Startups Look Beyond Money When Selecting VC-Backing

As competition increases within the venture capital industry to fund the next Google or Uber, the most highly desirable startups often have multiple investment offers and must decide upon the best. There are several factors that can affect evaluation of potential equity investors. For many startups, the decision may focus solely on the terms of the deal. However, there may be many more factors – outside of financial considerations – that impact the startup’s evaluation process.

To date, most of the discussion in the academic literature and research conducted has focused on the decision-making process for the investors. However, over the last few years, researchers have started to refocus their research on the entrepreneur’s perspective to better understand what makes a deal more desirable for startups looking for financing. They want to know what drives the decision-making process and what factors make an equity investor more desirable to the startups with the most growth potential.

Beyond the terms and financial incentives of the deal, researchers from several universities have found that entrepreneurs with multiple offers were more likely to spurn an offer from an investor who has a poor reputation for ethical behavior. In most circumstances, the researchers found that poor ethical behavior was the number one factor in the evaluation process.

The leading researchers in this field contend that entrepreneurs view investors with poor ethical records as opportunistic or that the investors will put their own interest in front of the needs of the company. Yassin, Wood and Drover found that this selection was driven by the dynamics of the relationship. In deals with which the venture capitalist would be highly involved (e.g., service provider, board membership), the entrepreneur was much less likely to accept the deal known to have past unethical behavior. In a more recent article from the trio of researchers, they found another factor that drives entrepreneurs to select ethical investors –fear of failure. Risk adverse entrepreneurs view investors not just as a source of capital but a partner during the process.

They also identify other highly important factors that influence the decision-making process that include, but are not limited to, the availability of value-added services and investment track record. These factors, however, in many cases may not be enough to overcome previous unethical behavior including bankruptcy.  In another study from Drover and Fassin, the authors found effects indicate that factors previously shown to drive entrepreneurial evaluations (e.g., value-added capabilities and investment track record) become largely contingent upon and in many cases subjugated by an investor’s ethical reputation.

For government-backed venture capital funds, venture development organizations, and other publicly supported capital providers, this new research highlights an opportunity for them as early stage investors of high potential firms. Although several tech-based economic development organizations have come under criticism from state lawmakers over ethical concerns in the last few years, these public and nonprofit organizations have strategic advantage in the evaluation process because they can be the low-risk ethical investors who can highlight their mission and put the startup’s interest at the forefront of the deal as well as be providers of a suite of value-added services to help the startups prosper.