Does Social Similarity Pay Off? Homophily and Venture Capitalists’ Deal Valuation, Downside Risk Protection, and Financial Returns in India

Abstract

We ask how social similarity between start-up founders and venture capitalists (VCs) influences VCs’ pricing decisions and returns on investments. We conceptualize how regional and caste similarity, two salient aspects of social similarity in India, affect two distinct aspects of deal pricing: premoney valuation and investors’ downside risk protection in the Indian venture capital market. We theorize that VCs reflect the benefits and costs of social similarity by setting higher premoney valuation when investing in companies led by socially similar founders while also minimizing their downside risks in these investments. We expect that social similarity’s impact on pricing is amplified when VCs face greater subjective uncertainty, such as for early-stage deals or if the VCs lack expertise in the start-up company’s product market. Finally, we claim that VCs achieve superior returns on investments when their deal pricing accurately reflects the impact of social similarity. We tested our conceptual model using both parametric and nonparametric methods on a hand-collected data set of all deals that occurred during 2005–2012, and we supplemented our analyses with in-depth, qualitative interviews that contextualize our findings. The pattern of findings on regional similarity are consistent with our model, but the effects of caste in our data are theoretically anomalous. Post hoc analyses to resolve the anomaly suggest an “intrinsic quality” mechanism, whereby higher-caste VCs set higher valuations when matching with lower-caste founders that signal high quality. Overall, our findings offer evidence that VCs incorporate social attributes into deal pricing in nuanced yet boundedly rational ways.