Young entrepreneurs should choose well known, well-connected initial investors or they risk losing out in the long run, according to new research from the University of Maryland.
If your first investors are only weakly connected to other companies, your chances of finding a big supporter in the future are slim. The research also shows that if you don’t have an exceptionally strong network of potential investors, it’s better to build your business up on the cheap before seeking financial help.
For his research, Benjamin Hallen, Assistant Professor of Management and Organization at the Smith School of Business, analysed the investment records of 92 internet security companies. The results showed that businesses whose first investors were well-connected to related companies and had a good reputation were much more likely to be successful and attract future investment than firms that took the first investors who came along.
Hallen calls this the “path-dependent” effect: “People whose social resume is not extraordinary… should wait before contacting potential investors, and then go for the big supporters straight away, instead of committing themselves to small ones out of financial despair”, he says.
“Business students are usually told that in order to get a good investor they need to know the right people”, says the author of the paper. “But I remember myself being a young entrepreneur who happened not to dine with Silicon Valley every night.”
Hallen, who co-founded a digital publishing company in 2000, didn’t know the right people. Or at least, he didn’t know them well enough: “I found it hard to get any advice from business textbooks on how to approach potential investors in this situation”, he says.
His research shows that in order to attract a good investor, entrepreneurs’ network ties have to be exceptionally strong: a social track record that must be built up over years of working with the right people. “Business schools rightly teach you to network as much as you can. But the kinds of connections people make at cocktail parties, although useful to get information about the market or a particular industry, will not be of any use when it comes to attracting actual money”, he argues.
In this situation, one most young entrepreneur find themselves in, it’s your accomplishments that count. Hallen cites Google and Facebook as businesses that had a track record before they approached potential investors. According to Hallen’s research, it was partly this strategy which made them so successful.
If you’re patient enough to get your business off the ground first, you’re likely to attract bigger investments over time. And while doing that, make sure to do your homework on the best investors for your business: “Research is crucial,” he says. “Check the track record of your potential investor”. Which other businesses have they sponsored? How successful were they in the long run? Are there any other big investors they have cooperated with? If yes, you’re likely to be able to use this relationship for your own company. “Your business will rely on your investor's network,” says Hallen, “And if you start small you will end up being locked into that network right from the beginning.”
Obviously, says Hallen, there are exceptions: “If your business requires a lot of initial capital, say you are developing a new drug, you won't get away without having a sponsor in the early stages”. But if your business has high potential and a manageable start-up cost, it is best to start things independently at first. “In the end, if you start small your status is very likely to remain low on the long run.”