A study of decision making, capabilities and performance in the venture capital industry

Understanding sequential resource allocation decisions within organizations is central to strategic management and organization theory. However, little is known about the management of sequential investments, and the performance implications thereof. This study aims to contribute to the understanding of resource allocation processes by examining sequential investments in the venture capital industry. I first examine whether the aggregate patterns of sequential investments in the venture capital industry conform to the normative model of decision making. The main argument is that if venture capitalists terminate investments at the right time, then the probability distribution of their sequential investment decisions over time should mirror the probability distribution of portfolio companies\u27 success over time. The longitudinal data set comprises venture capital investments spanning 1989–2001, and their performance. The results suggest that venture capital investment decisions depart systematically from the expectations of normative theory. Second, I report the results of a qualitative study that examines the behavioral micro-foundations of the observed pattern. This study involves interviews with venture capital professionals and portfolio company managers about the sequential investment decision making process. Findings suggest that individual decision biases only partially account for the observed results. I find that the structure of venture capital investments create perverse incentives for investors to continue investing in unsuccessful portfolio companies. In particular, co-investor pressure, interpersonal dynamics among general partners, and limited fond duration may create pressures to overinvest. Third, I investigate the differences among venture capital firms in their decision making practices and their performance implications. I examine the number of rounds invested in companies by each venture capitalist through a longitudinal data set of investments between 1979–2001. I find that there are no differences among venture capitalists in their ability to manage successful investments. In contrast, I find that venture capitalists differ significantly in their ability to terminate failing investments. In particular, firms with more investment experience and less organizational slack seem to be better at terminating unsuccessful investments. I also find that the ability to terminate unsuccessful investments at the right time is a significant predictor of long-run film performance