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From genome research to e-commerce, new ventures are popping up everywhere, competing for the cash needed to turn them into successful enterprises. When trying to secure backing for a high-risk start-up, whom you know can be just as important as what you know.
"Our work suggests that the functional backgrounds or experience levels of the top management team -- the CEO, CFO, and chief scientific officer, in particular -- aren't really the deciding factors for investment bankers," explains HBS associate professor Monica C. Higgins, coauthor of a new working paper titled "The Effects of IPO Team Ties on Investment Bank Affiliation and IPO Success." In research conducted with Ranjay Gulati of Northwestern's Kellogg School, Higgins found that "what matters most when executives are trying to raise money is their professional ties and company connections, their access to information and resources -- what we call social capital."
Organizational behaviorists have known for years that third-party endorsements are critical to a young firm's success. Higgins and Gulati wanted to understand the origins and nature of these important relationships. They pinpointed the biotechnology industry as an especially promising area for studying the effects of top executives' social capital on their ability to secure resources. "In biotech, it can take eight to ten years to developa product and cost hundreds of millions of dollars to bring it to market," says Higgins. "Therefore, funding is particularly crucial; yet it is also difficult for external parties to assess the quality of a young firm."
Higgins had noticed that in many pre-IPO discussions, venture capitalists would invariably ask company executives what firms they had worked for previously. "Prior service at a reputable company seemed to indicate competence at the young firm, thereby validating it and its potential for firm-level success," she says. Higgins and Gulati began their research by documenting the career histories of top managers from Boston-area biotech companies. They gathered additional data by examining the prospectuses of all public biotech firms going back twenty years. Information from 295 companies and more than 3,000 executives formed the core of their study.
The results showed that top managers' ties to notable pharmaceutical companies -- what the authors call "downstream" social capital -- had a direct impact on the size of the start-up's IPO. "Downstream social capital was essential in attracting the interest of a top investment bank and getting a high valuation for the IPO," Higgins says. Such downstream connections can be valuable sources of information about the FDA approval process and can offer insights about marketing and selling a young firm's products. They can also provide resources and contacts to facilitate these tasks. Another significant factor identified in the study was "intra-industry" social capital -- that is, top management's connections to major biotech firms. In contrast, "upstream" social capital -- team members' ties to important research institutions -- had no impact at all on the new organization's success. "In this industry," Higgins theorizes, "upstream connections may indicate that the enterprise is only in the early stages of product development." Each kind of social capital, she contends, helps mitigate three categories of investor uncertainty: technological, firm-based, and market-based.
Higgins maintains that an IPO team's connections are a crucial component of any start-up's portfolio. "There's no question that the new company must show promise that it has a good product and that it can bring favorable returns to investors," she says. "But that's just part of the package. It must also assemble a management team that brings a combination of influential and complementary affiliations to the table." Social capital, it turns out, is truly worth its weight in gold.
Adapted from the Fall 1999 edition of Working Knowledge, a publication of the HBS Division of Research.
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