Content uploaded by Daniel M. Cable
Author content
All content in this area was uploaded by Daniel M. Cable on Jun 05, 2014
Content may be subject to copyright.
Network Ties, Reputation, and the
Financing of New Ventures
Scott Shane • Daniel Cable
3355 Van Munching Hall, R.H. Smith School of Business,
University of Maryland, College Park, Maryland 20742
Kenan-Flagler Business School, University of North Carolina,
Chapel Hill, North Carolina 27599-3490
sshane@rhsmith.umd.edu • dan_cable@unc.edu
Explaining how entrepreneurs overcome information asymmetry between themselves
and potential investors to obtain financing is an important issue for entrepreneurship
research. Our premise is that economic explanations for venture finance, which do not con-
sider how social ties influence this process, are undersocialized and incomplete. However,
we also argue that organization theoretic arguments, which draw on the concept of social
obligation, are oversocialized. Drawing on the organizational theory literature, and in-depth
fieldwork with 50 high-technology ventures, we examine the effects of direct and indirect ties
between entrepreneurs and 202 seed-stage investors on venture finance decisions. We show
that these ties influence the selection of ventures to fund through a process of information
transfer.
(Entrepreneurship; Venture Finance; Social Capital)
Entrepreneurs are often wealth constrained, and need
to obtain external financing to pursue their oppor-
tunities, making financing central to the process of
entrepreneurship (Evans and Leighton 1989, Casson
1982). However, the financing of opportunities is
fraught with difficulties because entrepreneurs pos-
sess information about themselves and their opportu-
nities that potential financiers do not possess (Amit
et al. 1990, Barry 1994, Chan et al. 1990, Gompers
1995). Thus, financiers face high risks when select-
ing among entrepreneurs because entrepreneurs may
act opportunistically towards them, and because
entrepreneurs vary in their ability to identify and
exploit opportunities.
Given this information asymmetry, how do seed-
stage investors select which ventures to fund? Eco-
nomic explanations generally hold that three mechan-
isms—the allocation of contractual rights, the stag-
ing of capital, and risk shifting—lead entrepreneurs
to self-select and disclose information in ways that
overcome this information asymmetry (Gompers and
Lerner 2000). In contrast, organizational theorists have
generally proposed that seed-stage investors rely on
social relationships to select which ventures to fund
(e.g., Venkataraman 1997). In particular, organization
scholars have argued that two different mechanisms—
information transfer through social ties and social
obligation—influence investors’ decisions.
In this paper, we first review the venture finance
literature to justify our premise that economic
explanations for seed-stage financing decisions are
undersocialized. Second, we integrate in-depth field-
work with 50 high-technology ventures with the orga-
nizational literature to develop a socially embed-
ded explanation about how direct and indirect ties
between entrepreneurs and investors influence seed-
stage venture finance decisions. Finally, because qual-
itative research can overstate theoretical processes, we
complement our field interviews with a quantitative
study of 202 seed-stage investors.
Management Science © 2002 INFORMS
Vol. 48, No. 3, March 2002 pp. 364–381
0025-1909/02/4803/0364$5.00
1526-5501 electronic ISSN
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
Theory Development
Entrepreneurship is the process by which “opportuni-
ties to bring into existence ‘future’ goods and services
are discovered, created, and exploited” (Venkatara-
man 1997, p. 120). Because people possess different
information and beliefs, some individuals recognize
opportunities that others cannot yet see (Shane 2000).
Thus, idiosyncrasies of information and beliefs are
necessary for opportunities to exist (Kirzner 1973). If
aresource owner held the same beliefs and infor-
mation as an entrepreneur, she would try to cap-
ture the entrepreneurial profit by adjusting the price
of resources to the point where the entrepreneurial
profit would be eliminated (Shane and Venkataraman
2000). Likewise, if other entrepreneurs possessed the
same beliefs and information, competition between
entrepreneurs would eliminate the entrepreneurial
opportunity (Schumpeter 1934).
The Information Asymmetry Problem
The same idiosyncratic beliefs and information that
allow entrepreneurs to discover opportunities for
profit also create information asymmetry between
entrepreneurs and potential investors that make it dif-
ficult for the entrepreneurs to obtain external financ-
ing. Take, for example, a biotechnology start-up
founded by a university scientist and a Merck sales
representative to create a drug to cure hypertension.
The scientist’s research has led her to see an opportu-
nity to produce a drug that will reduce hypertension.
Because the scientist has worked on the development
of the drug, she is more knowledgeable than potential
investors about it. For example, her experiments have
shown her that the drug becomes less efficacious as it
is produced in larger volume. Moreover, she has tacit
knowledge about the drug’s production because her
experiments have shown that the drug’s performance
varies more when mixed in tall, thin beakers. Simi-
larly, over years of working at Merck, the scientist’s
partner has accumulated knowledge that introducing
a hypertension drug is a high priority at Merck.
The information possessed by the two entrepreneurs
creates two problems when they seek financing. First,
the entrepreneurs are reluctant to fully disclose this
information to potential investors because such dis-
closure will make it easier for other people to pursue
the opportunity. At the very least, the information
would allow others to bid for the same financial
resources, and for resource owners to raise their
prices, reducing the potential for entrepreneurial
profit. Therefore, the entrepreneurs are reluctant to
tell potential investors all that they know about the
opportunity, and investors must decide whether or
not to fund the opportunity with less information
than the entrepreneur possesses.
Second, because the entrepreneurs have informa-
tion that the investors lack, they can engage in oppor-
tunistic behavior. All entrepreneurs seeking funding
have psychological and financial incentives to con-
vince investors that their opportunities are impor-
tant and that they are entrepreneurial visionaries.
Not only is successful entrepreneurship socially desir-
able, but entrepreneurs who misrepresent their abili-
ties can gain personally by consuming investors’ cash
(Cable and Shane 1997) or by exploiting the reputa-
tions of successful investors to gain wealth or social
standing (Sahlman 1990). Finally, opportunistically
inflating the potential of the opportunity and one’s
own entrepreneurial talent will ostensibly increase the
probability of funding relative to other entrepreneurs.
Thus, the entrepreneurs in our example have incen-
tives to withhold the information that the drug that
they have developed is difficult to produce in large
volume without decreased efficacy. Similarly, they
will likely overstate their knowledge of Merck’s strat-
egy and the probability of a Merck partnership.
Theoretically, the information asymmetry described
above could make investors unwilling to invest in the
specialized assets necessary to develop the new ven-
ture unless the entrepreneur makes large, irreversible,
credible commitments to the venture (Venkatara-
man 1997). Unfortunately, these commitments cre-
ate a market for lemons (Akerlof 1970) by raising
entrepreneurs’ sunk costs and driving high-quality
entrepreneurs from the market. Thus, only undesir-
able deals will be available to investors, causing mar-
ket failure when investors abandon the market (Amit
et al. 1990).
Solutions to Information Asymmetry Problems
Despite the existence of information asymmetries in
venture finance, we do not observe failure in this mar-
ket. Many individuals successfully obtain resources
Management Science/Vol. 48, No. 3, March 2002 365
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
from seed-stage investors to start new businesses.
How do entrepreneurs obtain funding to exploit
opportunities when the information asymmetry that
gives rise to the identification of opportunity itself
makes financing problematic?
Economists argue that the allocation of contrac-
tual rights, the staging of capital, and risk shift-
ing lead entrepreneurs to self-select in ways that
overcome the problems engendered by information
asymmetry (Gompers and Lerner 2000, Kaplan and
Stromberg 1999). For example, Gompers (1997) has
noted that venture capitalists use convertible secu-
rities and covenants to delay the entrepreneur’s
compensation until the outcome of the venture is
revealed. Sahlman (1990) explains that venture capital
contracts are typically staged, providing the capital-
ist with the right to abandon if negative information
about the entrepreneur or venture is revealed. Hoff-
man and Blakely (1987) argue that entrepreneurs face
forfeiture provisions that require them to lose shares
if they have below-target performance, and punitive
dilution rates, which protect the investor’s investment
if the venture underperforms. From an economic
perspective, contract provisions select appropriate
entrepreneurs by shifting the risk of inappropriate
selection to the entrepreneur. As Sahlman (1990, p.
510) noted, “it would be foolish for the entrepreneur
to accept these terms if they were not truly confident
of their own abilities and deeply committed to the
venture.”
The premise of our paper is that these economic
explanations for how investors overcome informa-
tion asymmetry are incomplete for at least two rea-
sons. First, the overoptimism of entrepreneurs has
been well documented (Cooper et al. 1988), and over-
optimism undermines the effectiveness of the con-
tractual mechanisms described by economists. While
it might be foolish for untalented entrepreneurs
to accept financing from investors who shift risk
to them, entrepreneurial overconfidence makes self-
selection an ineffective mechanism in this setting.
Second, early-stage equity investors cannot shift
all of the risk of investing in a new venture to
entrepreneurs. Unlike the providers of debt, who can
demand collateral to cover the risk of total failure,
equity investors provide capital beyond the level that
can be guaranteed by a venture’s assets. As a result,
seed-stage equity investors must make investments
that risk the total loss of their capital. Thus, seed-
stage investors cannot shift risk to entrepreneurs com-
pletely, and must bear some of it themselves.
The Social Embeddedness Solution
Contrary to the asocial economic perspective, organi-
zational theorists have suggested that investors use
social ties to overcome the problem of information
asymmetry in venture finance decisions (Venkatara-
man 1997). Drawing on the concept of embedded-
ness (Granovetter 1985), organizational scholars argue
that social obligations between connected parties,
and information transfer through social relationships,
influence venture finance decisions. However, prior
research1on the social embeddedness of new venture
finance does not address two fundamental questions
that we examine here: First, do social relationships
operate through information transfer mechanisms,
social obligation, or both? Second, do social relation-
ships influence the probability that entrepreneurs will
receive seed-stage equity investments?
Organization theoretic explanations for venture
finance decisions often draw upon mechanisms of
social obligation as well as information transfer to
explain how social relationships influence venture
finance decisions. For example, Uzzi and Gillespie
(1999, p. 33) argue that social ties “interject expec-
tations of trust and reciprocity into the economic
exchange that, in turn, activate a cooperative logic
of exchange. This logic promotes the transfer of
private information and resources and moti-
vates [both parties] to search for integrative rather
than zero-sum outcomes. In this way, embedded
ties both created new collaborative opportunities and
induced the mutual rather than selfish distribution of
rewards.” However, if social ties influence the venture
1Some studies do not look at investors’ decisions to make seed-
stage equity investments in new firms. Larson (1992), for example,
explains that social ties enhance resource acquisition from strate-
gic alliance partners. However, because the mechanisms by which
investors make equity investment decisions are different from the
mechanisms by which managers make strategic alliance decisions,
studies of alliance assistance do not provide direct insight into the
question that we explore.
366 Management Science/Vol. 48, No. 3, March 2002
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
finance decision solely through information transfer
mechanisms, this type of social obligation explanation
is unparsimonious and oversocialized.
Moreover, most studies that explore the role of
social ties in venture finance do not examine the
central issue of investment selection. For example,
Kelly (2000) and Landstrom et al. (1998) examine the
negotiation of a financing agreement once the ven-
ture has been chosen, and Sapienza (1992), Sapienza
and Korsgaard (1996), and Steiner and Greenwood
(1995) all explore the post-investment relationship
between investors and entrepreneurs. However, these
studies cannot shed light on how social ties affect
investors’ initial decisions to invest. For example,
social relationships might influence entrepreneur-
investor relations over time without influencing the
initial decision to finance the venture. Thus, prior
research has not ascertained whether social relation-
ships provide an efficient mechanism for informa-
tion transfer to overcome information asymmetries
between entrepreneurs and investors.
Finally, prior studies do not explore the role of
social relationships in overcoming information asym-
metry problems in seed-stage venture finance. For
example, Stuart et al. (1999) find that young firms
with social ties to high-status strategic alliance part-
ners perform better than other new firms because
their social ties provide them with attributions of
quality when their actual quality is uncertain. How-
ever, Stuart et al. (1999) examine different issues from
those explored in the present paper because they
(a) focus on firm performance rather than on ven-
ture finance, (b) examine status transfer mechanisms
rather than information transfer mechanisms, and (c)
explore uncertainty rather than information asymme-
try problems.
In the next section, we combine the organization
theory literature with in-depth field work on high-
technology ventures to develop hypotheses about the
effects of social ties on seed-stage investors’ ven-
ture finance decisions. To this end, we conducted
field interviews with individuals involved with 50
companies that were started to exploit Massachusetts
Institute of Technology (MIT) inventions. We used
aretrospective design to obtain information on the
seed-stage financing of a random sample of 50 new
high-technology companies that were established
during the period 1980–1996. To create the sample,
every third company was selected from a list of 150
MIT companies that the Technology Licensing Office
records indicated were started to exploit inventions
in which the Institute was the assignee to the patent.
For each interview, we tape recorded the conversation
and then worked from tape transcriptions. In total, we
conducted 100 hours of interviews with 106 individu-
als. In all cases, the minimum informant set included
the lead investor and the firm founder.
Social Ties
We define a direct tie as a personal relationship
between a decision maker and the party about whom
the decision is being made (Larson 1992). We define
an indirect tie as a relationship between two individu-
als who are not directly connected but through whom
a connection can be made through a social network
of each party’s direct ties (Burt 1987). Direct and indi-
rect social ties between entrepreneurs and investors
can vary both across entrepreneur-investor dyads (i.e.,
cross-sectionally) and within a given entrepreneur-
investor dyad over time (i.e., longitudinally). In this
study, we focus on cross-sectional variation in ties. At
the point in time when an entrepreneur seeks financ-
ing from a seed-stage investor, that entrepreneur-
investor dyad has some level of direct and indirect
social ties as a result of prior activity. For example,
the two parties could have a strong direct tie because
they were roommates in college, or they could be
strangers and have no direct tie at the time financing
is sought. We seek to examine empirically the effect of
variation in the direct and indirect ties across investor-
entrepreneur dyads, at the time the entrepreneur
seeks seed-stage financing, on the investor’s decision
whether or not to finance a new venture.2
Direct Ties. Under conditions of uncertainty and
information asymmetry, direct ties can provide an
advantage to people who seek to obtain resources
from others (Podolny 1994). The explanation for this
behavior depends largely on two factors: social obli-
gation and access to private information.
2This study does not explore how the level of direct and indirect
ties change over time within a venture.
Management Science/Vol. 48, No. 3, March 2002 367
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
Theoretically, direct social ties between parties
could shift the logic of the transaction from one of
economic behavior to one of social relationship (Mars-
den 1981, Uzzi 1996). Unlike arm’s-length transac-
tions, which are governed by norms of self-interest,
social relationships are governed by norms of fair-
ness and equity (Granovetter 1985). Moreover, direct
social ties between parties transfer expectations about
people’s behavior from a prior social setting to the
new business transaction (Uzzi 1996). By embedding
a transaction in an ongoing social relationship, direct
ties (a) motivate both parties to maintain the rela-
tionship in a fair and trusting manner, and (b) gener-
ate a sense of obligation between the parties, which
causes the parties to behave generously towards each
other (Gulati 1995). Thus, in the absence of direct
prior social ties, people are more likely to engage
in zero-sum business transactions; in the presence of
direct ties, they shift from the pursuit of self-interest
to the pursuit of mutual gain (Uzzi 1996). Direct social
ties also enhance resource acquisition under condi-
tions of information asymmetry because direct ties
provide a fast mechanism for obtaining private infor-
mation about the quality of people’s talents and their
tendency to behave opportunistically (Aldrich and
Zimmer 1986, Gulati and Gargiulo 2000, Uzzi 1996).
Our fieldwork provided some evidence that
direct ties influence seed-stage investors’ deci-
sions to invest in new ventures. While unfunded
entrepreneurs tended not to have direct ties to
investors, funded entrepreneurs were likely to have
those ties prior to starting their companies. As one
entrepreneur explained, “our venture capitalist knew
[ENTREPRENEUR A] from his days as an investment
banker when [ENTREPRENEUR A] had acted as an
advisor and consultant to judge the viability of tech-
nologies. They stayed very much in touch and formed
apretty close bond over the years, starting in 1960
and lasting over 30 years.”
Many of the investors interviewed also pro-
vided qualitative evidence that direct ties are use-
ful, primarily because they provide information about
entrepreneurs’ abilities and skills. As one investor
said,
We got to know [ENTREPRENEUR B] in our prior
relationship. This enabled us to learn things about
him and we began to think very highly of him. We
decided that he was a person of high integrity, high
intellect, very well educated, and very purposeful.
He had the human qualities that would make him
an excellent partner and the sort of person who was
likely to accomplish what he set out to do in life if he
had the right opportunity and resources behind him.
We told him that if at some point he was ready to
bet his career on a particular project that we would
love to have the chance to at least look at it and
see whether or not it was something we wanted to
back. We started with the person rather than the
product .
Similarly, another investor explained
One of the founders worked for us the summer
between his first and second year. Everybody in my
company was impressed with him. He’s thoughtful,
hardworking, analytical, and impressive. We based
our decision to invest on him on his integrity, desire
and drive to do something on his own. I did very lit-
tle checking outside of the data that we asked him to
bring us. We didn’t call up any potential customers or
competitors. It would be fair to say that if I had not
known [ENTREPRENEUR C] and had him work for
me prior to coming to me with this business plan, I
never would have invested in this business.
A third investor noted
I had met [ENTREPRENEUR D] in the 1970s when
I got involved in financing some technology start-
ups in Israel. I had funded several companies when
Imet [ENTREPRENEUR D]; who was then start-
ing a company called [COMPANY E]. I ended
up funding [ENTREPRENEUR D’s] company and
I joined the board. I worked very closely with
[ENTREPRENEUR D] and his staff and we became
close personal friends I sold my stock when he
left because my relationship was with him person-
ally. We stayed in touch and remained good, close,
personal friends. When he came to the United States,
we started to discuss his ideas for [COMPANY E];
[ENTREPRENEUR D] asked me to be a founding
investor of the company. So I put in some money and
joined the board.
Thus, theoretical arguments from the organizational
literature combined with our own field research about
the effects of direct ties suggest the following hypoth-
esis:
Hypothesis 1. Investors are more likely to invest in
new ventures when they have a previously established
direct tie to the entrepreneur than when they do not.
368 Management Science/Vol. 48, No. 3, March 2002
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
Indirect Ties. Under uncertain conditions, indirect
ties can provide an advantage to people who seek to
obtain resources from others. The explanation for this
behavior again depends largely on two factors: social
obligation and access to private information. Several
researchers have suggested that indirect ties transfer
expectations about people’s behavior from one rela-
tionship to another (Uzzi 1996). Sociologists have long
argued that referrals by people in whose judgment
the decision maker has confidence make people more
favorably disposed to the person referred (Blau 1964).
With indirect ties, the go-between transfers behavioral
expectations from the existing relationship to the new
one (Uzzi 1996). In addition, the go-between exploits
a debt of reciprocity owed to him or her, and trans-
fers the credit to the entrepreneur (Uzzi 1996). Since
reciprocity is one of the major social norms present
in all societies (Gouldner 1960), people accumulate
social debts to each other. This norm of reciprocity
suggests that social relations generate obligations to
others that can be cashed in or transferred to other
parties (Coleman 1988).
In addition to creating social obligations, indi-
rect ties enhance resource acquisition because they
improve people’s ability to obtain information about
others. A network of social ties allows people to
obtain information about others with whom they do
not have a direct contact, providing access to more
information than what they could obtain alone (Burt
1997). “The network becomes an important screening
device. It is an army of people processing informa-
tion who can call your attention to key bits—keeping
you up-to-date on developing opportunities, warning
you of impending disasters” (Burt 1992, p. 14). Thus,
networking, or the creation and maintenance of ties
to information flows, enhances one’s ability to obtain
nonpublic information (Nohria 1992).
Indirect ties also reduce the cost of obtaining
information. Information is costly to acquire because
it requires human attention, a scarce commodity
(Coleman 1988). Indirect ties thus lower information-
gathering costs because “social relations, often estab-
lished for other purposes, constitute information
channels that reduce the amount of time and invest-
ment required to gather information” (Nahapiet and
Ghoshal 1998, p. 252). Clearly, speed of informa-
tion transfer is advantageous in settings like ven-
ture finance where information has a short half-life.
Referrals from indirect ties also provide information
about qualities that the decision maker finds hard to
observe, such as competence. As a result, indirect ties
improve the quality of applicants by helping to screen
out unqualified individuals (Fernandez and Weinberg
1997).
Our fieldwork supports arguments derived from
organization theory because indirect ties appeared
to influence seed-stage investors’ decisions to
invest in new ventures. Interviews suggested that
entrepreneurs who were not successful in obtaining
financing were outside of the financiers’ social net-
works. For example, one semiconductor entrepreneur
explained
We weren’t from the investors’ community. We were
just three engineers. We presented our business plan
at the MIT Enterprise Forum and the Technology Cap-
ital Network and met some angels and venture capi-
talists. We talked to one or two of them at length but
we never struck a deal, even though some of them
thought that our business was interesting.
Conversely, entrepreneurs who successfully obtained
financing often received money from investors who
made use of their social networks to obtain private
information about the entrepreneurs. One investor
said
[ENTREPRENEUR F] was a controversial fig-
ure at the time he approached us for money and we
needed to know if he was any good. The trick to
finding an answer is to get off the reference list and
get to people we know who also intimately know
the person in question so that we will get an unbi-
ased reference. We did that with [PERSON G]. There
were few people in [PERSON G’s] position. He was
on [COMPANY H’s] executive compensation commit-
tee for the board and really knew what was happen-
ing on the inside. Since [PERSON G] was also
on another company’s board with one of my part-
ners we knew him and could ask him things about
[ENTREPRENEUR F] that other people could not ask.
We made our investment largely because of [PER-
SON G]. We figured that he had better information
than us on [ENTREPRENEUR F] and if he believed
in [ENTREPRENEUR F], then we should too.
Management Science/Vol. 48, No. 3, March 2002 369
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
A third investor explained
Clearly I had a bias for anyone inside of MIT. Once
I step outside of the MIT family it is harder for
me to do due diligence. I did not know if they
are legitimate. Inside of MIT, I can call a department
chairman if I don’t know the person personally. So
it’s very easy to make a couple of phone calls to find
out about someone.
The field research also provided some evidence that
indirect ties were valuable because referrals provided
investors with information about the entrepreneurs.
An Internet entrepreneur explains the information
transfer process underlying referrals:
Venture capitalists will make this bet with people they
had invested in the past who have already made them
tens of millions of dollars, but we were a guy who has
never started a company before and two MIT under-
graduates. Most venture capitalists are not going to
take that gamble. Our investor did it because of his
knowledge of people who knew me. This is what led
them to write a check for $500,000. At the end of the
day it was because of the reference that I was paid
attention to.
Investors confirmed the information value of refer-
rals. As one investor explained:
We were heavily influenced by her high opinion of
[ENTREPRENEUR I] because we have a lot of confi-
dence in her judgement based on our prior relation-
ship with the licensing office and with [PERSON J] in
particular. We had done several deals with her before.
She is an extremely well-known person and her com-
petency in these matters is widely recognized.
Perhaps the strongest evidence for the referral pro-
cess comes from entrepreneurs who started without
referrals, but then shifted to using referrals over time.
As one software entrepreneur explains,
When we first sought financing, I looked for ven-
ture capital on my own. I pitched the idea to some
very good venture capital firms, but I did not get
any investment. I don’t think I had credibility with
them That’s when I asked our attorney for some
introductions. Then we received funding from two
venture capital firms that our attorney introduced us
to. Since he was a lawyer at Testa Hurwitz, he had a
large number of venture clients. People said he was a
very good source for deals.
Combining theoretical arguments with our field
research about the effects of indirect ties suggests the
following hypothesis:
Hypothesis 2. Investors are more likely to invest in
new ventures when they have a previously established indi-
rect tie to the entrepreneur than when they do not.
The Mediating Role of Reputation
As described above, two basic mechanisms have been
proposed to explain why social ties might provide
an advantage to people who seek to obtain resources
from others in situations of information asymmetry
(Podolny 1994). First, social ties may provide decision
makers with access to private information about the
actors and their opportunities, which allows them to
remove some ambiguity from the decision (Burt 1992).
Second, direct and indirect ties between parties may
create social obligations between the parties, which
cause them to behave generously towards each other
(Gulati 1995).
Interestingly, these two mechanisms provide very
different theoretical rationales regarding how social
ties may influence investors’ decisions. Specifically,
the “access to private information” rationale is con-
sistent with a self-interested perspective, in which
investors exploit their social relationships to locate
better investments. The “social obligation” rationale,
on the other hand, provides a far more socialized
view of investors’ decision making, such that invest-
ment decisions depend, in part, on the relation-
ships themselves, rather than competence-based cri-
teria. Given the differences between these rationales,
an understanding of why social ties influence ven-
ture finance decisions is needed. Unfortunately, to
date, research on the effect of social ties on venture
finance decision making has explored the effects of
information transfer and social obligation collectively.
Consequently, it is difficult to determine whether the
effect of social ties on these decisions exist because
those ties motivate information transfer, because they
motivate social obligation, or both.
To disentangle the “access to private information”
and “social obligation” explanations for why social
ties affect seed-stage investment decisions, we invoke
the concept of the entrepreneurs’ reputation. Repu-
tation is defined as information about an individ-
ual’s past performance (Podolny 1994). Because the
370 Management Science/Vol. 48, No. 3, March 2002
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
entrepreneur’s reputation provides information about
his or her ability to implement the venture, investors
should be more likely to fund opportunities proposed
by entrepreneurs with positive reputations.
Reputation can help to disentangle the effects of
social obligation and information access in venture
finance decisions. To the extent that social ties are
used only to gather information, and not to imbue
transactions with norms of social obligation, reputa-
tion should mediate the effects of direct and indirect
ties on the venture finance decision. That is, if infor-
mation about the quality of an entrepreneur is already
publicly available from his or her reputation, then
efforts to obtain private information about the indi-
vidual’s competence gathered via social ties will pro-
vide relatively little additional value to the investor.
In contrast, if social ties also generate obligations
that mitigate self-interested behavior and imbue a
transaction with norms of social relationships, then
social ties should affect the probability of venture
finance even after the informational benefits of repu-
tation have been controlled. Thus, to the extent that
social ties continue to predict investment decisions
after reputation is accounted for, evidence would exist
for the “social obligation” rationale of why social ties
matter to venture finance decisions.
Although the existing research literature provides
arguments for both the social obligation and infor-
mation transfer benefits of social ties, our field-
work strongly suggested that the primary mechanism
through which social ties operate in venture finance
is information transfer. As a result, we predict that
information about the entrepreneur’s reputation will
mediate the effects of social ties on venture finance
decisions. Thus, based on existing theory and our
field research, we hypothesize:
Hypothesis 3a. The reputation of an entrepreneur
mediates the effect of direct ties, such that the effect of direct
ties on investment decisions is removed when reputation is
included.
Hypothesis 3b. The reputation of an entrepreneur
mediates the effect of indirect ties, such that the effect of
indirect ties on investment decisions is removed when rep-
utation is included.
Methodology
Sample and Procedure
First, we surveyed the population of U.S. seed-stage
venture capitalists in 1998 about the most recent
seed-stage investments they evaluated.3We randomly
divided the sample into two groups. The first sub-
group was asked about the most recent seed-stage
investment that they evaluated and made. The second
subgroup was asked about the most recent seed-stage
investment that they evaluated, but did not make.
The population of venture capitalists, identified
from Pratt’s Guide to Venture Capital Sources, the indus-
try directory, consisted of 566 individuals listed in
the 1997 and 1998 directories who indicated that
they make seed-stage investments; 136 individuals
responded, resulting in a response rate of 24%. The
respondents had an average of 17 years of investment
experience, and had previously made an average of
12 seed-stage investments. The average size of their
seed-stage investments was $949317.
To examine the representativeness of our sample,
we compared respondents with nonrespondents in
terms of their firm, geographic location, and the
types of investments that they make. No statistically
significant differences emerged on these dimensions,
suggesting that the respondents were representative
of the population of seed-stage venture capitalists
operating in the United States at the time of the
survey.
To improve the generalizability of our sample, we
also surveyed two groups of business angels, or indi-
viduals who invest in new ventures outside of the
3A seed-stage investment is the initial stage in the financing of a
new firm. It consists of “a small amount of capital provided to an
inventor or entrepreneur to determine whether an idea is worthy of
further consideration and further investment. The idea may involve
a technology or it may be an idea for a new marketing approach. If
it is a technology, this stage may involve building a small prototype.
This stage does not involve production for sale” (Sahlman 1990,
p. 479).
Management Science/Vol. 48, No. 3, March 2002 371
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
legal structure of a venture capital limited partner-
ship. Since business angels are not listed in any direc-
tories, no information on the population exists, mak-
ing it impossible to randomly sample them. Therefore,
we sampled the largest and most well-known angel
groups. The first group, called the Band of Angels,
consists of 123 individual investors in Silicon Val-
ley. This is a high-profile group, having been fea-
tured in The New York Times and a Harvard Business
School case for investment in several major technol-
ogy new ventures. Our response rate from this group
was 27%. The second group of angels consisted of
128 investors who were members of the Technology
Capital Network (a Boston-area angel group), the old-
est and largest group of angels on the East Coast of
the United States. Our response rate from this group
was 26%. The angels had an average of 13 years of
investment experience. They had previously made an
average of 13 seed-stage venture capital investments,
and the average size of their seed-stage investments
was $362550.
In the case of both angel groups, we could not
obtain the lists of investors themselves (the orga-
nizations protect the identities of their members).
Rather, the organizations agreed to participate and
mail prepackaged surveys, cover letters, and response
envelopes to their members on our behalf. Again, we
randomly divided the groups into two parts. The first
subgroup was asked about the most recent seed-stage
investment that they evaluated and made. The second
subgroup was asked about the most recent seed-stage
investment that they evaluated, but did not make. We
pooled the angels and the venture capitalists in our
data because (a) we found no significant effects for a
dummy variable representing angel investors in our
regression analysis, (b) we did not find any significant
interaction effects between angel investor status and
the social tie measures when predicting finance deci-
sions, and (c) we found no substantive differences in
our results when we examine the data for the venture
capitalists alone.
Measures
Investment Decision. The dependent variable was
a binary variable of one if the investment was made
and zero if the investment was not made.
Social Ties. Unlike previous research that mea-
sured social ties through archival variables that do
not allow differentiation between the constructs of
reputation and social ties, we measure social ties
directly. The social tie variables were multi-item,
evenly weighted scales, and individuals responded to
five-point Likert scale items ranging from 1 =strongly
disagree to 5 =strongly agree. Each scale was cal-
culated by adding together the values for the items
that composed the scale and dividing by the number
of items. The items were derived from prior ethno-
graphic and archival research on different dimensions
of social ties (e.g., Podolny and Stuart 1995, Uzzi 1996,
Burt 1992, Larson 1992) and our field interviews.
The indirect tie scale was composed of four ques-
tions about indirect ties between the investors and the
venture team prior to the investment decision (Cron-
bach’s alpha =0.75). These items were: “Someone
whom I trust to discuss important confidential mat-
ters knew at least one member of the venture team”;
“A third party whose judgement I trust provided
me with nonpublic information about the venture
team”; “I could obtain information about the ven-
ture team from my network of contacts faster than
other investors could obtain the same information”;
“By calling people I know, I could obtain information
about the venture team in a relatively inexpensive
manner”.
The direct tie scale was composed of three ques-
tions about direct ties between the investors and the
venture team prior to the investment decision (Cron-
bach’s alpha =0.78). The items were: “Prior to seeing
the deal, I had a professional relationship with at least
one venture team member”; “Prior to seeing the deal,
at least one member of the venture team was someone
with whom I had engaged in informal social activity
(e.g., playing tennis, going to the movies)”; “Prior to
seeing the deal, at least one member of the venture
team was a personal friend”.
Reputation. The reputation scale was composed
of three questions about the members of the ven-
ture team’s reputation as entrepreneurs (Cronbach’s
alpha =071). The items were: “Someone on the ven-
ture team had a reputation for successfully build-
ing public companies”; “A third party I respected
vouched for the team’s ability to start a successful
372 Management Science/Vol. 48, No. 3, March 2002
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
company”; “At least one venture team member is
viewed by other investors as giving the venture cred-
ibility”. These items were derived from prior ethno-
graphic and archival research on different dimensions
of reputation (e.g., Podolny and Stuart 1995, Uzzi
1996). The reputation scale was evenly weighted
based on individual responses to questions adminis-
tered on a five-point Likert scale items ranging from
1=strongly disagree to 5 =strongly agree.
Control Variables. To provide more accurate esti-
mates of our hypothesized variables, we controlled
for other factors that previous research has found to
be important in explaining venture finance decisions.
We used a dummy variable to control for whether
or not the investor was an angel investor because
our sampling process was different for angels and
venture capitalists. We also controlled for industry
because prior research shows that venture capitalists
and angel investors favor certain industries for early-
stage investments (Haar et al. 1988). To control for
industry, we employed a series of dummy variables
for biotech, hardware, medical, Internet, software,
and telecom industries.4
In addition, we controlled for several dimensions of
the quality of venture opportunities presented to the
investors by the entrepreneurs. Thus, we controlled
for the venture’s expected market size by measuring
the dollar value of the U.S. market for the business
for the current year as stated in the business plan
because MacMillan et al. (1985) and Hall and Hofer
(1993) have shown that the size of the market influ-
ences investors’ decisions. We also controlled for the
attractiveness of the business opportunity by mea-
suring the forecasted dollar value of earnings before
interest and taxes of the venture (EBIT) in Year 5 as
stated in the business plan because previous research
has shown that the magnitude of the opportunity
influences investors’ decisions (Tyebjee and Bruno
1984). Likewise, we controlled for the dollar amount
of the investment request because the magnitude of
the investment influences investor decisions (Tyebjee
and Bruno 1984, Wetzel 1987).
4Other industry was the reference group in the regression.
Two final dimensions of ventures that past research
suggested should be controlled for are investors’ per-
ceptions of the technology (Haar et al. 1988, Roberts
1991) and the perceived quality of the business plan
(MacMillan and Subbanarasimha 1987, Roberts 1991).
Thus, we measured the perceived value of the tech-
nology with a scale composed of two items regard-
ing the value of the venture’s technology (Cronbach’s
alpha =086). The items were: “The technology
employed by the venture would provide a signifi-
cant competitive advantage”; “The venture’s technol-
ogy had a strong proprietary position”. We measured
perceived quality of the business plan with a two-
item scale (Cronbach’s alpha =092): “The business
plan was thorough in its coverage of key issues”; “The
business plan did an excellent job of articulating the
opportunity”.
We also controlled for several attributes of the
investors making the decision. We controlled for
the number of prior seed-stage investments made
by the inventor because Elango et al. (1995) found
that investors with significant seed-stage experience
made different decisions from those with little seed-
stage experience. We controlled for the number of
years that individuals have invested in start-ups
because Lerner (1994) found that more experienced
investors approach the investment process differ-
ently from less-experienced investors. Finally, we
controlled for investor gender because Sapienza and
Gupta (1994) and Sapienza and Timmons (1989)
found that relational demography influenced venture
investors’ decisions, and the pool of potential high-
tech entrepreneurs is predominantly male.
Results
First, to examine how well our survey questions
mapped onto the intended constructs, we used
LISREL 8 to conduct a confirmatory factor analysis
of the measurement model associated with the Likert
scale items in our study (Jöreskog and Sörbom 1996).
A goodness-of-fit index at or above 0.90, and a root
mean-squared error of approximation of below 0.08,
is believed to indicate acceptable fit (Browne and
Cudeck 1993, Medsker et al. 1994). Results indicated
that our model fit the data very well, as indicated
Management Science/Vol. 48, No. 3, March 2002 373
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
by a comparative fit index of 0.95, an incremental fit
index of 0.95, and a root mean-squared error approxi-
mation of 0.062. We also estimated alternative models
to examine whether a model with fewer constructs
fit the data better. We found that (a) models with
fewer constructs had a worse fit with the data than
the model with the five constructs we anticipated,
(b) no single higher-order construct emerged from
the five constructs or any combination of them, and
(c) none of the scales had superior reliabilities if any
of the items were removed. Finally, we estimated a
final confirmatory factor analysis where we focused
on the factor structure of only the theoretical predic-
tors (reputation, indirect ties, and direct ties), exclud-
ing the technology and business plan items. The fit
of this confirmatory factor analysis also was high
(fit indexes above 0.91), and the factor loadings were
clean (specifically, the average on-factor loading was
0.70, while the average off-factor loading was 0.11). In
general, these results support the construct validity of
our measures.
Investment Decision
We now turn to the analyses of the investment deci-
sion. Table 1 shows the descriptive statistics and cor-
relation matrix. The business plan and technology
scales have means around the midpoint of the scale,
most likely because our sample was evenly weighted
among investments made and investments not made.
Thus, on average, investors find the plans and com-
petitive advantages presented by entrepreneurs to be
average, lending some confidence to the design of our
study.
Table 2 provides the results of the logistic regres-
sion predicting the investment decision as a func-
tion of the social tie dimensions, controlling for
other factors. Model 1 is the base model, includ-
ing the four measures of the attributes of the inven-
tors (angel, gender, prior deals, and experience), the
four measures of opportunity (market size, Earn-
ings Before Interest and Taxes (EBIT) in Year five,
business plan, technology); the size of investment
request; and industry dummies (biotech, hardware,
Internet, medical, software, and telecom industries).
The results indicate that among the control vari-
ables, four variables significantly predicted the deci-
sion to fund a venture opportunity: the business plan
(ExpB =206p < 00001), the technology (ExpB =
221p < 00001), the amount of the funding request
(ExpB =100p < 005), and the dummy variable
for the telecommunications industry (ExpB =476
p<005).
The control variables provide some important
insight about entrepreneurial activity. As prior
research has predicted, venture funding is more likely
when entrepreneurs have better business plans and
technology that provides a strong and proprietary
competitive advantage. Moreover, results showed that
the greater the amount of money requested, the lower
the likelihood of funding.
Several results for the control variables provide
an interesting contrast to previous research. Past
research on entrepreneurial finance indicates that
investors prefer to fund more profitable opportuni-
ties in bigger markets (MacMillan et al. 1985, Hall
and Hofer 1993). Our results suggest that investors
do not prefer to fund opportunities that entrepreneurs
claim are more profitable opportunities in larger mar-
kets. This finding is perhaps not surprising, given
that entrepreneurs face no cost to opportunistically
present their business opportunities as financially
desirable. Moreover, overoptimism (Cooper et al.
1988) leads entrepreneurs to express unrealistic expec-
tations about their ventures. Therefore, entrepreneurs’
claims about the value of their opportunities as stated
in their business plans do not influence investors’
decisions.
Models 2 and 3 show the individual effects of
direct and indirect social ties. Each of these vari-
ables has a significant effect on the venture finance
decision. Model 2 shows that direct ties are strongly
and positively related to the probability of investment
ExpB =148p < 005. The addition of the direct
tie measure also significantly improves the model’s fit
chi-square of change =406p < 005.
Model 3 indicates that indirect ties also are
positively related to the probability of investment
ExpB =166p<0001. The addition of the indirect
tie measure to the base model significantly improves
the fit of the prediction of which opportunities are
financed chi-square of change =605p < 005.
Model 4 examines both types of social ties simul-
taneously. The model shows that the effects of direct
374 Management Science/Vol. 48, No. 3, March 2002
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
Table 1 Descriptive Statistics and Correlation Matrix N =202
12 3 4 5 678910111213141516171819
1. Financed 100
2. Angel 006 100
3. Amount −006 −020∗100
4. EBIT 007 −002 023∗100
5. Market 006 −008 −007 034∗100
6. Plan 034∗017∗006 001 012 100
7. Technology 037∗001 004 008 002 021∗100
8. Reputation 038∗012 002 002 007 035∗017∗100
9. Indirect tie 016∗−010 010 016∗012 −008 008 028∗100
10. Direct tie 019∗008 −000 013 009 013 008 038∗034∗100
11. Biotech −008 −021∗009 −009 −005 −007 −007 −010 004 −004 100
12. Hardware 006 002 −001 −002 −001 008 016∗010 002 −010 −011 100
13. Internet −007 018∗−002 −002 −006 010 −009 −001 −010 −001 −014∗−012 100
14. Medical −006 −018∗−000 −005 −001 −004 002 000 012∗011 −017∗−014∗−018∗100
15. Software −005 −004 −011 −007 −007 −004 −004 −011 −008 −007 −015∗−007 −016∗−019∗100
16. Telecom 020∗−001 013 018∗008 −001 001 016∗012 008 −015∗−007 −016∗−019∗−017∗100
17. Male 001 005 010 −004 000 004 006 −007 −003 −001 004 009 −000 −006 006 −005 100
18. Prior 002 −012 −007 024∗008 −007 005 −005 007 −002 −009 −009 002 002 001 003 −011 100
19. Experience −003 −001 −009 008 007 −009 −004 −001 005 014∗000 −008 −002 −004 000 −000 018∗048∗100
Mean 055 032 326e61807e6480e9321 365 297 365 206 011 008 013 018 014 014 093 1608 1282
Std. Deviation 050 047 446e63136e6176e10 111 107 096 089 094 032 028 034 039 035 035 026 1715 903
Minimum 000 000 000 −1200e7000 100 100 100 100 100 000 000 000 000 000 000 000 000 100
Maximum 100 100 4000e6200e81 200e11 500 500 500 500 500 100 100 100 100 100 100 100 10000 5000
∗=Significant at p<005 or better in a two-tailed test.
Management Science/Vol. 48, No. 3, March 2002 375
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
Table 2 Regressions Predicting Venture Funding N =202
Model 1 Model 2 Model 3 Model 4 Model 5
Variable B(S.E.) ExpB B(S.E.) ExpB B(S.E.) ExpB B(S.E.) ExpB B(S.E.) ExpB
CONTROLS
Angel −023 042080 −032 042073 −026 043077 −030 044074 −036 044070
Male 010 071110 006 071106 010 072111 009 072109 035 073141
Prior deals 000 001100 000 001100 000 002100 000 001100 000 001100
Experience 000 002100 −001 002099 000 002100 −000 002100 −001 002099
Market −67e12 10e11100 −81e12 11e11 100 −92e12 11e11100 −98e12 11e11 100 −92e12 11e11 100
EBIT 26e966e9100 13e968e9100 16e967e9100 98e10 68e9100 24e970e9100
Plan 072 017206∗∗∗∗ 069 017199∗∗∗∗ 079 018219∗∗∗∗ 075 018212∗∗∗∗ 063 018188∗∗∗
Technology 079017221∗∗∗∗ 079 018221∗∗∗∗ 077 018216∗∗∗∗ 077 018217∗∗∗∗ 076 018214∗∗∗∗
Amount −77e840e8100∗−76e841e8100∗−88e843e8100∗−86e844e8100∗−89e844e8100∗
Biotech −070 064049 −078 064046 −086 065043 −087 065042 −073 067048
Hardware −039 067068 −036 067070 −054 068058 −049 068061 −067 069051
Internet −067 059051 −070 060050 −070 060050 −071 061049 −073 064048
Medical −046 053063 −064 055053 −071 055049 −078 056046 −078 057046
Software −052 057060 −051 056060 −054 058058 −054 058058 −043 058065
Telecom 156068476∗151 069453∗141 069409∗140 070406∗124 071346∗
PREDICTORS
Direct tie # 039 020148∗#026 021130 011 022112
Indirect ties # # 051 021166∗∗∗ 041 022151∗030 023135
Reputation ####057 022177∗∗∗
−2LL 213.48 209.41 207.45 205.86 199.09
Chi-square 6457∗∗∗∗ 6863∗∗∗∗ 7062∗∗∗∗ 7219∗∗∗∗ 7896∗∗∗∗
Chi-square change # 406∗605∗762∗1434∗∗∗
Key: ∗∗∗∗ =p<00001∗∗∗ =p<0001∗∗ =p<001∗=p<005 in one-tailed tests.
376 Management Science/Vol. 48, No. 3, March 2002
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
ties ExpB =130p>010are mitigated when indi-
rect ties ExpB =151p<005are measured. These
results suggest that while direct ties may encour-
age investments, they are superceded by informa-
tion from indirect sources. Thus, Hypothesis 1 is
supported, but Hypothesis 2 is not supported. How-
ever, taken together, the results support organiza-
tional theoretic arguments that social relationships
influence investors’ decisions about which ventures to
finance.
Model 5 examines the role of reputation, and thus
offers more direct evidence about whether social ties
are valuable because they provide a mechanism for
information transfer, because they imbue transac-
tions with norms of social obligation, or both. Our
results support Hypotheses 3a and 3b, suggesting
that social ties operate primarily as a mechanism
for information transfer. Model 5 reveals that when
entrepreneurs’ reputations are considered ExpB =
177p < 0001, the effects of indirect ties ExpB =
135p>010and direct ties (ExpB =112p>010)
are mitigated. In general, these results suggest that
once information is publicly available about the qual-
ity of an entrepreneur, social ties no longer influence
the investment decision.
It also is possible that direct and indirect ties have
multiplicative effects with reputation on the proba-
bility of venture finance rather than additive effects.
We explored whether interactions between direct and
indirect ties, between direct ties and reputation, and
between indirect ties and reputation have any signif-
icant effect on the probability of venture finance. We
found no significant effects for any of the interactions,
suggesting that the effects of direct and indirect ties
have neither additive effects nor multiplicative effects
on the probability of venture finance once reputation
is considered.
Discussion
Our study was based on the premise that eco-
nomic explanations for venture finance decisions are
incomplete and undersocialized, and that social ties
provide an important mechanism through which
information asymmetry is overcome in venture
finance. Since both our qualitative and quantita-
tive results show that social ties influence seed-stage
finance decisions, we received general support for our
premise.
However, our results also suggested that organiza-
tional theoretic explanations for the role of social rela-
tionships in venture finance are unparsimonious and
oversocialized. The literature to date has relied on two
very different theoretical mechanisms to explain why
social ties should matter: access to private informa-
tion and social obligations. We examined the extent to
which these two mechanisms are operative by incor-
porating the concept of reputation. Our data suggest
that reputation mediates the effects of social ties, indi-
cating that investors exploit their social ties to gather
private information, but does not support the argu-
ment that investors make investment decisions based
on social obligations.
These results are important because they promote
a Schumpeterian (1934) perspective on entrepreneur-
ship. Knight (1921) and Schumpeter (1934) disagreed
on whether individuals could easily obtain financ-
ing to pursue new business opportunities. Schum-
peter (1934) believed that if individuals perceived
viable opportunities, others would provide resources.
Knight (1921), on the other hand, presaged the mod-
ern finance literature when he emphasized the infor-
mation asymmetry problem in venture finance. Given
information asymmetry, Knight argued that the pur-
suit of opportunity involved the joint possession
of capital and entrepreneurial insight. Evans and
Jovanovic (1989) tested these alternative explanations
and found a liquidity constraint that prevents people
from becoming entrepreneurs. Not considering the
role of social relationships, they used this evidence
to “reject Schumpeter in favor of Knight” (Evans and
Jovanovic 1989, p. 810). Results from our study indi-
cate that such a rejection may be premature. Since
social relationships are used to overcome market fail-
ure in venture finance, entrepreneurship does not
require the perception of an opportunity and the pos-
session of financial capital.
Our results also have important implications for the
interpretation of prior research on venture finance.
For example, Fried and Hisrich (1994, p. 31) found
that “while VCs receive many deals ‘cold’ (without
any introduction), they rarely invest in them. Most
funded proposals come by referral.” Although we
Management Science/Vol. 48, No. 3, March 2002 377
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
agree with this descriptive finding, our results sug-
gest a particular normative interpretation. The reason
why most funded proposals come by referral is that
the referral provides information. If, however, infor-
mation is already publicly available, the entrepreneur
will not need a referral to obtain financing.
Although prior research has examined some aspects
of the questions that we discuss (e.g., Freear et al.
1994, Haar et al. 1988), methodological weaknesses
such as sample selection biases, averaging effects,
and univariate testing have limited the acceptance of
their findings. Our study provides several important
methodological advances. For example, we surveyed
arepresentative sample of active investors about
the most recent investments they evaluated. Accord-
ingly, we were able to minimize retrospective ratio-
nalization and the averaging effect that has hindered
past studies, where respondents report their general
approach to investing. Moreover, using direct survey
measures rather than proxies permitted us to differ-
entiate between effects of social obligation and infor-
mation transfer on venture finance decision making.
Limitations
This study is not without limitations. First, we
assumed that social contacts would provide infor-
mation about entrepreneurs, and that more infor-
mation would make investors more likely to invest.
This assumption is tenable because investors know
that every entrepreneur has both strengths and
weaknesses, and that more information about both
strengths and weaknesses should make the investor
more likely to invest. Although this assumption is
consistent with the “mere exposure” (e.g., Zajonc
1968) and the “consideration set” (e.g., Tybout and
Artz 1994) literatures in social psychology, it would
be interesting for future research to examine both the
amount and the favorableness of information gleaned
from social contacts about an entrepreneur. Informa-
tion about the favorableness of the information would
allow more specific tests of how a social network
operates, and would allow researchers to examine
whether social contacts help or penalize genuinely
gifted entrepreneurs who experience early bad luck
and receive sullied reputations.
Second, we asked investors to report about past
decisions. As a result, our results might have been
affected by retrospective recall bias (e.g., Golden
1992). In addition, the decision to invest may involve
post-hoc justification. All else being equal, it is possi-
ble that higher reputation ratings would be given by
those who decided to invest than those who did not
as a way of justifying decisions. However, Miller et al.
(1997) found that retrospective reporting is a viable
research methodology if the measures used to gener-
ate the reports are adequately reliable and valid. In
this study, we demonstrated the reliability of our mea-
sures using confirmatory factor analysis, and we max-
imized the validity of our data by asking investors
about the most recent funding decision that they made.
Because our respondents make investment decisions
on an ongoing basis, they were reporting about a deci-
sion that likely occurred no more than three months
prior to answering our survey.5This approach mini-
mizes the risk of retrospective recall bias because the
ventures they described should have changed very
little after the investment decision but before complet-
ing our survey. Nevertheless, future research should
examine how changes in venture performance alter
the way that investors report the reasons for their
investment.
Third, our study examined only seed-stage invest-
ments made by venture capitalists and business
angels. Consequently, we can generalize the effects of
social ties on financing decisions only to those invest-
ments for which these sources of capital are used.
Because venture capitalists and business angels gen-
erally invest in high-technology businesses that are
highly uncertain, one potential boundary condition
for our findings is the uncertainty of the opportunity.
Future research is necessary to know if social ties are
equally important to investment decisions about less
uncertain opportunities (e.g., a franchise outlet).6
5Because investors decide not to invest in approximately 10 times
as many ventures as they decide to invest in, the decision-to-invest
group was asked to recall a decision that occurred, on average,
ten months before, whereas the decision not-to-invest group was
recalling a decision that occurred approximately one month before.
6We thank an anonymous reviewer for bringing this observation
to our attention.
378 Management Science/Vol. 48, No. 3, March 2002
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
Fourth, the implications of our results are limited to
explaining the initial decision to invest in a new ven-
ture. While our results indicate that social obligations
are not an important factor in investment decisions,
we cannot conclude that they do not influence other
aspects of the venture finance process. The presence of
direct and indirect ties is a good, but imperfect proxy
for social obligations. In addition, investors might
become influenced by social obligations that develop
over time within a venture (Sapienza and Koresgaard
1996, Steiner and Greenwood 1995). Future research
is necessary to explore different mechanisms through
which social ties influence other aspects of venture
finance before researchers can conclude that infor-
mation transfer is the central mechanism in venture
finance.
Future Directions
Because this study examined only U.S. investments,
future research should consider the extent to which
our explanation is universal or is linked to societal
context, as Zucker (1986) has argued. Although social
ties are important to overcoming problems of market
failure in the pursuit of new business opportunities,
there may be interactive effects between social ties
and institutional context. The use of social ties might
vary across economies or sociocultural contexts. Pos-
sible approaches to researching this question include
cross-national comparisons of new venture financing
in different institutional settings, and experimental
studies designed to manipulate financing decisions in
simulations of firm creation.
Another related boundary condition is newness of
industry, which is directly related to the inability to
judge competence among transactors. In the context
of imitative entrepreneurship, for example, social ties
may be less valuable than in the case of new indus-
try creation because information problems are less
severe. This suggestion is consistent with Aldrich and
Fiol (1994), who identified the importance of social
ties to new organizational forms that result from the
creation of new industries. Future researchers could
follow this research stream to examine the relative
value of social ties in new versus mature industries.
This study also suggests an important avenue for
research on new venture legitimacy. Although the
relationship between social ties and legitimacy is
most directly related to new venture uncertainty
rather than information asymmetry, our results sug-
gest some ideas for how new firms gain legitimacy.
Specifically, social ties might lead newly financed
firms to possess different endowments of social cap-
ital (Shane and Stuart 2002). Because social capital
can be exploited to generate legitimacy, this varia-
tion in social capital endowment might generate vari-
ation in legitimacy that influences new firm perfor-
mance (Stuart et al. 1999). Thus, while population
ecologists imply that organization and industry char-
acteristics are the source of new venture legitimacy,
future research may demonstrate that individual-level
attributes, such as social ties, also influence legiti-
macy.
Finally, our results suggest a future direction
for research examining the geographic concentra-
tion of high-technology firms. Lerner (1998) explains
that new high-technology firms are geographically
concentrated. Economic explanations for this phe-
nomenon include knowledge spillovers, specialized
labor markets, and the existence of other firms closely
related in the value chain (Henderson et al. 1998,
Krugman 1991). This literature does not discuss the
importance of social ties to this clustering process.
Since people tend to have greater social ties, on aver-
age, with others with whom they interact with more
frequently, the geographic concentration of high-
technology firms might result from the effect of social
ties on the venture finance process. For example,
Nohria (1992, p. 257) contends that “since trust is
largely process based and relies on reputational cred-
ibility built on occupational history, certification by
mutually known contacts, and the prospect of future
exchange—participants from outside the region have
a hard time in this market.” Consistent with the
arguments of Sorenson and Audia (2000), our results
imply that the clustering of new high-technology
firms occurs because entrepreneurs need to locate in
certain areas given the role of social ties in the process
of funding new technology companies.
Conclusion
Given the importance of new business creation
to global innovation and economic growth, an
Management Science/Vol. 48, No. 3, March 2002 379
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
understanding of how people successfully obtain
financing to pursue entrepreneurial opportunities is
a fundamental area of research for entrepreneur-
ship scholars. The basic contribution of this paper is
straightforward. Social ties provide a mechanism by
which investors obtain information, thereby allow-
ing entrepreneurs without high-capital endowments
to obtain resources to pursue business opportunities.
Acknowledgments
The authors thank Bob Anderson, Lita Nelsen, Lori Pressman, Hans
Severeins, and Allan Will for their assistance in obtaining access
to the data sources. Ken Morse provided us with helpful feedback
on the questionnaire. We would like to thank participants in the
Organizations and Markets seminar at the University of Chicago,
the Entrepreneurship Research seminar at NYU, the Organization
Studies seminar at MIT, Howard Aldrich, Ted Baker, Robert Baron,
Diane Burton, Holly Raider, Ed Roberts, and Toby Stuart for useful
comments.
References
Akerlof, G. 1970. The market for lemons: Quality uncertainty and
the market mechanism. Quart. J. Econom.84 4889–5000.
Aldrich, H., M. Fiol. 1994. Fools rush in? The institutional context
of industry creation. Acad. Management Rev.19(4) 645–670.
,C.Zimmer. 1986. Entrepreneurship through social networks.
D. Sexton, R. Smilor, eds. The Art and Science of Entrepreneurship.
Ballinger, Cambridge, MA.
Amit, R., L. Glosten, E. Muller. 1990. Entrepreneurial ability, ven-
ture investments, and risk sharing. Management Sci.38(10)
1232–1245.
Barry, C. 1994. New directions in research on venture capital
finance. Financial Management 23(3) 3–15.
Blau, P. 1964. Exchange and Power in Social Life.Wiley, New York.
Browne, M. W., R. Cudeck. 1993. Alternative ways of assessing
model fit. K. A. Bollen, J. S. Long, eds. Testing Structural Equa-
tion Models. Sage, Newbury Park, CA. 136–162.
Burt, R. 1987. Social contagion and innovation: Cohesion versus
structural equivalence. Amer. J. Sociology 92 1287–1335.
. 1992. Structural Holes: The Social Structure of Competition. Har-
vard University Press, Cambridge, MA.
. 1997. The contingent value of social capital. Admin. Sci. Quart.
42 339–365.
Cable, D., S. Shane. 1997. A prisoner’s dilemma approach to
entrepreneur-venture capitalist relationships. Acad. Manage-
ment Rev.22(1) 142–176.
Casson, M. 1982. The Entrepreneur. Barnes and Noble Books,
Totowa, NJ.
Chan, Y., D. Siegel, A. Thacker. 1990. Learning, corporate control
and performance requirements in venture capital contracts.
Internat. Econom. Rev.31(2) 365–382.
Coleman, J. 1988. Social capital in the creation of human capital.
Amer. J. Sociology 94 S95–S120.
Cooper, A., C. Woo, W. Dunkelberg. 1988. Entrepreneurs perceived
changes for success. J. Bus. Venturing 397–108.
Elango, B., V. Fried, R. Hisrich, A. Polonchek. 1995. How venture
capital firms differ. J. Bus. Venturing 10 157–179.
Evans, D., B. Jovanovic. 1989. An estimated model of
entrepreneurial choice under liquidity constraints. J. Political
Econom.97(4) 808–827.
,L.Leighton. 1989. Some empirical aspects of entrepreneur-
ship. Amer. Econom. Rev.79(3) 519–535.
Fernandez, R., N. Weinberg. 1997. Sifting and sorting: Personal con-
tacts and hiring in a retail bank. Amer. Sociological Rev.62 883–
902.
Freear, J., J. Sohl, W. Wetzel. 1994. The private investor market for
venture capital. Financier 1(2) 7–15.
Fried, V., R. Hisrich. 1994. Toward a model of venture capital invest-
ment decision making. Financial Management 23(3) 28–37.
Golden, B. R. 1992. The past is the past – Or is it? The use of retro-
spective accounts as indicators of past strategy. Acad. Manage-
ment J.35 848–860.
Gompers, Paul A. 1995. Optimal investment, monitoring, and the
stages of venture capital. J. Finance 50 1461–1489.
. 1997. An examination of convertible securities in venture cap-
ital investments. Working paper, Harvard University, Boston,
MA.
,J.Lerner. 2000. The Venture Capital Cycle.MIT Press,
Cambridge, MA.
Gouldner, A. 1960. The norm of reciprocity: A preliminary state-
ment. Amer. Sociological Rev.25 161–179.
Granovetter, M. 1985. Economic action and social structure: The
problem of embeddedness. Amer. J. Sociology 91(3) 481–510.
Gulati, R. 1995. Does familiarity breed trust? The implications of
repeated ties for contractual choice in alliances. Acad. Manage-
ment J.38(1) 85–112.
Gulati, R., M. Gargiulo. 2000. Where do interorganziational net-
works come from? Amer. J. Sociology.
Haar, N., J. Starr, I. MacMillan. 1988. Informal risk capital investors:
Investment patterns on the east coast of the U.S.A. J. Bus. Ven-
turing 311–29.
Hall, J., C. Hofer. 1993. Venture capitalists’ decision criteria in new
venture evaluation. J. Bus. Venturing 825–42.
Henderson, R., A. Jaffe, M. Trajtenberg. 1998. Universities as a
source of commercial technology: A detailed analysis of uni-
versity patenting, 1965–1988. Rev. Econom. Statis.78 119–127.
Hoffman, H., J. Blakely. 1987. You can negotiate with venture capi-
talists. Harvard Bus. Rev.65(2) 6–24.
Jöreskog, K. G., D. Sörbom. 1996. LISREL 8: User’s Reference Guide.
Scientific Software International, Inc., Chicago, IL.
Kaplan, S., P. Stromberg. 1999. Financial contracting theory meets
the real world: An empirical analysis of venture capital con-
tracts. Working paper, University of Chicago, Chicago, IL.
Kelly, P. 2000. Private investors and entrepreneurs: How con-
text shapes their relationship., Unpublished Ph.D. dissertation,
London Business School, London, U.K.
Kirzner, I. 1973. Competition and Entrepreneurship. University of
Chicago Press, Chicago, IL.
380 Management Science/Vol. 48, No. 3, March 2002
SHANE AND CABLE
Network Ties, Reputation, and the Financing of New Ventures
Knight, F. 1921. Risk, Uncertainty and Profit. Augustus Kelley,
New York.
Krugman, P. 1991. Geography and Trade.MIT Press, Cambridge, MA.
Landstrom, H., S. Manigart, C. Mason, H. Sapienza. 1998. Contracts
between entrepreneurs and investors: Terms and negotiation
processes. P. Reynolds, W. Bygrave, N. Carter, S. Manigart,
C. Mason, D. Meyer, K. Shaver, eds. Frontiers of Entrepreneurship
Research. Babson College, Boston, MA.
Larson, A. 1992. Network dyads in entrepreneurial settings: A
study of the governance of exchange relationships. Admin. Sci.
Quart.37 76–104.
Lerner, J. 1994. The syndication of venture capital investments.
Financial Management 23(3) 16–27.
. 1998. Venture capital and the commercialization of academic
technology: Symbiosis and paradox. Working paper, Harvard
Business School, Boston, MA.
MacMillan, I., R. Siegal, P. Subbanarasimha. 1985. Criteria used by
venture capitalists to evaluate new venture proposals. J. Bus.
Venturing 1119–128.
MacMillan, I., P. Subbanarasimha. 1987. Characteristics distinguish-
ing funded from unfunded business plans evaluated by ven-
ture capitalists. Strategic Management J.8579–585.
Marsden, P. 1981. Introducing influence processes into a system of
collective decisions. Amer. J. Sociology 86 1203–1235.
Medsker, G., L. Williams, P. Holahan. 1994. A review of current
practices for evaluating causal models in organizational behav-
ior and human resources management research. J. Management
20 439–464.
Miller, C., L. Cardinal, W. Glick. 1997. Retrospective reports in orga-
nizational Research: A reexamination of recent evidence. Acad.
Management J.40 189–204.
Nahapiet, J., S. Ghoshal. 1998. Social capital, intellectual capital,
and the organizational advantage. Acad. Management Rev.23(2)
242–266.
Nohria, N. 1992. Information search in the creation of new business
ventures. N. Nohria, R. Eccles, eds. Networks and Organizations.
Harvard University Press, Cambridge, MA, 241–261.
Podolny, J. 1993. A status-based model of market competition.
Amer. J. Sociology 98 829–872.
. 1994. Market uncertainty and the social character of economic
exchange. Admin. Sci. Quart.39 458–483.
,T.Stuart. 1995. A role-based ecology of technological change.
Amer. J. Sociology 100 1224–1260.
Roberts, E. 1991. High stakes for high-tech entrepreneurs: under-
standing venture capital decision making. Sloan Management
Rev.32(2) 9–20.
Sahlman, W. 1990. The structure and governance of venture capital
organizations. J. Financial Econom.27 473–521.
Sapienza, H. 1992. When do venture capitalists add value? J. Bus.
Venturing 79–27.
,A.Gupta. 1994. Impact of agency risks and task uncer-
tainty on venture capitalist-CEO interaction. Acad. Management
J.37(6) 1618–1632.
,M.Korsgaard. 1996. The role of procedural justice in
entrepreneur-venture capital relations. Acad. Management J.38
544–574.
,J.Timmons. 1989. The roles of venture capitalists in new ven-
tures: What determines their importance? Acad. Management
Best Papers Proc. 74–78.
Schumpeter, J. 1934. The Theory of Economic Development: An Inquiry
Into Profits, Capital, Interest, and the Business Cycle. Harvard
University Press, Cambridge, MA.
Shane, S. 2000. Prior knowledge and the discovery of entre-
preneurial opportunities. Organ. Sci.11(4) 448–469.
,T.Stuart. 2002. Initial endowments and the performance of
university start-ups. Management Sci.48(1) 154–170.
,S.Venkataraman. 2000. The promise of entrepreneurship as a
field of research. Acad. Management Rev.25(1) 217–226.
Sorenson, O., P. Audia. 2000. The social structure of entrepreneurial
activity: Geographic concentration of footwear production in
the United States, 1940–1989. Amer. J. Sociology 106(2) 424–462.
Steiner, L., R. Greenwood. 1995. Venture capital relationships in
the deal structuring and post-investment stages of new firm
creation. J. Management Stud.32(3) 337–357.
Stuart, T., H. Huang, R. Hybels. 1999. Interorganizational endorse-
ments and the performance of entrepreneurial ventures.
Admin. Sci. Quart.44 315–349.
Tybout, A., N. Artz. 1994. Consumer psychology. Annual Rev. Psych.
45 131–169.
Tyebjee, T., A. Bruno. 1984. A model of venture capital investment
activity. Management Sci.30 1051–1066.
Uzzi, B. 1996. The sources and consequences of embeddedness
for the economic performance of organizations: The network
effect. Amer. Sociological Rev.61 674–698.
,J.Gillespie. 1999. Corporate social capital and the cost of
financial capital: An embeddedness approach. R. Leenders,
S. Gabbay, eds., Corporate Social Capital and Liability, Kluwer
Academic Publishers, Boston, MA.
Wetzel, W. 1987. The informal venture capital market: aspects of
scale and market efficiency. J. Bus. Venturing 2299–313.
Venkataraman, S. 1997. The distinctive domain of entrepreneurship
research. Adv. Entrepreneurship Res., Firm Emergence Growth 3
119–138.
Zajonc, R. 1968. Attitudinal affects of mere exposure. J. Personality
Social Psych.91–29.
Zucker, L. 1986. Production of trust: Institutional sources of
economic structure, 1840–1920. B. Staw, L. Cummings, eds.
Research in Organizational Behavior.Vol. 8 JAI Press, Greenwich,
CT, 53–111.
Accepted by Ralph Katz; received November 2000. This paper was with the authors 3 months for 2 revisions.
Management Science/Vol. 48, No. 3, March 2002 381
