The sources of legitimacy for new venture angel investors

The sources of legitimacy for new venture angel investors John R. Becker-Blease* Assistant Professor of Finance Oregon State University College of Business 200 Bexell, Bx 418B Corvallis, OR 97331-2603 Phone: 541-737-6061 Fax: 541-737-4890 Email: john.beckerblease@oregonstate.edu Jeffrey Sohl Professor of Entrepreneurship and Decision Sciences University of New Hampshire Whittemore School of Business and Economics 15 Academic Way Durham, NH 03824 USA Phone: 603-862-3373 Email: jeff.sohl@unh.edu ABSTRACT We examine the relation between legitimacy and angel investor assessment. Employing two common measures of legitimacy including sociopolitical normative, and cognitive as well as a third based on the industry of operation we find that sociopolitical and cognitive sources are predictive of angel investor interest. Specifically entrepreneurial ventures with quality top management teams, identified external investors and advisors, along with developed products are rated more favorably by angel investors, have better access to these investors, and are more likely to receive investments. This research provides new insights into the establishment of legitimacy within the economically important angel capital market. Keywords: Sources of legitimacy, angel investing, sociopolitical normative, cognitive legitimacy, investment criteria * Corresponding author 1

1. Executive summary Researchers have long recognized the critical importance of early stage capital acquisition for nascent ventures. While early research efforts examine the role of venture capital and bank loans, more recently, business angels are identified as the critical source of vital early stage equity capital for nascent ventures (Sohl, 2007; Madill et al., 2005; Maxwell et al., 2011). What induces a potential business angel to make an investment in a venture remains an open question. Zimmerman and Zeitz (2002) and Deeds et al. (2004), among others, suggest that resource flow is dependent upon the perceived legitimacy of the venture, which helps to attenuate the innate agency and information problems inherent in new venture investments. To date, however, there is limited evidence of what confers legitimacy to a new venture from an angel investor s perspective. In this study, we employ a unique database of 176 business plans submitted and evaluated by teams of 5-10 angel investors to examine the relation between deal characteristics and angel evaluation and investment. The study makes several contributions to the literature. First, the evidence suggests the nature of the relation between legitimacy and the acquisition of a particular form of external resource, specifically financial capital. Consistent with the recent evidence by Zott and Huy (2007), we find that legitimacy is linked to resource acquisition for nascent ventures. Further, we find that legitimacy from angel investors is multifaceted, with both sociopolitical normative and cognitive sources. A particularly prevalent source of legitimacy derives from characteristics of the top management team (TMT), consistent with the conclusions of Packalen (2007). In 2

particular, prior industry experience and advanced or venture-specific education are positively associated with both angels overall evaluation of the attractiveness of an enterprise as well as angels willingness to actually make an investment. The results also support the conclusions of McMullen and Shepherd (2006) and Zott and Huy (2007), who argue that theories of action rather than firm or industry characteristics are better descriptors of successful resource acquisition by entrepreneurs. Consistent with this argument, we find no evidence that industry influences evaluation or funding for angels. Rather, in answer to the Zimmerman and Zeitz (2002) call for greater understanding of what leads to the acquisition of legitimacy, we have found that TMT quality and the presence of reputable advisors, factors over which entrepreneurs can potentially exercise control, are significant contributors to legitimacy. 2. Introduction The acquisition of early stage external capital is a critical step for many entrepreneurial ventures (Wetzel, 1986; Gaston and Bell, 1988; Mason and Harrison, 1992; Carter and Rosa, 1998; Cassar, 2004). However, finding willing investors can be challenging. Agency conflicts and asymmetric information can make accessing both debt and equity markets prohibitively expensive. Debt financing can be particularly unattractive for high-growth entrepreneurial ventures due to the incentive conflicts between investors and entrepreneurs, the often intangible nature of the assets, and the perverse selection effects described by Stiglitz and Weiss (1981). However, external equity financing can suffer from a significant lemon s discount especially if the perceived information disparity between investors and the entrepreneur is severe (Akerlof, 3

1970). The adverse selection problem is particularly acute if equity ownership is to be diffuse as the resulting financial incentive to develop additional information is diminished (Jensen and Meckling, 1976). Lerner (2002) describes how specialized financial intermediaries have evolved in capital markets in response to early stage funding difficulties. In particular, private equity investors in the form of angel and venture capitalists have emerged to provide important funding access to nascent ventures. Although both angel and venture capital provide early stage financing, there are important differences between the two. Angel capitalists are typically high-net-worth individuals, often with relevant business experience, who make personal investments in new ventures. Venture capital, in contrast, is frequently set-up as a professionally managed pooled investment vehicle in which many or most of the investors have no personal involvement with the venture. Angel and venture capitalists also differ in the typical size of investments made, with angel capitalists more willing to invest modest amounts from less than $25,000 to $1 million (Sohl, 2003; Wiltbank, 2005), amounts that are insufficient to garner formal review by many traditional venture capital funds. In fact, emerging evidence suggests that angel investment can be a critical first-stage to receiving later-stage venture capital (Madill et al., 2005). Zimmerman and Zeitz (2002) and Deeds et al. (2004), among others, suggest that the flow of capital and other resources into a new venture depends largely on the perceived legitimacy of that venture. Organizational legitimacy, or the acceptance of an organization within its environment, is especially critical for the survival of a nascent venture (Aldrich and Fiol, 1994; Baum and Oliver, 1991) as failure to receive start-up resources can quickly lead to an enterprise s demise (Jones, 1979; Rao, 1994). Despite the important role of legitimacy for 4

nascent ventures, there is little empirical evidence of what lends funding proposals legitimacy in the eyes of an angel investor. In this paper, we investigate the deal characteristics that are associated with new venture legitimacy focusing explicitly on angel investors. We employ a unique two-year sample of angel investor evaluations of 176 new venture proposals and subsequent angel funding within the next 12 months to explore the salience of three theoretically derived sources of legitimacy including sociopolitical normative, cognitive, and industry. 3. Literature review and hypotheses 3.1. Legitimacy Legitimacy is a vital resource for firms to develop. Resources flow to the firm as a result of its legitimacy and the resource flow, in turn, adds to the legitimacy of the firm (Zimmerman and Zeitz, 2002). Starr and MacMillan (1990) similarly describe legitimacy as a critical ingredient for new venture success. Legitimacy can be particularly crucial for early stage firms that typically gravitate towards failure unless sufficient resources are marshaled to grow and thrive. If new ventures rely so critically on legitimacy, it is important to understand from where this emanates. There are four common sources of legitimacy identified in the literature. Scott (1995) and Hunt and Aldrich (1996) define regulative or sociopolitical regulative legitimacy as derived from rules, regulations and standards of recognized official entities including governments, credentialing associations, and other organizations. This form of legitimacy is most prevalent 5

when the perception is that the venture is voluntarily participating in adhering to the standards or expectations of the regulatory entities. The second source, also described by Scott (1995) and Hunt and Aldrich (1996) is normative or sociopolitical normative legitimacy, and refers to legitimacy gained by a venture s associations with appropriate norms and values, such as fair treatment of relevant stakeholders (customers and employees), external endorsements, and network memberships (Zimmerman and Zeitz, 2002). Sociopolitical normative legitimacy can be particularly important to new ventures because it tends to flow from external economic actors into the firm and is therefore, to a potentially large degree, something new ventures cannot misrepresent. For instance, ventures cannot purchase endorsements or force customers, suppliers, and employees to remain stakeholders. These relationships must be earned and maintained, and therefore can provide credible signals of quality and legitimacy. A third source is frequently referred to as cognitive legitimacy. Suchman (1995) characterizes cognitive legitimacy accruing when ventures are perceived as desirable or proper because they match extant beliefs of how best to organize economic resources to generate social value. Zimmerman and Zeitz (2002) suggest that a venture acquires cognitive legitimacy by apparently endorsing and implementing methods, models, practices, assumptions, knowledge, ideas, realities, concepts, modes of thinking that are widely accepted and considered useful and desirable in one or more of the domains in which it operates. The fourth source of legitimacy is the industry in which a venture participates. Aldrich and Fiol (1994), Suchman (1995), and Zimmerman and Zeitz (2002), among others, suggest that legitimacy can be conferred to new ventures by other firms operating in the same industry. For instance, all mortgage lenders suffered a damaged reputation in the 2007-2008 financial crisis, 6

regardless of their particular financial circumstances or choices. Similarly, during the so-called dot-com bubble, many entities with few or no other sources of legitimacy were viewed as legitimate because of their participation in the on-line retailing industry. One important indicator of legitimacy for many new ventures is the acquisition of external investors and capital. As with other resources, the securing of external capital is both an indicator of and a contributor to legitimacy. The role of legitimacy in securing external capital is well-documented among IPOs (Carter and Manaster, 1990; Certo, 2003; Daily et al., 2003; Cohen and Dean, 2005; Downes and Heinkel, 1982; Lester et al., 2006; McBain and Krause, 1989; Zimmerman, 2008). However, comparatively little is known regarding the role of legitimacy in nascent entities access to external capital. One strand of literature has examined whether the presence of a formal business plan is associated with greater legitimacy in the eyes of venture capitalists. Kirsch et al. (2009), Honig and Karlsson (2004), and Honig (2004) find limited evidence that business plans contribute significant legitimacy, while Delmar and Shane (2003) find more supportive evidence. These studies, however, are largely silent on the contributors of legitimacy for early stage ventures seeking start-up funding, which is typically the purview of angel investors. 1 3.2. Angel financing Angel investors are typically cashed-out entrepreneurs or executives who provide early stage funding to entrepreneurs in exchange for a portion of the equity in the venture. Unlike venture capital firms, which traditionally make investments in excess of $1 5 million, angel investors are the major source of seed and start-up capital for entrepreneurial ventures in the US 1 An important exception is Zott and Huy (2007), who interview 7 nascent venture teams and affiliated stakeholders. 7

and UK, with typical investment amounts in the US$100,000 to US$1 million range (Harrison and Mason, 2000; 2005; Mason, 2001; Sohl, 2003). Thus, angel investors provide a crucial role in developing new ventures. The results for legitimacy among angels are important for a number of reasons and especially given the stage and the critical role filled by angel capital and in contrast to the position of venture capitalists in the financing of entrepreneurial ventures. First are the issues of information that are disclosed, or available, for an investment decision. While information asymmetry exists for both angels and venture capitalists, it is especially acute for angel investors and some smaller venture capital funds, given their position as very early stage investors. As the stage of investing increases the degree of information asymmetry would typically decrease, on a relative basis. That is, later stage venture capitalists generally face less information asymmetry issues since there exists more firm level information whereas the early stage investors must largely rely on the entrepreneur for information, who by nature would be reluctant to disclose information that would not be advantageous to the firm. With respect to information availability it is a colloquialism that in the early stage investors are betting on the jockey and not the horse, given the general lack of a financial history for the firm and the need to manage agency risk. While asymmetric information is one issue (the entrepreneur has the information and the angel needs it), rather than asymmetric, in this context it is that the information simply does not exist on aspects of the entrepreneur or the venture. It is in this information sparse environment that identifying what factors are indications of legitimacy is important given the scarce information that is available. Thus these two matters of information, asymmetry and availability, accentuates the need to understand how firms gain legitimacy to angel investors. 8

The second reason for the importance of understanding the influence of legitimacy to angel investors is resource availability. In comparison to venture capitalists, angels do not have management fees based on a fund size nor do they typically have staff to conduct due diligence. For venture capitalists these back office activities are paid for by the management fee but for angels they are largely undertaken by the lead investor without compensation. That is the nature of the angel market and it accentuates the importance of legitimacy. In the presence of scarce resources for the investment decision, understanding what types of legitimacy are important to angels assists in allocating attention to these factors, for both the entrepreneur and the angel. Third, angels typically experience less diversification across ventures due to a limited amount of capital to invest, even when they pool their money. For venture capitalists, whose fund size allows for several investments, often in the same market niche, diversification is an available strategy. Since angels cannot use diversification as a way to mitigate risk it is imperative that the available investment dollars are spent wisely, which in turn accentuates the need for understanding legitimacy in the context of investment criteria. Lastly, with respect to follow-on rounds, it is possible that the legitimacy exhibited during the early stages, and any legitimacy gained as a result of investments by angels, may have a carryover effect on later stage institutional investors. As with other investors, angels are likely influenced by the legitimacy of the ventures they consider and their decision to make an investment can contribute substantially to the ventures extant legitimacy. Also important is what entrepreneurs can undertake in order to gain this legitimacy. If entrepreneurs have an understanding of what is important to angel investors then they are able to work on positioning themselves and their venture to acquire the legitimacy that is important to angel investors. Taken collectively, what constitutes legitimacy for new venture investing by angels and what factors are 9

important, provides insight into the process of angel investing for both the investor and the entrepreneur seeking early stage capital. However, due to data constraints, researchers know very little about what characteristics angels consider when making an investment decision and, more importantly, what conveys legitimacy to an angel investor. In this paper, we explore this critical question of legitimacy. 3.3. Hypotheses In summary, business angels play a critical role in new venture development. Given the potential greater prevalence of asymmetric or unavailable information, the resource restrictions and limited diversification compared to other investors, it is possible that legitimacy accrues through different means than for venture capitalists or IPO investors. Maxwell et al. (2011) examine the decision-making of business angels within a popular TV program and find that participants employ elimination-by-aspects as suggested by Tversky (1972) to make investment decisions rather than jointly considering multiple characteristics. Our testable hypotheses are then: Hypothesis 1. Ventures with a high degree of social political identity have greater legitimacy with angel investors. Hypothesis 2. Ventures with a high degree of cognitive identity have greater legitimacy with angel investors. Hypothesis 3. Ventures with a high degree of industry-based identity have greater legitimacy with angel investors. 10

4. Sample and methodology 4.1. Sample In October 2008 and 2009, the New Hampshire High Technology Council and the New Hampshire Small Business Development Center co-sponsored Speed Venture Summits (SVS). The events each brought together entrepreneurs and investor groups from the New England region for 15-minute meetings designed to match capital constrained entrepreneurs with investors. Participation in the SVS was not open to all, but to roughly 50 participants out of an applicant pool of over 100 each year. The process for selecting participants in the Speed Venture Summit (SVS) was a multistage procedure. The selection process was identical for each year of the SVS. The application to participate in the SVS consisted of several documents in various formats, ranging from specific responses to questions to free form documents allowing the applicant to submit company and deal information in an open ended text format. Video material was also permitted in addition to the text based application. For the specific responses a series of 40 questions were completed by each applicant. These included company contact information, the management team and its qualifications, a company profile, a one line investor pitch, both current and potential customer profiles, identification of the market niche, the business model, sales and marketing strategy, the competitive landscape, and a detailed financial summary including both current and pro forma financials for five years. In addition to responses to these specific questions applicants submitted an executive summary, a full business plan and a complete financial plan. 11

To select the participants in the SVS each application was evaluated by a selection committee comprised of present and former business executives, technology marketing and sales personnel, management consultants, investment and commercial bankers, accountants, lawyers, and business/economic development officials. Based on the submitted information each applicant was evaluated by at least 5 people on the selection committee, and often by 8 to 10. Each evaluator had access to all documentation including the specific question summary sheet, business plans, videos, and other materials and information furnished by each applicant. Each reviewer evaluated a venture on a 1 to 5 scale (5 being the highest) based on five criteria: strength of management, product, market, deal terms and an overall rating. This initial scoring by the evaluators was completed independently (between applicants) and without consultation among the judges. To arrive at a final composite score a three stage process was undertaken. The average of the initial scores on each of the five criterion from each recording judge became that judge s score for that applicant (single score), and the average of all single scores then became that applicant s total score. If there was a wide variation between single scores for a specific applicant the selection committee met and discussed each recording judge s views, and after a more complete discussion of the applicant s business model, management team, product niche and marketing strategy each judge was afforded the opportunity to revise her/his single score before determining that applicant s revised final composite score. All well-qualified applicants, defined as those with a final composite score greater than 3.5, were accepted to present at the summit. Approximately one-half of the final group of presenters met this advanced approval standard (those with a final composite score greater than 3.5). The remaining half of the presenters was selected from a pool of all remaining applicants on the basis of those that had the best final composite score among the group with scores below the 3.5 threshold. 12

Six-months following the SVS, we attempted to contact both participants and nonparticipants via phone to determine their recent success in raising funding. We conducted 72 successful interviews from 176 attempts, a success rate of 41%. These data offer an unusual opportunity to understand how angel investors evaluate potential investment opportunities. We have access to all of the original application material filed by the entrepreneurs as well as the evaluations made by the SVS reviewers. Combined with the phone-survey follow-up data, these offer a unique opportunity to understand what venture characteristics appear to matter to angels and what characteristics coalesce to raise the legitimacy of the venture in the eyes of the investor. 4.2. Methodology We investigate the sources of legitimacy for new ventures using correlation and regression analysis that employs both OLS and Probit estimation. We define the dependent and independent variables below. The dependent variables include two measures of angels assessments of different investment opportunities. The first dependent variable is a score based on the submitted material by the new venture owners. The SVS team, comprised of business executives, technology marketing and sales personnel, management consultants, investment and commercial bankers, accountants, lawyers, and business/economic development officials, evaluate each proposal along four specific dimensions including strength of management, product, market, and deal terms. Proposals were awarded one to five points in each of the four categories and the sum of these scores is the SVS Rating. 13

The second dependent variable is an indicator variable of whether the venture received external equity investment following the SVS. We surveyed all SVS applicants, whether they participated or not, regarding their success in acquiring equity capital six-months following the SVS forum. We received usable data from 72 of the 176 applicants, a response rate of 41%. 2 Legitimacy can emanate from many potential sources including sociopolitical regulatory, sociopolitical normative, cognitive, and industry. Given data limitations, we focus on the last three sources of legitimacy. 3 We describe and operationalize these measures below. 4.2.1. Sociopolitical normative Sociopolitical Normative is derived from the norms and values of society, or in other words is generally a result of acting in accordance with societal values, norms and scripts. Zimmerman and Zeitz (2002) suggest that in the case of new ventures, profitability, fair treatment of employees, endorsements and networks all are valuable sources of normative legitimacy. We identify five potential sources of sociopolitical normative legitimacy among new venture firms. Committed capital: Holmström (1979) and Holmström and Tirole (1997) propose models of agency and moral hazard wherein firms with high levels of perceived asymmetric information require a high level of monitoring and due-diligence by qualified investors prior to other, less informed, investors making investments. The initial investors have both an information and moral hazard problem in that their incentive is to encourage additional 2 Although the participants were asked to report both the source and amount of any additional venture financing, many elected to only identify the source, not the amount. As a result, in order to preserve degrees of freedom, we focus on a simply binary response rather than the actual amount raised. 3 Sociopolitical Regulatory is frequently operationalized using articles of incorporation, trade memberships, or other official filings or documents. However, our questionnaire does not enable us to reliably distinguish between those ventures with or without these items. 14

investment and ownership, especially for over-valued ventures and their efforts in monitoring the venture are unobservable. These problems can be mitigated with larger investments by the initial investor. We measure these dimensions using the level of previous capital invested. First, for the level of previous investment, we calculate a 10-point scale of previous capital invested ranging from 0 (none) through 10 ($1 million or greater). Intermediate values are calculated as amount raised divided by $100,000. Second, we employ indicator variables of whether this capital commitment was made internally by insiders (including founders and family) or externally by outsiders (including advisors not listed as managers, friends, and recognized angel groups). 4 Venture stage: Stinchcombe (1965) discusses the challenges new ventures face due to the liability of newness. This liability can derive both from the newness of the industry in which the venture operates and the newness of the venture itself (Zimmerman and Zeitz, 2002; Hannan and Freeman, 1984). Ventures in unproven industries or with unproven products and markets are typically viewed as less legitimate. Although angel investors are perhaps more comfortable than other investors in this environment of newness, it is still possible that newness will affect angels perception of the legitimacy of the venture. However, it is possible that angel investors view newness as an asset. That is, angels are comfortable with high degrees of uncertainty and may deem a new venture in a new arena as more investable than one in a more established industry with less, for lack of a better word, panache. Other factors that add to the comfort with new, early stage, ventures is the lack of established competitors, the relatively small amounts of capital that can make a critical impact on the development of the venture and the investors experience with start-up firms. Thus, while we investigate the impact of newness, we do not 4 Although friends could be potentially considered insiders, we elect to treat these as external investors because many entrepreneurs elected to specifically name their investors rather than generically identifying them as friends. Thus, we are unable to distinguish between these two. In addition, in the context of this research and the form of the pre-summit application questions, friends are considered to be external equity investors seeking a capital return. 15

hypothesize a particular direction for the effect. We address the industry effect below, but to gauge the newness of the venture itself, we create a three-point scale based on the stage of the venture. In order to limit the subjectivity of the entrepreneur in categorizing the stage of a venture, we define the three stages as: pre-product-ready (Group 1), product-ready but no current sales (Group 2), and venture with trailing 12-month revenues (Group 3). Employees: Human and Provan (2000) and Khaire (2010), among others, argue that employees are an important resource and affect, and are affected by, firm legitimacy. Short et al. (2009), for instance, report that the number of employees is positively associated with firm sales, sales growth, and survival. Similarly, investors understand the opportunity cost associated with employee commitment to a given firm and likely infer legitimacy based on this commitment. We measure the legitimacy conveyed by employee commitment based on the number of non-top management team employees reported. We employ a three-point scale of 0 if there are one or fewer employees, 1 if there are 2 to 10 employees, and 2 if the venture has more than 10 employees. Venture age: Ritter (1984) and Carter and Manaster (1990) have suggested that the age of the firm can be an important indicator of the severity of the asymmetric information problem and likely also indicate ventures with greater potential staying power. Although the relation between age and survival is obvious, the prospect for survival indicated by age may comprise an economically important source of legitimacy for a venture. Indeed, Hannan and Freeman (1989) argue that older organizations are seen as more reliable and accountable and, as argued by Carroll and Hannan (2000) are also likely to have more developed stakeholder networks, which are both indicators of legitimacy. Among our sample, we have a skewed distribution of firm age ranging from newly launched ventures to ventures with reported ages of more than a decade. We 16

therefore elect to categorize firm age into four groups (newly launched, one-year, two to three years, greater than 3 years). Advisors: Sociopolitical normative legitimacy is also a result of the network of a new firm. A number of scholars suggest that the network of a new venture, particularly with existing organizations, can contribute to the new venture s legitimacy (e.g. Deeds et al., 1997, Dowling and Pfeffer, 1975). Zimmerman and Zeitz (2002) specifically point to networks with auditors, banks and corporate boards as good sources of normative legitimacy. Because we do not have the industry insight to categorize each advisor in the new venture, we employ a dichotomous indicator variable taking the value of 1 if at least one advisor is reported in the firm s documents, 0 otherwise. 4.2.2. Cognitive legitimacy Cognitive legitimacy for new ventures is frequently considered to flow from adherence to extant business practices (e.g. having a formal business plan) and from the quality of the management team. Cognitive legitimacy can be particularly important for early stage ventures as these can provide important signals of quality absent greater information. We defined two potential sources of cognitive legitimacy. Number of submitted documents: One important source of cognitive legitimacy is the volume and quality of documentation a venture is able to provide. Although apparently careful documentation does not necessarily insure quality information, it provides a signal to potential investors of the seriousness of the entrepreneurs and demonstrates the entrepreneurs understanding and ability to adhere to standards. That is, a well-written business plan conveys 17

not only the venture-specific information in the plan, but also the entrepreneurs knowledge that such information is expected and his/her ability to generate that knowledge. Applicants for the SVS submitted various levels of documentation to support their cases, including business plans, executive summaries, financials, and written endorsements. Due to the inevitable subjective nature of such classification, we are reluctant to attempt to code the quality of such submissions. We instead rely on a simple count of the number of documents as an indication of the cognitive legitimacy conveyed. Due to the skewness in this value (0-18 documents), we adopt a three-point scale of 0 if no documents submitted, 1 if 5 or fewer documents are submitted, and 2 otherwise. Top management team characteristics: A second source of cognitive legitimacy is the composition of the top management team (TMT). Zimmerman and Zeitz (2002) argue that TMT composition represents a valid signal of the economic potential of a firm and therefore conveys cognitive legitimacy to the venture. Cohen and Dean (2005), Higgins and Gulati (2006), Zimmerman (2008), and Zhang and Wiersema (2009) each report evidence consistent with this prediction related to initial public offerings of equity. As suggested by Zimmerman and Zeitz (2002), we examine TMT legitimacy based on experience, education, and other respected credentials. We operationalize this using three indicator variables taking the value of 1 if any member of the management team has relevant industry experience, previous top-management-team experience, and identified specialty or advanced education, respectively. 4.2.3. Industry 18

Aldrich and Fiol (1994), Suchman (1995), and Van de Ven (1993) suggest an industry pattern in legitimacy with certain industries conveying greater legitimacy to its established members and new entrants than others. Zimmerman and Zeitz (2002) formalize this by proposing that new ventures are awarded legitimacy by the industries they become associated with. Determining the level of legitimacy conveyed by operating within a particular industry is not particularly easy to ascertain. As Zimmerman and Zeitz (2002) suggest, the effect may be nonlinear in that the newest industries and the most established industries may have comparatively less legitimacy than the relatively new, rapidly growing industries. We contend that angel capitalists are likely interested in those industries that are also interesting to venture capitalists and rely on investment patterns among venture capitalists to indicate the relative legitimacy of new ventures within particular industries. We employ historical trend data from PricewaterhouseCooper s MoneyTree Report to determine the annual average of both number of deals and dollars invested by venture capital groups in the US from Q1 1995 to Q1 2009 for each industry. These industry-level data are expressed as a percent of the total investment and number of deals. For example, the software industry accounted for nearly a quarter of all venture capital investment over the time period. Each new venture in the sample is then assigned the decimal equivalent of this number, with the expectation that industries that attract the highest levels of investment are seen as the most legitimate for capital investment by the investment community. 5. Analysis 19

We conduct two basic analyses. The first employs the entire sample and regresses the SVS score on the predicted contributors of venture legitimacy using OLS analysis. The second analysis is based on a subsample of 72 firms for which we have phone-survey data. In this specification, the dependent variable is an indicator variable taking the value of 1 if the firm received angel investment following the SVS forum, 0 otherwise, and the model is estimated as a probit. Table 1 reports variable definitions and basic descriptive statistics including minimum, maximum, mean, and median values for each variable employed in the analysis. Most ventures have approximately $267,000 of invested capital with 70% having received funding from internal and 33% from external investors. Roughly half of the ventures are currently generating revenues, have 1-10 employees, and are 2-3 years old. We find that 84% have identified advisors, and most have submitted multiple documents to support their proposals. Top management teams have industry experience in 73% of ventures, previous TMT experience in 21% of ventures, and advanced or industry-specific education in 20% of ventures. Finally, ventures tend to occur in the same industries in which venture capitalists historically have funded. Table 2 reports an abbreviated correlation table between the dependent variables and the independent variables. Each cell reports the Pearson Correlation Coefficient. We note that in three instances (Current Capital Investment, External Investors, and TMT Industry Experience), the independent variables are significantly associated with both dependent variables and in the predicted directions. We have more mixed results with internal investors, venture stage, advisors, and TMT education. 20

Table 3 reports the results of the OLS regression analysis of the SVS Combined Rating on the Sociopolitical Normative, Cognitive, and Industry sources of legitimacy. We initially estimate each of the three basic groupings in isolation (regressions 1-3), and finally combined all sources into a single regression (regression 4). In all instances, the regressions use the full sample of 176 observations and each regression, as suggested by its F-statistics and Adjusted-R2, is both statistically and economically significant. As hypothesized, we find several important sources of legitimacy for angel investors. Among the sociopolitical sources of legitimacy related to Hypothesis 1, we find that the presence of external investors, a more developed product or one that is already in the market, an older venture, and one with identified advisors are all associated with high SVS ratings, and these results persist or strengthen in the full model (column 4). Similarly, among the sources of cognitive legitimacy related to Hypothesis 2, we find that TMT industry experience and advanced or industry-specific education are positively associated with SVS ratings in both specifications (columns 2 and 4), although the effect is attenuated in the full model. Interestingly, we find little evidence supporting Hypothesis 3 of an industry-effect in legitimacy, contrary to the predictions of Zimmerman and Zeitz (2002). The industry-effect is not significant in either isolation (Model 3) or when combined with the sociopolitical normative or cognitive sources in the OLS regressions. The lack of significance on the proportion of venture capitalist funding within an industry is unexpected. The existence of industry-patterns in VC funding is a well-established finding and similar patterns appear to exist within the angel financing arena as well. However, our results suggest that ventures in the industries that are attractive to VCs are not associated with higher legitimacy for angel investors. 21

We conduct two additional robustness tests to verify this result. First, rather than using the actual proportion of funding, we devise a truncated scale with three possible values (0-5% industry-funding, 6-10% industry-funding, >10% industry-funding). Second, we individually dummy each industry (10 are present in our sample) to determine whether certain industries, perhaps independent of interest by venture capitalists, garner greater legitimacy from angel investors. Zimmerman and Zeitz (2002) suggest the possibility of an S -shaped effect of industries wherein relatively new, as compared to very new or well-established, industries have the greatest legitimacy. Individual industry dummies will help to identify such a pattern. However, we fail to find any significant indication, at traditional levels, of an industry effect for either of these robustness tests. Table 4 reports results from a probit analysis of receiving angel funding in the 6-monthperiod following the SVS Forum on the three broad sources of legitimacy. 5 Overall, we find persistent evidence that the number of employees, TMT industry experience, and TMT education (at the one-tail-level) are positively associated with the likelihood of receiving funds, and some weaker support for higher levels of current investment, younger ventures, ventures with greater documentation, and ventures less favored by VCs as attracting more angel interest. The negative coefficient on VC funding is potentially quite interesting as it may suggest that angel investors see greater investment opportunity in ventures that are outside of traditional VC arenas than those more likely to receive VC investments. However, as indicated in the table, the effect is weak. 5 In the phone survey, it is possible that the entrepreneurs misunderstood the question regarding the timing of the recent angel financing in that some may have re-reported external equity investments. If such is the case, then it is not appropriate to include External Investors in the analysis. We have therefore elected to omit both internal and external investor parameters from these specifications. As a robustness check, we included these two variables and found a positive coefficient on external funding, an insignificant coefficient on internal funding, and other parameter results relatively unchanged. 22

As a whole, these results paint a relatively consistent picture of what characteristics angel investors value. Most importantly, firms with experienced management teams and those that boast managers with advanced or specific education are viewed most favorably, as are those that have previously attracted external investors. There is more sporadic evidence that venture stage, the amount of previous capital, the volume of filed documents, and industry influence legitimacy. Perhaps most interesting are those potential sources of legitimacy that do not appear to influence angel investors including previous internal investment or previous top management team experience among managers. 6. Implications and conclusions This paper provides important new insights into the investment decisions of angel investors. Angel financing is a critical resource for new-stage high-growth ventures and relatively little is known regarding what influences angels to make a capital commitment to a venture. We examine three theoretically motivated sources of legitimacy for new ventures based on venture-specific ratings of an angel-team as well as actual investment decisions made by angels over a 6-month period. Our results suggest several common sources of legitimacy for angel investors. Most importantly, we find consistent evidence that the composition of the top management team is predictive of both angel ratings and investment decisions. These results support the theoretical predictions and anecdotal evidence of Packalen (2007) that affiliative and achieved status, linked to educational achievement and prior industry experience, respectively, are important determinants of legitimacy. Further, these results may also be consistent with the importance of 23

social capital, as evidenced by prior industry experience, in the acquisition of external resources. These insights provide valuable information to entrepreneurs regarding team formation and composition efforts and the resulting influence on the venture s access to capital and resulting growth potential. Perhaps as informative are those venture characteristics that do not appear to influence investment decisions. In particular, previous management experience among the top management team and the previous commitment of internal equity capital do not appear to affect the perception of legitimacy among angels. Further, contrary to the predictions of Zimmerman and Zeitz (2002), we find little evidence that industry conveys a sizeable amount of legitimacy. However, given the endogenous nature of the sample, we cannot conclude that industry does not matter, only that within the subsample of new ventures that seek external equity funding from angel groups, particular industries do not appear to provide added legitimacy. This research is unique in several dimensions. First, the research represents the first attempt at linking the concept of venture legitimacy and angel investor decision making. Second, much of the previous research on angel investment decision making is based either on experiential settings (investors are asked to evaluate case studies of contrived investment opportunities) or post-investment analysis (investors are queried as to why they made a particular decision in the past). In the context of this research the data is collected in a live, real time setting with a panel of experts assessing the legitimacy of the venture with respect to participation in the SVS. Lastly, the post-summit survey data provides a second set of measurements to enhance the understanding of legitimacy in nascent ventures. One potential area for future research is the identification of any carry over effects of legitimacy. Does legitimacy gained at the early stage or imparted by securing capital from angel 24

investors extend to later stage institutional investors or does a related but substantially different set of legitimacy factors come into play? In a similar context is the comparison of the sources of legitimacy for angels and venture capitalists. Are the sources different or are they similar, given the same set of companies? This research would require a matching data set to create dyads of the firm, the angels and the venture capitalist and require tracking the ventures over an extended period of time. An analysis of legitimacy by sectors that typically require several rounds of financing, such as medical devices or biotech ventures, with those of companies that require less financing rounds, such as software or social media, could prove to be a fruitful line of inquiry. For the practitioner, this research provides important new insights. Attention should be paid to identifying and attracting competent management teams with relevant experience and to have the venture vetted, in some manner, by an external source when possible. Retaining and identifying advisors and having some track record of sales are also important. However, relying on the appeal of a particular industry or relying on the prior experience of the management team as signals of legitimacy do not seem to resonate well with investors. 25

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