Bullish or Foolish? Collective Expectations and Diversification in the Venture Capital Industry

Abstract

We examine how collective expectations affect firm diversification behavior in the U.S. venture capital (VC) industry. Departing from prior accounts that focus on potential benefits and costs of diversification, we theorize how elevated collective expectations–signaled by trends in the broader environment, such as initial public offering (IPO) activities–encourage firms to venture into new industries, resulting in higher levels of diversification. However, not all firms are equally likely to diversify during a boom. We predict why some firms are more susceptible than others based on two theoretical approaches to social influence. The rational-actor account suggests that a firm’s tendency to diversify during the boom will be contained by its experience; whereas the embedded-actor account suggests that this tendency is moderated by a firm’s immediate network and the local community. We further posit that a firm’s diversification behavior during the boom will lead to a subsequent worse performance. We test these predictions with all U.S.-based VC investments from 1990 to 2016. Results support our arguments that firms tend to diversify during a boom and that doing so has negative performance implications. Moreover, our findings lend stronger support for the embedded-actor account compared to the rational-actor account.