Recent Research: How Do Tech Startups Indicate Their Value?

Getting venture capitalists to invest their limited dollars in a particular business is difficult. Entrepreneurs must aggressively pursue potential investors and use every means at their disposal to pitch their business as a future revenue generator. A recent academic article attempts to explain the role that patenting and investment by the entrepreneur's family and friends play in this interplay between investor and investee. The authors of Show Me the Right Stuff: Signals for High Tech Startups examine the meaning that both patents and family and friends money hold for investors. They find that patents serve as a proxy for technology quality. Family and friends' funding (FFF), on the other hand, indicates the commitment level of the company founder. A mix of both signals yield the best results for firms seeking venture support.

Authors Conti, Thursby and Rothaermel use ten years of data from the Advanced Technology Development Center (ATDC) at the Georgia Institute of Technology to examine firm investment in these signals to investors. ATDC's data collection practices provide them with access to each firm's angel and venture support, patents filed and funding from family and friends. The authors also examined business plans provided to ATDC at the time of their admission to the incubator and conducted a survey of business founders. A censored regression model, isolating many factors influencing investor decisions, is used to gauge the relative importance of FFF in signalling the worthiness of an investment.

The results confirm that both FFF and patents are meaningful signal to angel and venture investors. Patenting serves as a proxy for technology quality. Investors that value technology quality, tend to prefer firms with a greater number of patents. In situations where investors have pursued firms based on the quality of the technologies they are commercializing, firms seeking investment tend to sink more money into patenting their discoveries. FFF tends to indicate a founder's commitment level and a lower opportunity cost. The two factors together seem to have greater positive signaling power than they do separately.

The authors demonstrate that the two signals differ in importance for angel and for venture investors. Angel investors prefer company founders to have something at stake in their companies. For this reason, angels tend to favor companies with high FFF support, while patents do not play a statistically significant role in their decisionmaking. The opposite is true for venture investors, who may replace the companies' founders as CEOs with outsiders but require high quality technologies to eventually achieve an exit. Venture investors respond to a high number of patents, but FFF appears to be less important.

Purchase "Show Me the Right Stuff: Signals for High Tech Startups" ($5) at: http://www.nber.org/papers/w17050.