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    VENTURE CAPITAL FIRMS DIVERSIFICATION INTO NEW GEOGRAPHIC MARKETS:

    AN INTEGRATION OF INSTITUTIONAL AND SOCIAL NETWORK PERSPECTIVES

    Pek-Hooi Soh School of Business

    National University of Singapore 1 Business Link

    Singapore 117592 Tel: (65) 6874-3180 Fax: (65) 6779-2621

    Email: bizsohph@nus.edu.sg

    Jane W. Lu Lee Kong Chian School of Business Singapore Management University

    469 Bukit Timah Road Singapore 259756

    Tel: (65) 6822 0758 Fax: (65) 6822 0777

    E-mail: janelu@smu.edu.sg

    January, 2005

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    VENTURE CAPITAL FIRMS DIVERSIFICATION INTO NEW GEOGRAPHIC MARKETS: AN INTEGRATION OF INSTITUTIONAL AND SOCIAL NETWORK PERSPECTIVES

    ABSTRACT Integrating institutional and social network perspectives, this study examines the dual forces of institutional influences and network influences on the new market entry decisions of venture capital firms. In a sample of 2,130 venture capital firms and their investments over 1994-2003 in 88 geographic markets, we found support for both influences as the frequencies of entries by both other venture capital firms and co-investors in a geographic market enhance the propensity of focal firms entry into the same market. Further, firms central in co-investment networks are more likely to enter into new geographic markets. Finally, the centrality of a firm in its co-investment networks weakens institutional influences. These findings show the importance of legitimating signals arising from alternate sources in the institutional environment and how they interact and affect a firms diversification into new markets.

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    Strategic management scholars have long been interested in how firms draw on prior knowledge

    and acquire information cues in order to reduce uncertainty surrounding their investment

    decisions. Incumbents are likely to enter into new markets when they possess industry-

    specialized supporting assets (Mitchell, 1989). As the number of large and profitable firms in a

    new market increases, it signals the legitimacy of operating in that market and thus attracts other

    firms to follow the entry (Haveman, 1993). Alternatively, firms may garner diverse experiences

    from their network partners because more complex and useful tacit information about investment

    decisions can be better conveyed through networks (Beckman & Haunschild, 2002). For

    established firms, diversification into new markets is a strategy to change or expand the core

    business domain of organizations (Fligstein, 1991). New market entry necessarily entails

    significant technical and market uncertainty since firms may face the risk of assets being locked

    into undesirable position and not appropriating the strategic value. Therefore, with relevant

    knowledge and information signals, firms face a lower risk of losing the value of firm specialized

    assets deployed in new markets, thus increasing the incentive to invest.

    Existing studies have suggested two main explanations as to why firms diversify into

    lines of business that are to any extent unrelated to their core activities. One explanation is the

    rational-choice decision, the other is mimetic isomorphism. Rational-choice arguments suggest

    that firms will be quick to expand when they are able to utilize existing capabilities needed to

    survive in a new market (Brittain & Freeman, 1980), when they are under competitive pressure

    to sustain their market dominance (Mitchell, 1989; Haveman & Nonnemaker, 2000), or when the

    market success of new investments becomes more likely (Cohen & Klepper, 1996). The second

    explanation focuses on the mimetic behaviour of firms in new market entry (Haunschild, 1993;

    Haveman, 1993, Henisz & Delios, 2001). Neoinstitutional theory predicts that firms tend to

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    adopt the same investment strategies as other firms within the same industry or as their network

    partners because of normative or informational influence flowing through the competitive or

    cooperative interactions among firms. The increase in the number of other firms in a new market

    will legitimate that market and signal the feasibility of entering that market, whereas the

    experiences of network partners reduce the range of uncertainty.

    Although the literature on diversification is substantial, most previous work has focused

    on inducement effects on organizational change in established firms. Little attention has been

    paid to the factors that drive the variation in perceived legitimation and access to experiences

    generated by others. The institutional perspective has assumed that the availability of

    information about potential investment opportunities is not a constraint and that organizations are

    more attentive to investment decisions made by highly visible firms. In contrast, network studies

    have shown how attributes of social structure can influence and constrain accessibility and

    quality of information (Burt, 1992; Uzzi, 1996). Besides the legitimating and signalling effects

    from other firms, information arising from the social networks does direct a firms attention to

    experiences associated with the decisions of its partners to enter into new markets.

    This paper investigates how firms simultaneously respond to alternate information

    sources arising from the investment patterns of other firms and network partners, and how

    attributes of social structure shape their responses. We argue that firms differ in their strategic

    assessment of the risks and costs associated with potential market entry. We do not suggest that

    their internal decision rules differ but that these firms vary in their attention to and perception of

    external information sources regarding the investment opportunities. Under high uncertainty,

    firms economize on search costs and vary in their degree of interaction with others within the

    same industry and network. Some firms will interact more intensively than others with certain

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    other firms in the same organizational environment. Consequently, differential access to

    uncertainty-reducing information will lead to different risk assessment of the same investment

    opportunities. We propose that a firms first entry decision in a new market will be jointly

    influenced by the percentages of other firms and partners in that market, but the signalling effect

    of other firms is dampened as the centrality of the firm increases.

    Our predictions found support in an examination of the investment decision of 2,130

    venture capital firms to enter into 88 new geographic markets worldwide from 1994 to 2003. The

    decision of a venture capital firm to invest in a new venture in a different nation is similar to the

    decision of an existing firm to enter a new business domain. In both cases, information must be

    gathered on the nature of potential new markets. Unlike established firms which operate in

    particular product markets, venture capital firms do not face the risk of cannibalization of

    existing assets and structural inertia which would otherwise counter their incentives to enter into

    new markets. To a greater extent, venture capital firms rely on knowledge and information from

    diverse sources to inform them of the risks surrounding the new ventures in new markets.

    Therefore, venture capital industry provides an appropriate empirical context for this study of

    informational influences.

    The study contributes to a greater understanding of how institutional and network forces

    influence firms diversification into new markets and have implications concerning firms ability

    to take advantage of alternate sources of information about risky investments.

    THE INVESTMENT DECISION OF VENTURE CAPITAL FIRMS

    For more than forty years, the Venture Capital (VC) industry has played a notable role in

    shaping the landscape of new enterprise formation. Venture capitalists provide funds and assist

    in the formation of new ventures. The investment decision is presumably made based on the

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    technical merits of the business proposals. This rational investment rule predicts that venture

    capital firms are likely to invest in projects that are expected to produce acceptable rate of return

    (Brealey & Myers, 1996). Prior studies have found that the attractiveness of industry or

    geographic market and technology, the ability and experience of management team/founder,

    stage of start-ups, amount of capital required, control, liquidity and exit options are regarded as

    important investment decision criteria (Bygrave, 1987; Hall & Hofer, 1993; Macmillan, Siegel &

    Narasimha, 1985).

    While prior studies provide parsimonious theoretical explanation of investment decisions

    by venture capital firms, they tend to focus on individual economic exchanges to predict the

    investment decisions based on the maximization of efficiencies. Such focus has been criticized

    for offering an under-socialized view of organizational activities (Granovetter, 1985). This

    criticism is especially relevant in the decision making of venture capital firms because new firms

    typically represent risky and unproven organizational propositions. It is difficult to assess the

    quality of new ventures. The decision becomes more uncertain when venture capital firms do not

    have any experience in a new product or geographic market. As a result, venture cap

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