Comparing the information acquisition strategies of venture capital and commercial lenders: A computer-based experiment

Abstract

Owners and financial planners in new ventures prefer using internal sources of capital as much as possible because they are uncertain about how to obtain external financing and how the involvement of others will impact their ventures. Because undercapitalization and financial problems are at the center of nearly all business failures, it would appear useful for owners and financial planners to reduce the uncertainty surrounding external financing. Obtaining information about one source of this uncertainty, a lack of understanding of the decision processes followed by venture capitalists, is the focus of research in this paper and a growing body of literature. To further this line of study, we investigate the differences in decision behavior of venture capitalists, using bankers as a benchmark for comparison in cases in which debt and debt-related financing are sought. To the extent that venture capitalists have unique decision processes, owners and financial planners might improve their ability to obtain financing through knowledge of the unique features of venture capitalists' decision processes. In addition, venture capitalists might improve their decision effectiveness if made aware of systemic biases in their decision procedures. Using a computer software package to trace information acquisition processes, we found that venture capitalists acquired less information and followed a pattern of acquisition that was deeper within categories of information than bankers. In addition, venture capitalists showed a stronger preference for strategic data and less interest in historical financial data. Both groups minimized the use of financial forecasts and followed decision processes persistently across different types of companies (start-up and well-established). The implications of this study for practice are two-fold. First, if the owners or financial planners of a new or relatively new venture are seeking financing from external sources, they should package the business plan and request in a manner that is consistent with the source of financing. For example, requests from venture capitalists should highlight strategic information, such as descriptions of the product or process, patentability prospects, product market, and management team. Less emphasis should be placed on financial information, particularly financial projections. In contrast, requests for financing by banks should highlight historical financial information. Such differences between venture and bank financing may lead individuals who are seeking financing to conclude that because historical financial information is of primary importance to bankers, bank financing should be sought after the business has developed a positive financial history and trend. This would confirm intuition and research findings that venture financing is the primary source of external financing in the early stages of a new venture. Second, bankers and venture capitalists, like all decision-makers who have developed a degree of expertise in a particular specialty, should attempt to gain some insight into their decision processes. The goal of obtaining this information would be to provide feedback on processes, such as information acquisition, which tend to become automatic over time. With this knowledge, bankers and venture capitalists could examine any biases in their behavior with the ultimate goal of improving performance. This paper also has important implications for researchers. In particular, we have demonstrated that computer-based approaches for studying decision behavior offer promise for interesting explorations into important issues such as how venture capitalists make decisions. The computer minimizes researcher intrusion in the decision task and permits the collection of process data from samples large enough to permit statistical analyses. In addition, the subjects determine the length of the task and the direction of the search much as they would in practice, which increases the external validity of the research method.