If one were asked to describe a "typical" private investor, research conducted in the US (Wetzel, 1981; Gaston & Bell, 1988), Canada (Short & Riding, 1989), UK (Mason, Harrison & Chaloner, 1991) and Sweden (Landström, 1993) would characterise the individual as:
·a middle-aged male; with
· reasonable net income and personal net worth; and
· previous start-up experience; who
· makes one investment a year, usually close to home; and
· prefers to invest in high technology and manufacturing ventures; with
an expectation to sell out in three to five years time.
While it is appealing to conclude that private investors as a group across a number of countries share similar traits, the evidence collected to date supports the notion that the informal venture capital market is rather heterogeneous in character (Freear & Wetzel, 1992). There is a growing awareness among researchers in the informal venture capital area of the need to disaggregate the unit of analysis further. A number of authors have developed typologies (Gaston, 1989; Postma & Sullivan, 1990; Stevenson & Coveney, 1994; Landström, 1992) to identify distinct sub-groups within the population classifying individuals based on a number of different criteria including: investment motivation, background experience, operating style and the number of investments made.
As a first step towards addressing this need, in this study we have restricted our attention to the most active market segment, namely informal investors which have made more than three investments in privately-owned firms. There is a growing body of evidence to suggest that a significant minority of private investors have yet to make their first investment ("virgin angels") or invest rather infrequently, while a smaller yet substantial group of investors are very active, often large scale, investors (Mason, Harrison & Chaloner, 1991; Stevenson & Coveney, 1994; Landström, 1993). We refer to this latter group as "serial investors". The decision to concentrate exclusively on serial investors is motivated by several factors: i) in all likelihood, these investors account for a disproportionately large percentage of actual investment activity; ii) it is reasonable to suggest that experience effects may be operating - in this respect, we may have the most to learn from serial investors; and iii) understanding the active segment of the market may serve to stimulate additional investment activity from relatively inactive investors.
Generally speaking, private investors are remarkably entrepreneurial individuals in their own right, a majority have started a business of their own or have previous management experience in the new venture setting (Wetzel, 1981; Sullivan, 1992; Neiswander, 1985; Short & Riding, 1989; Landström, 1993; Mason, Harrison & Chaloner, 1991; Stevenson & Coveney, 1994). It seems reasonable to suggest that private investors face a challenge in making the transition from "entrepreneur" to "investor" and that based on the level of investment activity reported, serial investors seem to make this transition much easier than less active informal investors.
With the aim of exploring some of the dynamics underlying this process or role transition, we sought to address a number of issues. How do serial investors build up and effectively manage a number of investments simultaneously? Can investors achieve a degree of portfolio diversification by participating in investment syndicates? Are there limits to portfolio size when an investor chooses to be actively involved? At present, we know more about the nature of the opportunity referral networks used by private investors but relatively little about the patterns of their actual co-investment activity.
An investor bears risk any time an investment is made. Inherently, investment returns are impacted by external developments in the firm's competitive domain; what has been referred to in the finance literature as business or market risk. In addition, there is the ever present possibility that entrepreneurs will not always act with the best interests of the investor in mind, commonly referred to as agency risk. In a theoretical world of perfect information, neither of these risks would exist - investors would be able to select investments that offer the most profitable and durable profit stream directed by an entrepreneur that is fully aware of, and acts in complete accordance with, the interest(s) of the investor. In the practical world, investors seek out ways to manage business and agency risk. For purposes of clarity, it is useful to separate out the discussion of how to manage risks inherent to the opportunity (business risk) from those embodied in the individual(s) who wish to exploit it (agency risk).
Managing Business Risk
Conventional finance theory suggests that, in part, business risk can be reduced through diversification. That is to say an investor can gain some measure of protection from business risk by investing in a number of ventures at varying stages of development, competing in different industries and/or geographic areas. Investors should prefer more diversity to less, particularly if they view the risk/reward tradeoff as unalterable (Gupta & Sapienza, 1992). Under such circumstances, there is little, if any incentive for an investor to be actively involved as such efforts would neither reduce risk or increase rewards, rather their interests would be better served concentrating on the selection of investments to include in the portfolio.
Previous research has demonstrated, however, that private investors display a tendency to specialise rather than diversify in terms of the investments held in their portfolios which implies that investors do not view the risk/reward tradeoff to be necessarily fixed. Private investors have a strong propensity to invest in earlier stages of development in the US (Wetzel, 1981; Tymes & Krasner, 1983; Freear & Wetzel, 1988, 1990; Aram, 1989; Postma & Sullivan, 1990; Ehrlich et.al, 1994) and to a lesser extent in the UK (Mason, Harrison & Chaloner, 1991; Mason, Harrison & Allen, 1995) and Sweden (Landström, 1993). Moreover, private investors in the US (Wetzel, 1981; Tymes & Krasner, 1983; Aram, 1989) and Canada (Riding & Short, 1987) demonstrate a clear preference for investing in high technology manufacturing industries. This might, in fact, be a product of geographical context as the samples were drawn from fertile areas of innovative activity. Other studies conducted in the US (Gaston & Bell, 1988; Postma & Sullivan, 1990), UK (Mason, Harrison & Chaloner, 1991) and Sweden (Landström, 1993) indicate much wider investor diversity in terms of industries backed. Informal investment activity is also highly localised in the US (Wetzel, 1981; Tymes & Krasner, 1983; Aram, 1989; Postma & Sullivan, 1990; Freear, Sohl & Wetzel, 1994a), Canada (Riding & Short, 1987), and the UK (Mason, Harrison & Chaloner, 1991).
Like venture capitalists (Tyebjee & Bruno, 1984), informal investors prefer to invest in markets and/or technologies which are familiar to them or in which they have had some direct experience (Sullivan, 1991; Mason, Harrison & Chaloner, 1991; Landström, 1993; Aram, 1989). In his studies, Fiet (1991; 1995a; 1995b) provided empirical support for the notion that business risk is considered more important by venture capitalists surveyed than was the case for private investors (p<.05). In view of their larger deal flow, venture capitalists are well positioned to assess market risk across a variety of different contexts. Based on their experience in business and industry, Fiet suggested that private investors may be comfortable in their abilities to deal effectively with business risk. He implies that a linkage may exist between investor characteristics and perceived business risk. It is important to note that Fiet's conclusion is couched in relative terms - one can not conclude that informal investors are not concerned with business risk at all.
Information economics literature often assumes that risk reducing information can be acquired but at a cost to acquiror. There is an incentive to develop specialisation insofar as information acquired for one purpose can be used, in whole or in part, for other purposes. It seems reasonable to suggest that an investor's base of prior experience can be viewed as a highly specialised source of risk reducing information. What implications does this have for individual investors? The answer it seems is dependent upon investment style.
When an investor chooses to invest solo or as a "lone wolf" (Gaston, 1989), opportunity evaluation and post investment monitoring is largely undertaken by the individual investor although they may consult their network of connections informally for additional information as required. Being largely self-reliant to assess business risk, private investors may restrict their opportunity set to areas in which they have some direct experience, hence:
P1: When an investor chooses to invest alone, they should display a propensity to invest in industries in which they have previous experience.
Investing as part of an investment syndicate would appear to offer a number of advantages to investors: i) the ability to participate in larger investments that could not be underwritten alone; ii) benefits arising from bringing together a more diverse set of investor skills and experience to bear on a venture; and iii) the opportunity to expand a network of contacts as a source of future investment leads. Depending on the nature of the experience base of its members, it also seems reasonable to suggest that an investment syndicate has a greater capacity to assess business risk over a wider variety of contexts. One can reasonably expect, however, that opportunities will be restricted to areas in which at least one member of the syndicate has direct experience, hence:
P2: When an investor chooses to invest with others, they should display a propensity to invest in industries in which at least one syndicate member has previous experience.
Managing Agency Risk
Fiet (1991; 1995a; 1995b) reported very strong support for the notion that informal investors were much more concerned about agency risk - the extent to which entrepreneurs and investors hold differing and possibly divergent interests - as opposed to business risk (p<.01). This finding is not altogether surprising given the consistent emphasis informal investors place on the quality of the entrepreneur/team as a discriminating criteria during the evaluation phase (Haar, Starr & MacMillan, 1988; Harrison & Mason, 1992; Stevenson & Coveney, 1994; Riding & Short, 1987). How do investors manage agency risk?
A number of authors have suggested that informal investors attempt to manage agency risk by becoming actively involved with the venture in a number of supportive or direct roles (Harrison & Mason, 1990; Landström, 1992; 1993). Evidence from the US (Wetzel, 1981; Tymes & Krasner, 1983; Gaston, 1989a; Freear, Sohl & Wetzel, 1990), Canada (Venture Economics, 1990), UK (Mason, Harrison & Chaloner, 1991; Mason, Harrison & Allen, 1995), and Sweden (Landström, 1993) indicate that a vast majority, usually 75% or more, of investors can be considered "active" although a substantial minority prefer to manage their investments in a "passive" fashion, receiving only periodic financial and operating reports. Aside from active involvement, investors can choose to limit their investments to opportunities presented to them by entrepreneurs which are known to them personally (Harrison & Mason, 1990; Landström, 1993) or to the referrer of the deal. In either case, the individual investor or the referrer can be a source of agency risk reducing information. Assuming that informal investors prefer to back deals with perceived lower levels of agency risk, one would expect that:
P3: When an investor chooses to invest alone, they should display a propensity to back entrepreneurs which are either know to them personally or to the referrer of the deal.
P4: When an investor chooses to invest with others, they should display a propensity to back entrepreneurs which are known to them personally, to other member(s) of the investment syndicate, or to the referrer of the deal.
Fiet (1991; 1995a; 1995b) concluded that private investors are generally more concerned with agency as opposed to business risk. In attempting to deal with agency risk, investors can choose to be actively involved with the venture in a number of capacities and/or limit their investment activity to opportunities lead by an individual known to them personally, to other investors in the syndicate and/or to referrer of the deal. Previous research has confirmed that the time commitment required of investors to actively manage their investments is often quite large. Neiswander (1985) reported that US private investors spend, on average, five hours per week with each venture in the first six months, and three and a half hours per week thereafter. A typical UK private investor spends one or two days a week assisting ventures (3i, 1994; Mason, Harrison & Allen, 1995) and Swedish investors surveyed by Landström (1993) spend, on average, twelve hours per month with investee firms. What is the implication of active involvement in terms of portfolio size? We suggest that the answer to this question is also dependent upon investment style.
A perceived advantage of investing by way of syndicates is the ability to diversify risk over a larger number of investments. It is reasonable to suggest that it is not necessary for a given investor to be actively involved with all the ventures in which he has invested, rather a member(s) of the syndicate whose background is best suited to the task can assume an active role while other members are only passively involved. It follows that time constraints will be particularly acute for investors who forgo the benefits of co-investment and choose to invest primarily on their own, hence:
P5: The greater the propensity of an investor to invest on their own, the smaller the number of investments in their portfolio.
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