Are Ven­ture Cap­i­tal­ists Hope­lessly Bi­ased?

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CLOSE SCRU­TINY OF VC DEAL terms in In­dia re­veals a nu­anced pat­tern of ob­jec­tiv­ity and dis­crim­i­na­tion.

No matter how ra­tio­nal we may claim or want to be, no hu­man be­ing is en­tirely free of bias. The chal­lenge is to be aware of one’s own bias – or, fail­ing that, to de­sign pro­cesses that mit­i­gate bias – so that ob­jec­tive...

Bala Vissa

CLOSE SCRUTI NY OF VC DEAL terms in In­dia re­veals a nu­anced pat­tern of ob­jec­tiv­ity and dis­crim­i­na­tion.

No matter how ra­tio­nal we may claim or want to be, no hu­man be­ing is en­tirely free of bias. The chal­lenge is to be aware of one’s own bias – or, fail­ing that, to de­sign pro­cesses that mit­i­gate bias – so that ob­jec­tive con­sid­er­a­tions can pre­vail. This chal­lenge be­comes es­pe­cially per­ti­nent in a field such as ven­ture cap­i­tal, where in­trin­sic un­cer­tainty ren­ders de­ci­sion mak­ers par­tic­u­larly prone to ir­ra­tional in­flu­ences.

Some re­cent re­search sug­gests that bias is rife in the world of ven­ture cap­i­tal­ists. Stud­ies us­ing U.S. data have found, for ex­am­ple, that VCs show a marked pref­er­ence for founders who share their eth­nic­ity, re­gard­less of fi­nan­cial per­for­mance. The same ten­dency to­wards ho­mophily (favour­ing so­cially sim­i­lar oth­ers) may also help ex­plain the male-dom­i­nated sec­tor’s stub­born, size­able gen­der gap.

It would be pre­ma­ture, how­ever, to count out ra­tio­nal­ity just yet. In a re­cent pa­per forth­com­ing in Or­ga­ni­za­tion Sci­ence, we delved into how so­cial sim­i­lar­ity in­flu­ences pric­ing in VC deals. Our find­ings sug­gest that VCs are rea­son­ably adept at struc­tur­ing deals that re­flect both the ben­e­fits and the costs of so­cial sim­i­lar­ity. In­trigu­ingly, this some­times in­volves VCs pro­vid­ing more favourable terms to founders who are so­cially dis­sim­i­lar to them­selves.

In­dia’s VC mar­ket

Our study di­verges in sev­eral key ways from past re­search on how so­cial sim­i­lar­ity reg­u­lates VCs’ deal mak­ing. First, in­stead of us­ing data from the United States, we looked at 622 deals within In­dia’s rapidly ma­tur­ing VC in­dus­try. Sec­ond, in ad­di­tion to study­ing how VCs se­lect com­pa­nies to fund, the fo­cus of much prior re­search, we ex­am­ined how VCs price the cap­i­tal they pro­vide – specif­i­cally, val­u­a­tion and down­side risk pro­tec­tion. The lat­ter refers to con­trac­tual terms such as liq­ui­da­tion pref­er­ences, cu­mu­la­tive div­i­dend rights, re­demp­tion rights and anti-di­lu­tion rights, which reg­u­late VCs’ fu­ture cash flows from the deal. Third, we fac­tored in sim­i­lar­ity be­tween VCs and founders on two un­der-stud­ied so­cial at­tributes: the In­dian re­gion and caste that VCs and founders be­long to.

Although it is largely viewed to­day as an un­wanted ves­tige of an im­per­fect past, caste strat­i­fi­ca­tion is a lin­ger­ing in­flu­ence in In­dian so­ci­ety, es­pe­cially in ru­ral ar­eas where re­cent so­cial and tech­no­log­i­cal de­vel­op­ments are not as force­fully ev­i­dent. Con­versely, while re­gional dif­fer­ences in In­dia can in­clude wide lin­guis­tic and cul­tural gaps, they do not carry caste’s au­to­matic as­so­ci­a­tions with so­cial hi­er­ar­chy.

As with past stud­ies, we also mea­sured the VCs’ fi­nan­cial re­turns from each deal. Im­por­tantly, how­ever, we used in­ter­nal rate of re­turn (IRR) as our met­ric, rather than in­di­ca­tors such as whether there was a suc­cess­ful

IPO launch. We rea­soned that IRR was a bet­ter barom­e­ter of value cre­ation driven, in part, by the col­lab­o­ra­tion be­tween founders and in­vestors.

So­cial sim­i­lar­ity and dis­sim­i­lar­ity

Our analy­ses yielded a nu­anced pic­ture on how so­cial sim­i­lar­ity mat­ters. When it came to re­gional sim­i­lar­ity, we found that VCs con­fer higher pre-money val­u­a­tions to com­pa­nies led by re­gion­ally sim­i­lar founders. This pat­tern is con­sis­tent with a logic whereby VCs ra­tio­nally an­tic­i­pate the ben­e­fits of so­cial sim­i­lar­ity – it is eas­ier to build a col­lab­o­ra­tive, trust­ing re­la­tion­ship with sim­i­lar oth­ers – and price it in at the deal-mak­ing stage. Yet, strik­ingly, VCs also en­gaged in greater down­side risk pro­tec­tion on these very same deals!

In essence, VCs seem to recog­nise the dan­gers of so­cial sim­i­lar­ity (such as po­ten­tial free rid­ing or lack of op­ti­mal ef­fort by re­gion­ally sim­i­lar founders) and at­tempt to pro­tect them­selves through more strin­gent down­side pro­tec­tion terms. This pat­tern is con­sis­tent with ra­tio­nal be­hav­iour by VCs rather than ev­i­dence of bias. More­over, we found that the strat­egy seems to be work­ing, as greater re­gional sim­i­lar­ity was in­deed cor­re­lated with higher fi­nan­cial re­turns for the VCs.

Switch­ing fo­cus to caste strat­i­fi­ca­tion, we found no sta­tis­ti­cally sig­nif­i­cant, over­ar­ch­ing im­pact on deal flow. How­ever, matches be­tween higher-caste VCs and low­er­caste founders were gen­er­ally as­so­ci­ated with higher val­u­a­tions as well as bet­ter fi­nan­cial per­for­mance for the VC. This in­ter­ac­tion was es­pe­cially prom­i­nent when the lower-caste founders had elite ed­u­ca­tional cre­den­tials, such as grad­u­at­ing from the pres­ti­gious IITs and IIMs. Again, this is con­sis­tent with ra­tio­nal be­hav­iour by VCs rather than non-ra­tio­nal mo­ti­va­tions, as would be the case if high-caste VCs were in­dis­crim­i­nately fund­ing low­caste en­trepreneur­s out of al­tru­is­tic no­tions of no­blesse oblige.

Rank-or­dered so­cial at­tributes

Our con­clu­sions point to a broader logic that may gov­ern the ra­tio­nal uses of ho­mophily in the VC space. As stated above, the pri­mary dif­fer­ence be­tween re­gional sim­i­lar­ity and caste sim­i­lar­ity is that the lat­ter is rank-or­dered, i.e. as­so­ci­ated with so­cial hi­er­ar­chy. Our find­ings sug­gest that VCs are quite ra­tio­nal in an­tic­i­pat­ing and pric­ing-in the ben­e­fits as well as the pit­falls of so­cial sim­i­lar­ity when the so­cial at­tribute in ques­tion is not rank-or­dered – such as re­gional sim­i­lar­ity in In­dia. We would ex­pect sim­i­lar re­sults in par­al­lel con­texts, e.g. how sim­i­lar­ity or dif­fer­ence in na­tion­al­ity af­fects the VC mar­ket in Western Europe.

In con­trast, the more a so­cial at­tribute is in­fused with hi­er­ar­chi­cal con­sid­er­a­tions, the more nu­anced its ef­fects on pric­ing in VC mar­kets, with dis­sim­i­lar­i­ty­based mech­a­nisms driv­ing be­hav­iour. While the caste system is unique to In­dia, rank-or­dered at­tributes can be found in ev­ery cul­ture. For ex­am­ple, caste could be likened to im­mi­gra­tion or na­tiv­ity sta­tus in the de­vel­oped

Western economies. While VC as a global in­dus­try has a long way to go as re­gards di­ver­sity, the good news is that in­vestors seem per­haps less bi­ased than some prior re­search sug­gests. It may also help to high­light that the bit of ex­tra ef­fort re­quired to find out­stand­ing tal­ent among marginalis­ed groups can pay off just as much as close re­la­tion­ships care­fully cul­ti­vated with so­cially sim­i­lar founders.

Bala Vissa is a Pro­fes­sor of En­trepreneur­ship at INSEAD.

Kim Claes is As­sis­tant Pro­fes­sor of Man­age­ment at SKK Grad­u­ate School of Busi­ness.

“This ar­ti­cle is re­pub­lished cour­tesy of INSEAD Knowl­edge(http://knowl­ Copy­right INSEAD 2019

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