms that were younger and in the software industry. However, when we examined our hypothesis, we find that few of these variables explain whether firms with women on the team or CEO received seed funding from early or later stage VCs. Stated another way, smaller, software-based firms are more likely to receive seed funding than other types of funding, if the company lacks female leadership. However, companies with women on the team are equally likely to receive seed funding regardless of venture size, industry or VC firm status. Hypothesis 2 (2a and 2b) is not supported because higher status firms do not appear to be less likely to offer seed funding, with the exception that older firms are less likely to offer seed funding overall. And neither the VC firm nor the firm s characteristics explain whether ventures with women on the team or women CEOs receive seed as opposed to early/late stage VC funding. Discussion and Implications This study finds venture capital firms status produces a difference in risk tolerance and risk aversion in terms of VC firms investments in companies with women entrepreneurs. Our investigation of hypothesis 1A and 1b shows that older, larger and more established venture capital firms were much more likely to invest in companies with women on the team - while younger, lower reputation venture capital firms were much less likely to do so. Our results suggest that higher reputation venture capital firms are more risk tolerant when it comes to the risk potential of investing in companies led by women. One possible explanation is that higher status VC firms are more well-established in the venture capital community and have bigger networks because of their experience and reputation and are therefore more likely to have the ability to identify opportunities to invest in companies with women. Further, because of their reputation, size and established networks, they may also have the ability to conduct greater due diligence that provides them with more information that then lessens their perceived risk of investing in companies with women entrepreneurs. Although we did find differences for venture capital firm status and investments in women entrepreneurs, we did not find differences in support of our hypothesis 2A and 2B - between the stages of investment and investments in companies with women on the team. This may be that reputation of the firm does not indicate a preference for stage of investment in terms of women entrepreneurs. However, our investigation did indicate that smaller software companies with no women were more likely to receive seed funding. This finding might be associated with the greater perceived uncertainty in the technology sector generally, because it is often more difficult to patent or protect IP in such ventures. While higher status firms were more likely to invest in companies with women on the team or women CEOs, these firms appear to mitigate this risk through control mechanisms like having more co- investors and less frequently investing in seed or early stage deals. VCs may seek to increase their shared risks of investing in women entrepreneurs. A future research question might be to explore the perceived uncertainty associated with different sectors, in that higher sector uncertainty might be perceived greater when there is perceived risk associated with the entrepreneurs experience, human capital or roles. Future research might investigate if the level of investment varies, that is, if the overall amount invested varies depending on the number of investors (or level of syndication) in the deal. This study contributes to theoretical research on status and reputation (Washington & Zajac, 2005) and connects it to research on women entrepreneurs and the venture capital funding Frontiers of Entrepreneurship Research 2015 5

Frontiers of Entrepreneurship Research, Vol. 35 [2015], Iss. 7, Art. 1 182 FRONTIERS OF ENTREPRENEURSHIP RESEARCH 2015 landscape. As we find that businesses with women on the team access VC funding primarily through higher status VC firms with multiple co-investors, we conclude that they that may face further disadvantages from this dynamic because of less favorable terms at investment. CONTACT: Candida Brush (T) + 1-781-239-5014; (F) +1-781-239-4178; Babson College, 246 Forest St., Wellesley, MA 02457, USA Table 1. Logistic Regression Analysis (VC firms Investing) Invested in firm with women on mgmt. team Invested in firm with woman CEO CA 0.76 *** 1.01 ** (0.22) (0.33) MA 0.98 *** 1.13 ** (0.29) (0.45) NY -0.5-0.42 (0.39) (0.65) Number of investment professionals 0.04 *** 0.05 *** (0.01) (0.01) Year VC founded 0.009 0.009 (0.009) (0.01) Constant -20.13-21.26 (17.55) 21.25 N 691 691 Chi-Square 53.65 *** 44.33 *** df 5 5 Pseudo R2 0.0727 0.1018 *=p<.05 **=p<.01 ***=p<.001 Table 2. Generalized Estimating Equations for Seed Funding Entire Sample No Women on Mgmt Team Women on Mgmt Team Man CEO Woman CEO California 0.08 ** 0.09 ** -0.04 0.09 ** -0.09 (.03) (0.03) (0.07) (0.03) (0.10) Massachussetts 0.06 0.09 * -0.1 0.08 * -0.26 (.04) (0.04) (0.09) (0.04) (0.14) New York 0.14 *** 0.16 *** -0.03 0.15 *** -0.03 (.04) (0.04) (0.08) (0.04) (0.12) Number of investment professionals -0.003 ** -0.003 * -0.003-0.002 * -0.004 (0.001) (.001) (0.002) (0.001) (0.002) Year founded VC -0.00004 * -0.00004-0.00006-0.00004-0.00005 (.00002) (0.00002) (0.00003) (0.00002) (0.00005) Year founded firm 0.02 *** 0.01 *** 0.03 *** 0.02 *** 0.02 (0.002) (0.002) (0.007) (0.002) (0.17) Software industry 0.09 *** 0.09 *** 0.07 0.09 *** 0.11 (0.02) (0.018) (0.05) (0.02) (0.07) Constant -31.14 *** -29.04 *** -68.77-30.43-40 (3.34) (3.42) (14.65) (3.35) (35.09) N 3338 2915 423 3126 212 Observations per VC 1-579 1-503 1-76 1-538 1-41 Wald Chi-Square 158.8 *** 141.42 *** 41.88 *** 149.96 *** 17.19 * df 7 7 7 7 7 Within VC correlation 0.0791 0.1046 0.0119 0.0997 0.0427 *=p<.05 **=p<.01 ***=p<.001 Posted at Digital Knowledge at Babson http://digitalknowledge.babson.edu/fer/vol35/iss7/1 6