THE LOCATION DECISION IN THE INFORMAL VENTURE
CAPITAL INVESTMENTS
Sofia Avdeitchikova
School of Economics and Management
Lund University
Box 7080, SE-220 07 Lund
Tel. + 46 (46) 222 14 23
Fax + 46 (46) 222 44 37
Sofia.Avdeitchikova@fek.lu.se
2
Introduction
Over the past 25 years, the USA has pioneered a new technological revolution, based on a
large number of new small enterprises, financed by a dynamic venture capital market (Norton,
2001). The European Union, however, has been lagging behind in entrepreneurial activity and
development of technological sector, and, compared to the US, small entrepreneurial firms
find it harder to get access to finance for start-up and growth (Martin et al., 2002). The
dominant view is that the reason behind that is the nature of capital markets in Europe. Across
much of Europe, young small enterprises have traditionally relied on banks as major providers
of finance. Banks, however, normally only lend if the loan can be secured against some kind
of collateral (Lumme et al., 1998). The companies’ assets at the early stage of development
are scarce, and the traditional forms of collateral can rarely be provided. Banks are for
instance reluctant to invest in risky technology-based businesses whose main assets are
immaterial, such as patents. Therefore, the development of well-functioning venture capital
market is crucial to stimulate the emergence and development of innovative high-technology
firms that contribute to economic growth and value creation (Martin et al., 2002).
The last two decades have been characterized by a considerable expansion of institutional
venture capital industry in many developed economies (Mason and Harrison, 1997).
However, its role in the entrepreneurial process has been increasingly limited by several
factors (Mason and Harrison, 1995). The investment focus of the venture capital industry has
shifted progressively away from early stages and technology based ventures towards more
established companies and management/leveraged buyouts. This has in its turn led to a
substantial increase of the average size of investments over the past few years (Mason and
Harrison, 2000). Further, the studies of the institutional venture capital have shown that there
is a high level of geographical concentration of venture capital activity to financial centres
and regions with high entrepreneurial activity (Martin, 1992, Mason and Harrison, 1995,
NUTEK, 2004). Together, this development has lead to an increasing shortage of relatively
small, geographically dispersed investments in early stages of entrepreneurial ventures’
development.
Informal venture capital, i.e. private individuals who invest risk capital directly in unquoted
companies in which they have no family connection, has been increasingly recognized as an
important source of early-stage finance. Informal venture capital investors usually invest
smaller sums of money, which better matches the external capital needs of young
entrepreneurial firms (Landström, 1993). Further, they are believed to make more risky
investments, partially because they do not commit their entire savings to the unquoted
company sector. According to Mason and Harrison (1994) informal investors allocate about 5
to 10 per cent of their investment portfolio to unquoted companies, which allows them to take
a larger portion of risk. Finally, informal venture capital investments are expected to be less
geographically concentrated than institutional venture capital, which, if true, means that they
3
are important for providing finance to remote regions and bridging the regional equity gap
(Mason and Harrison, 1995).
This notion that informal venture capital is geographically dispersed is largely based on two
observations. Firstly, as indicated by Gaston (1989) in his study of the US market, informal
investors seem to be found practically everywhere. Secondly, informal investors are expected
to invest in the geographical proximity of their homes. This was initially suggested by Gaston
(1989) and later repeatedly confirmed in several European countries (see for example
Landström 1993, Mason and Harrison, 1994, Lumme et al., 1998) and in the US (Sohl, 1999).
For instance, Lumme et al. (1998) have shown that 60 per cent of investments take place
within a radius of 100 kilometres from investor’s home or workplace, while according to
Mason and Harrison (2002), three-quarters of investors would not invest in companies further
away than two hours journey. The local nature of informal investments has been explained by
a hands-on nature of informal investments, implying considerable involvement in the object
of investment, reliance on personal social and business networks for information on potential
deal, as well as investors’ reluctance to make the time commitment to visit potential
investment object at distant locations.
However, the recent study of the Swedish informal venture capital market (Avdeitchikova and
Landström, 2005) has surprisingly shown that a large part of the informal investments in
Sweden are made without the geographic proximity to the investment object. In fact,
geographical proximity was found in only just over 40 per cent of cases. Instead, other factors
have shown to be of major importance, such as previous connection to the industry, to the
company and to the entrepreneur. With such a significant part of investments taking place at a
distant location from investors home, it is important to provide explanations for what drives
the location decision in informal venture capital investments.
With this background, insights from the survey study based on more than 400 actual
investments will be used to investigate the location decisions in the informal venture capital
investments. Social capital theory and financial theory are used as a theoretical ground for the
analysis. The rest of paper is structured as following. First, I present the key definitions to
position this study against other studies in this area. In the next section contains the discussion
of social capital approach and financial approach, which I bring together into a model. In
subsequent section I formulate a number of hypotheses based on the theoretical discussion.
This is followed by a description of method used. The empirical data is presented, followed
by the test of the hypotheses. Finally, the findings and the implications of the study are
discussed.
4
Definitions
Informal venture capital
The key definition that has to be clarified in the dissertation is what is meant by informal
venture capital investors. Informal investors in this study are defined as private individuals
who invest equity capital directly in unquoted companies in which they have no family
connection, which implies that the potential investors (Freear et al., 1994; Coveney and
Moore, 1998 etc.) and corporate investors (Coveney and Moore, 1998) are excluded from the
study. This also means that investments in own or family owned companies are excluded.
While those investments together may comprise a large part of small business finance market,
they are not considered to be informal investments in this study.
It is particularly important to distinguish this group of individuals from those called “business
angels”. Business angels are considered to be investors with high investment activity that
contribute considerable resources to the companies they invest in. The definition of informal
investors in this study, on the other hand, includes also investors with low investment activity
and those who do not contribute considerable resources to the firm. The definition used in this
study gives therefore a broader perspective on the informal venture capital investments, but
also makes us reconsider the applicability of our previous knowledge based on studies of
business angels.
Measure of distance
Further, it is important to define the measure of distance used in this study. Compared
previous studies, where such measures as absolute distance in kilometres (miles) and travel
time where used to describe the distance (Landström 1993, Mason and Harrison, 1994,
Lumme et al., 1998, Sohl, 1999, Mason and Harrison, 2002), here I use the local labour
market as a measure of distance. Sweden contains 87 local labour markets, and the
investments within the same local labour market is considered to be a local investments (or
“home investments”), while the investments outside the investors local labour market are
considered to be distant investments (or “non-home investments”). I believe that this is a fair
measure of distance, because it incorporates the absolute distance between the investor and
the object of investment of the one hand, and the relative measures of travel time and
accessibility on the other hand.
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Frame of reference
Social capital theory
The concept of social capital has been used to describe a wide range of social phenomena, and
there is no uniform definition of what social capital is. However, the definitions of social
capital can be broadly divided in two categories. The first one is mainly focused on the
relations an individual actor establishes and develops with other actors, while the second one
is concerned with the structure of relations among actors within a community or collective
(Sørheim, 2003). The first definition that is based on the individual actor level is called the
“bridging view” and was introduced by Burt (1992:9), who defines it as “friends, colleagues,
and more general contacts through whom you receive opportunities to use your financial and
human capital”. This framework is based on a network concept introduced by Granovetter
(1973), though it is narrowed down and primary concerned with two issues: information and
trust. These are two key concepts that I would like to elaborate on and analyse their impact on
investment location decision.
Information
Investing in new and high-technology based ventures is associated with high degree of
uncertainty, risk and asymmetrical information. Therefore, gaining reliable and timely
information about companies, entrepreneurs, competitors and market conditions is crucial for
the success of the investment. Access to information has been used as one of the main
arguments to explain the local nature of investment activity. For instance, Caves (1996:58)
argues that when investing at the home location, the investor can access the “social and
cultural milieu as a spillover without explicit costs”. Making investments at the distant
location, the investor will therefore be faced with higher information costs, leading to
competitive disadvantage. Due to recent development of informational technology, hard
information, i.e. such information that may easily be reduced to numbers (Peterson, 2002),
can be transmitted freely across space. On the other hand, soft information is embedded in
social relations, and is difficult to access at distant location. The “sticky” quality of soft
information has been used to explain the concentration of economic activity far beyond the
area of financial investments. The access to local information is a part of traditional
framework developed by Marshall (1920), which is used to explain the industrial clustering in
economic geography (Zook, 2002).
As the complexity of information increases, it is not only the amount of information that
becomes important, but also the reliability of information. Even if this kind of information
may reach the financial actors in other regions, it will, firstly, take longer time, and secondly,
the reliability of such information will be much harder to establish (Gompers and Lerner,
1999). Even more significantly, some researchers have suggested that the soft information can
not be accessed at any cost without the local presence (Zook, 2002).
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Trust
It has been widely argued that social capital is better developed in the close geographical
proximity of the individual. One of the arguments for that is that social capital can only be
developed on a basis of trust, which is considered to be something that emerges over time and
through frequent interactions. For instance, as described by Lublinski (2003:457), “…To
develop trust, agents need to be able to learn about each others motives, character,
performance and socio-cultural background in order to be able to evaluate each other’s
reputation capital and overall trust worthiness.” Therefore trust would be better established
where face-to-face contacts frequently take place, which means between geographically
proximate agents.
In their study of the role of trust in informal investor’s investment decision, among others Fiet
(1995) and Harrison et al. (1997) have distinguished between trustful relationship between the
investor and the entrepreneur on one hand, and between the investor and the network of
informants on the other hand. They have showed that trust between the investor and the
entrepreneur reduces risk for opportunism and uncertainty associated with investment. Hence,
investors are more likely to provide finance to entrepreneurs with whom they have a previous
social relationship. Further, the investor perceives information gained from known parties as
more reliable, which increases the likehood of positive investment decision.
Figueiredo et al. (2002) in their study of entrepreneurs’ choice of business location have
talked about “investor’s home base” that reflects the entrepreneur’s social capital, defined as
personal factors, such as community ties and friendships, as well as proximity to home and
family. They have particularly shown that there is a trade-off between personal factors and
strictly economic decision-making criteria. For instance, they found that entrepreneurs could
accept over three times higher labour costs to stay in their resident area of business. The
investor’s social capital can therefore constitute an important asset that is not easy to replicate
outside the investor’s home base.
Lack of geographical proximity – possible explanations
So far I have argued that the geographical, or physical, proximity is an important factor for
accessing information and relying on trustful personal relations in the informal venture capital
investments. However, a number of factors can be identified from previous research which
can be expected to limit the importance of geographical proximity.
The insights from the social capital theory point at the importance social capital for access to
timely and relevant information and the development of trust between parties. However, as I
have noticed in the introduction, a surprisingly large amount of investments take place outside
the geographical proximity of the investor. In other words, there is a reason to believe that
informal investors can invest at distant location if they in some other way can compensate for
7
a higher degree of the uncertainty. Alternatively, they can undertake non-home investments if
they for some reason require a lower degree of control than other investors.
To support the first argument, we can look at the study conducted by Figueiredo et al. (2002)
on the location decisions of the entrepreneurs. While the title itself indicates that
entrepreneurs doing business at the previous location of their activity experience a “homefield advantage”, the authors make an important exception, by referring to the advantage of
possessing industry-specific information. In other words, the investor may compensate for the
uncertainty associated with investing at a distant location, by making use of the industryspecific information acquired from personal background or developed on the local market.
Thus there might be a case of geographically dispersed professional networks that reduces the
importance of geographical proximity because of the superior industrial knowledge.
The same evidence has been provided by Sørheim (2003), who noticed the importance of
individual’s previous track record for the future investment behaviour. In particular, he
showed that investors with previous track record related to a specific region, will tend to keep
making investments to that region. At the same time, individuals with an industry specific
experience will mostly invest within the same industry, not restricted to any particular
geographical location. As Sørheim (2003:337) puts it, “regional track record will be replaced
by industry specific record”. Note that the regional track record does not necessarily refer to
the investor’s home region. The same pattern has been for instance indicated by Caves (1996)
in his study of multinational enterprise, who argues that the costs that are related to making
business at a certain location can be seen as learning costs rather that reoccurring costs
(Caves, 1996). This implies that this cost is most significant for new-entrants, diminishing
with every new deal.
Further, as argued by Mason and Harrison (1997) at a more general level, if information on
the investment opportunity is available from reliable non-local sources, as for instance
national business angels’ networks, the investors should not exhibit a tendency to invest
locally.
Another reason to invest at non-home location, as indicated above, is if investor can accept a
lower degree of control. The study of Avdeitchikova and Landström (2005) has shown that
informal investors that are actively involved in the activities of the firm after the investment
tend to invest near their homes to a larger extent than those who are not. The same tendency
has been found in the area of institutional venture capital, where among others Gorman and
Sahlman (1989), Bygrave and Timmons (1992) and Lerner (1995) have shown that the extent
of the monitoring role is dependent upon the distance between venture capitalists and the
investment objects. Therefore, investors that are less actively involved in their investments
will be less concerned with investing in ventures that are geographically close (Van
Osnabrugge, 1998).
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Financial theory
While the social capital theory can be useful for understanding why and when the
geographical proximity is important, it only states the fact the there be a case on non-local
investments. Thus it does not provide explanations for whether there should be any location
patterns in non-home investments. For that purposes I would like to use some insight form
financial theory.
Webber (1972) in his seminal work on uncertainty and location has stated explicitly that
investors, when operating at distant markets, will value factors that reduce uncertainty. In
particular they will favour agglomeration economies and proximity to the large markets.
Informal venture capital investments are characterized by a high degree of uncertainty, risk
and ambiguous information. Therefore, in making investments at distant locations, informal
investors are likely to benefit from presence of other investors at the same location as it
increases access to information (Gompers and Lerner, 1999, Mason and Harrison, 1999,
Porteous, 1999). They are also likely to locate their investments near the core regions, in this
case financial centres and areas of high entrepreneurial activity, to reduce uncertainty and take
advantage of informational spillovers (Figueiredo et al., 2002).
As pointed out by Gehrig (1998), a factor driving the concentration of financial activity is
market liquidity. In liquid markets individual transactions cause no significant price
fluctuations whereas in illiquid markets even small transactions may cause considerable price
movements. Risk averse investor would prefer to trade where market liquidity is high, as the
risk of price fluctuation is lower. As a consequence, liquid markets will attract more trading
volume, which is another reason for the concentration of investment activity.
Summary of the theoretical analysis and formulation of the hypotheses
The social capital theory indicates that access to information and trustful relations between
actors is the primary reason for the local nature of investments. Therefore, the first hypothesis
can be formulated as following:
H1: In home investments, informal investors are more likely to obtain information on the
investment deals from their social network than in non-home investments.
When investing at distant location, investors are exposed to a higher risk, than when investing
at the home base. Everything else equal, the investors are supposed to prefer home
investments to non-home investments. Therefore, when investing at a distant location the
investors should require a higher monetary return than in home investments. Our second
hypothesis is:
9
H2: Informal investors have higher monetary return requirements when making investments
at distant locations.
Cost of making investments at a remote location can be seen as a learning cost that diminishes
over time. The investors are therefore supposed to appropriate on the learning costs by make
their investments at the same region. Therefore, the next hypothesis will be:
H3: The subsequent non-home investments will take place at the same geographical location
as previous non-home investment.
Further, investors that possess a certain industry specific experience will be less
geographically constraint to their home base in their investment location decisions. We can
therefore predict that:
H4: The investors with previous experience of the industry of investment are more likely to
make non-home investments than those without that experience.
The active involvement in the object of investment is one of the important reason for the
decision to invest locally. Therefore we can expect following:
H5: Investors that are less actively involved in their investments will be less concerned with
investing in ventures that are geographically close.
Finally, as financial theory indicates, the non-home investment will tend to agglomerate and
concentrate to large financial markets, to take advantage of higher market liquidity and
informational spillovers, thereby reducing the uncertainty associated with informal venture
capital investments. Therefore our last hypothesis will be:
H6: Non-home investments will be concentrated to financial centres and areas with high
entrepreneurial activity.
The expected locational pattern can be summarized in the model presented in Figure 1. The
model illustrates that the investments will first and foremost be located at the investor’s home
base, which is shown by grey arrows, as predicted by social capital theory. The investments
that take place outside the investor’s home base will be concentrated to the financial centres
and regions with high entrepreneurial activity, as predicted by financial theory. This is
illustrated by white arrows in the model.
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Peripheral regions
Home
investments
Core
region
Non-home
investments
Figure 1. The expected location pattern of informal venture capital investments
Methodological issues
This study is based on 422 informal venture capital investments conducted under the period
1973-2005 in Sweden. Because of the large time span, I have conducted a comparative
analysis to identify any changes of the location pattern over time. The analysis showed that
the investments exhibit a constant location pattern, therefore the further analysis does not
have to be controlled for time issue.
The data on the investments was gathered from a large sample of Swedish population. The
study started with a random survey of 24 166 private individuals between 18 and 79 years to
determine the number of informal venture capital investors in this group. After the
preliminary survey we were able to identify some 861 persons that claimed that they have
made investments in unquoted companies in which they have no family connection within the
last 5 years. Those 548 who agreed to participate in the second phase of this study were
contacted during summer and fall 2004, to get detailed information about their informal
investments. The proposed methodological approach enhances the reliability of results and
allows statistical nationwide generalizations. The sample developmental process is illustrated
in Table 1.
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Table 1. The sample developmental process
Category
Individuals randomly sampled
Number of “Yes” answers to the screening
question
Agreed to participate (first phase)
Failed to establish contact
Refused to participate (second phase)
Interviews completed
Not investors
Informal venture capital investors
Total
24 166
861
Percent Percent Percent
100%
3.6%
548
-115
-32
401
-124
277
2.3%
100%
21.0%
5.8%
73.2%
100%
30.9%
69.1%
Strengths and weaknesses of the study
This study’s strength lies in the fact that it is based on a large random sample of informal
investors. This is a first study within the area of informal venture capital conducted on a
representative sample of a countries population. This means that the results can be are
representative for the whole population of informal venture capital investors in Sweden.
Another methodological strength is that the data gathering was conducted through telephone
interviews. The response rate is very high (79 per cent) compared with similar studies in other
countries (Sørheim and Landström, 2001; Harrison and Mason, 1992). Furthermore, the
personal contact with the respondent reduces risk for the misinterpretation of the questions.
Finally, all data on investment behavior is based on the actual investment history rather than
hypothetical assumptions. This enhances the objectivity and reliability of the data.
The weakness of this study is that the data are gathered solely from the respondents own
words. Neither the investment activity nor the background information has been doublechecked with the tax authorities. However, we chose this way of gathering data because of our
belief that not all investment activity is registered, and because of the difficulties to gain
access to non-public information through tax authorities.
Empirical results
Summary of the empirical results
The data used for the test of the hypotheses in subsequent section is summarized in table 2.
For the purpose of the analysis I distinguish between home and non-home investments and
give a brief describing characteristic of each category.
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Table 2. Description of the empirical material.
Characteristic
Home investments
(n=174)
Non-home investments
(n=245)
Obtained information on
investment opportunity from
social network.
High return potential as primary
investment criteria.
Investment located in financial
centre.
79.9 per cent
63.1 per cent
33.3 per cent
46.7 per cent
55.7 per cent
34.8 per cent
Test of hypotheses
H1 predicts that in home investments, informal investors will be more likely to obtain
information on the investment deals from their social network than in non-home investments.
To test this hypothesis, I have compared the share of investors obtaining information from
their social network in home investments versus non-home investments. The results showed
that in home investments, in 139 out of 174 cases information was obtained from social
network, while in non-home investments that was true in 154 out of 244 cases. Chi-square test
gives us a value of approximately 13.628. H1 is therefore supported, p<0.001.
According to H2, informal investors should have higher monetary return requirements when
making investments at distant locations than in home investments. The data shows that in
non-home investments, 114 out 244 investments were made with high return potential as
primary investment criteria. The corresponding number for home investments is 58 out of
174. Chi-square test gives us a value of 7.518. H2 is therefore supported, p<0.01.
H3 suggests that subsequent non-home investments will take place at the same geographical
location as the first non-home investment. Because I needed to compare geographical location
of two or more investments, I have only looked at those individuals for whom the data on the
last two or more investments were available. The results show that out of 67 cases where the
investor repeatedly made non-home investments, in only 19 cases the investments were made
at the same geographical location. This means that the majority of subsequent non-home
investments are not made at the same location. H3 is rejected.
According to H4, the investors with previous experience of the industry of investment are
more likely to make non-home investments than those without that experience. The data
shows that out of 189 investments made with previous experience of the industry, 91 where
non-home investments. In those cases where the investor did not have previous experience of
the industry, 153 of 229 investments where non-home investments. Therefore, the investors
with previous business experience are not more likely to make non-home investments. H4 is
rejected.
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H5 suggests that investors’ tendency to invest near their home or workplaces can be explained
by the hands-on nature of informal investments. To test this proposition we compare the share
of investments conducted near homes or workplaces for active and passive investors. In 99
cases out of 418, the investor was actively involved in the firm. In the remaining 319 cases the
investor was passive. Out of the 99 investments accompanied by investors active
involvement, 59 had geographical proximity to investors home or workplace, compared to
112 out of 319 for investments not associated with active involvement. Chi-square test gives a
value of 18.739, which shows that there is a significant difference between the proportion of
investment with geographical proximity to home or workplace between the groups. H5 is
therefore supported.
Finally, H6 suggests that non-home investments will be concentrated to financial centres and
areas with high entrepreneurial activity. To test this hypothesis, I have looked at the location
of investments that took place outside the geographical proximity from investors home. The
core regions are defined as large financial markets, regions with concentration of income,
wealth and high entrepreneurial activity, in accordance with Avdeitchikova and Landström
(2005). Out of 212 non-home investments, 85 where located in core regions. Because the
population on core and periphery regions is approximately the same in Sweden, we can
establish that the majority of non-home investments are therefore not made in core regions.
H6 is rejected.
The results of hypothesis testing are summarized in Table 3.
Table 3. Summary of the empirical results.
Hypotheses
H1: In home investments, informal investors are more likely to
obtain information on the investment deals from their social
network than in non-home investments.
H2: Informal investors have higher monetary return requirements
when making investments at distant locations.
H3: The subsequent non-home investments will take place at the
same geographical location as the first non-home investment.
H4: The investors with previous experience of the industry of
investment are more likely to make non-home investments than
those without that experience.
H5: Investors that are less actively involved in their investments
will be less concerned with investing in ventures that are
geographically close.
H6: Non-home investments will be concentrated to financial
centres and areas with high entrepreneurial activity.
** Significant on the 0.01 level
*** Significant on the 0.001 level
Chi – square Supported
13.628***
Yes
7.518**
Yes
No
No
18.739***
Yes
No
14
Conclusions and contributions
In this study I have found support for three important statements. Firstly, the social network
seems to be more important in obtaining information on potential deals in home investments
than in non-home investments. This supports the view that investor’s social capital is
regionally rooted and not easily transferable or replicated. Secondly, informal venture capital
investors are more concerned with monetary return in non-home investments than in home
investments. This is in accordance with the view that there is a trade-off between the lack of
geographical proximity higher return rate requirements to compensate for additional risk.
Finally, the investors that are less actively involved in their investments will be less concerned
with investing in ventures that are geographically close.
Rather unexpectedly, I have not found any support for hypotheses 3, 4 and 6. Even more
significantly, there seem to be an opposite relationship in all three cases. The test has shown
that the majority of non-home investments are not located in core regions. On the contrary,
the majority of investments seem to flow to other peripheral regions, and in some cases,
abroad. These findings will develop our model as follows (Figure 2):
Peripheral regions
Home
investments
Core
region
Investment flows
between peripheral
regions
Non-home
investments
Further, the informal investors don’t seem to appropriate on their learning cost of making
investments on distant locations. The majority of investors that engage in non-home
investments do not seem to make several subsequent investments at the same region. In fact,
they do not seem to have any particular geographical priorities at all.
Finally, the previous experience from the industry of investment do not seem to lead to more
non-home investments. On the contrary, those who do not have previous experience from the
industry of investment make more non-home investments than those who do.
15
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