Entrepreneurial Uncertainty and Expert Evaluation: an Empirical Analysis
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This article was downloaded by: [131.215.225.9] On: 20 July 2019, At: 22:58 Publisher: Institute for Operations Research and the Management Sciences (INFORMS) INFORMS is located in Maryland, USA Management Science Publication details, including instructions for authors and subscription information: http://pubsonline.informs.org Entrepreneurial Uncertainty and Expert Evaluation: An Empirical Analysis Erin L. Scott, Pian Shu, Roman M. Lubynsky To cite this article: Erin L. Scott, Pian Shu, Roman M. Lubynsky (2019) Entrepreneurial Uncertainty and Expert Evaluation: An Empirical Analysis. Management Science Published online in Articles in Advance 19 Jul 2019 . https://doi.org/10.1287/mnsc.2018.3244 Full terms and conditions of use: https://pubsonline.informs.org/page/terms-and-conditions This article may be used only for the purposes of research, teaching, and/or private study. 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For more information on INFORMS, its publications, membership, or meetings visit http://www.informs.org MANAGEMENT SCIENCE Articles in Advance, pp. 1–22 http://pubsonline.informs.org/journal/mnsc/ ISSN 0025-1909 (print), ISSN 1526-5501 (online) Entrepreneurial Uncertainty and Expert Evaluation: An Empirical Analysis Erin L. Scott,a Pian Shu,b Roman M. Lubynskyc a Sloan School of Management, Massachusetts Institute of Technology, Cambridge, Massachusetts 02142; b Scheller College of Business, Georgia Institute of Technology, Atlanta, Georgia 30308; c Venture Mentoring Service, Massachusetts Institute of Technology, Cambridge, Massachusetts 02139 Contact: [email protected], http://orcid.org/0000-0003-3189-0918 (ELS); [email protected], http://orcid.org/0000-0002-5826-9702 (PS); [email protected] (RML) Received: October 27, 2016 Abstract. This paper empirically examines the evaluations of 537 ventures in high-growth Revised: March 18, 2018 industries performed by 251 experienced entrepreneurs, investors, and executives. These Accepted: July 18, 2018 experts evaluated ventures by reading succinct summaries of the ventures without meeting Published Online in Articles in Advance: the founding teams, and their evaluations were not disclosed to the entrepreneurs. We find July 19, 2019 that experts can differentiate among early-stage ventures on grounds of quality beyond the https://doi.org/10.1287/mnsc.2018.3244 explicit venture and entrepreneur characteristics contained in the written summaries. They can only do so effectively, however, for ventures in the hardware, energy, life sciences, and Copyright: © 2019 INFORMS medical devices sectors; they cannot do so for ventures in the consumer products, con- sumer web and mobile, and enterprise software sectors. Our results highlight sector- specific heterogeneity in the information needed to effectively screen ventures, a finding that has implications for the design of optimal investment strategies. History: Accepted by Gustavo Manso, finance. Funding: The authors thank the NBER Entrepreneurship Working Group, the National University of Singapore [Start-up Grant R-313-000-106–133], and the Division of Research at Harvard Business School for financial support. Keywords: entrepreneurial uncertainty • early-stage firms • screening • expert evaluation • venture financing 1. Introduction “spray and pray” (Kerr et al. 2014b, Nanda and The uncertainty associated with early-stage ventures Rhodes-Kropf 2015,Ewensetal.2018). Building on poses serious challenges for financial intermediar- the insight that a venture’s idea quality may be ex ante ies (Hall and Lerner 2010). Because new ideas defy unobservable, the theoretical literature emphasizes existing norms and principles, they are inherently dif- the importance of experimentation and tolerance for ficult to evaluate (Arrow 2012). Even successful in- early failure in venture financing (Bergemann and vestors assert that screening early-stage venture ideas Hege 1998,Manso2011). is a noisy process.1 This sentiment accords with the This paper provides new empirical evidence on empirical observation that, among ventures selected the feasibility of idea screening. We examine whether by venture capitalists (VCs) for investment, the vast experienced entrepreneurs, seasoned investors, and majority fail (Hall and Woodward 2010). The selec- start-up experts can effectively evaluate the commercial tion preferences of VCs and angel investors—that is, viability of early-stage ventures in high-growth sectors the criteria by which they invest—are well studied by reviewing succinct summaries of the ventures with- (Quindlen 2000,GompersandLerner2001,Bernstein out meeting the founding teams. In our empirical setting, et al. 2017). In contrast, systematic evidence on the expert evaluation is unlikely to influence start-up out- effectiveness of screening early-stage ventures is scant, comes via resource allocation or the entrepreneurs’ be- primarily because early-stage ventures that elicit posi- havior: all the entrepreneurs have access to the same tive evaluation from investors subsequently receive resources, and the evaluation itself is not disclosed. additional resources (e.g., funding, professionalization) We find that experts can differentiate among early- that positively influence their trajectories.2 External stage ideas on grounds of quality. However, we also evaluationmayalsoaltertheamountofeffortthat find important variation in the effectiveness of eval- entrepreneurs expend on their ventures, resulting in a uation across venture sectors. self-fulfilling prophecy.3 Understanding the feasi- Our empirical setting is the Massachusetts Institute bility of idea screening has implications for optimal of Technology (MIT) Venture Mentoring Service (VMS), investment strategy: when screening is ineffective, in- a free educational service that provides advice and vestors should consider alternative approaches such as mentorship to aspiring MIT-affiliated entrepreneurs 1 Scott, Shu, and Lubynsky: Entrepreneurial Uncertainty and Expert Evaluation 2 Management Science, Articles in Advance, pp. 1–22, © 2019 INFORMS (alumni, researchers, and students). As a research time, forgoing conventional employment and attractive university with a rich history in entrepreneurship salaries. By 2017, the ventures in our sample had jointly (Roberts et al. 2015), MIT provides an appropriate raised nearly $2 billion in venture financing; nearly 28% context to source early-stage, high-growth venture had achieved commercialization (defined as having ideas. We examine the evaluation of these nascent recurring revenue and expenses associated with the sale ventures by a pool of mentors affiliated with VMS. of products and/or services in keeping with the com- We collected detailed data on 251 mentors active at pany’s business objective). VMS between 2005 and 2012. Nearly 70% have start- Our empirical analysis uses panel data at the up founding experience; almost half have start-up mentor–venture level to examine how mentors ex- investing experience (although, importantly, not while press interest. We first show that mentors are selective serving as mentors).4 Fully 80% of the sample has ei- in their expressions of interest and do not express ther founding or investing experience. The remaining interest at random. The average mentor expressed 20% have worked closely with start-ups by providing interest in only 4.4% of the summaries that the mentor functional services (e.g., legal or accounting assistance). reviewed. Mentors are systematically more likely to The median mentor holds a master’s or professional express interest in ventures in the industry sector in degree and has more than 20 years of professional which their own experience is concentrated. They are experience at the beginning of our sample period. also more likely to express interest in ventures whose Each month, these mentors receive a digest con- summaries indicate evidence of equity funding, plans sisting of concise summaries of ventures recently for intellectual-property (IP) protection, or origins in enrolled at VMS; the summaries are typically drafted academic research. None of the reported character- by the same VMS staff member and adhere to a stan- istics of the founding team had a significant influence dardized structure. On the strength of these sum- on mentor interest. maries alone without meeting the entrepreneurs, We use a venture’ssubsequentachievementof mentors decide whether to express interest in men- commercialization as a proxy for unobserved ven- toring particular ventures.Althoughanexpression ture quality. Controlling for the observed venture- of interest does not necessarily lead to a mentoring summary characteristics and including mentor fixed relationship, it indicates a mentor’s willingness to effects, we find a positive and statistically