When entrepreneurs are casting about for venture capitalists to invest in their startup, one important aspect they should look at is if the VC has been involved in a crisis, especially lawsuits.
If they have, it can actually be a good thing. A new study from the University of Iowa’s Tippie College of Business finds that venture capitalists who have been involved in lawsuits are more apt to stick with their ventures when they experience a similar crisis.
The new study looks at under what circumstances venture capitalists are more likely to pull the plug on their relationship with a business in crisis by seeing how they address startups that face a lawsuit. Researchers looked at 105 startup ventures that were sued between 2006 and 2009 and how 435 venture capitalists related with those ventures responded to the suits.
The study found that VCs with more investment experience were more likely to make additional investments despite the lawsuits, and VCs that already invested a significant amount of money into a venture were more likely to continue investing.
But the VC’s own lawsuit experience turned out to be an important factor in determining whether the funding relationship continued.
“Venture capitalists learn through their own experience and develop ‘scar tissue’ that gives them more confidence in their abilities to manage a crisis in their venture,” said Miranda Welbourne Eleazar, assistant professor of management and entrepreneurship in the Tippie College of Business and John Pappajohn Entrepreneurial Center (Iowa JPEC).
This helps the business, she said, because VCs with greater experience can minimize the uncertainty associated with the venture lawsuit, making the VCs more likely to see the lawsuit as acceptable and the venture worthy of continued investment. This is particularly true when the VCs were able to resolve their own lawsuits through a settlement. However, VCs that were sued, rather than bringing the lawsuit, were less likely to continue to invest, likely due to their own negative experience with lawsuits.
Researchers also conducted a series of interviews with venture capitalists who acknowledged that while lawsuits and other crises in their ventures are “awful and scary,” they are not a cause for panic and not something that will necessarily keep them from making later investments.
Welbourne Eleazar said the study suggests entrepreneurs should look deeper into a potential VC’s background to see if they’ve been involved in their own crises such as lawsuits and how those experiences turned out before committing to a relationship. That will help entrepreneurs assess their risk of being abandoned when crisis strikes.
“By understanding the VC’s crisis history and developing deeper relationships with those VCs, the entrepreneurs can more fully control potential funding outcomes in the event of a crisis,” she said.
The study, “Who Will Stay When Crisis Strikes? Venture Capitalist Threat-Defiant Learning Response to Ventures in Crisis,” was co-authored by Haemin Dennis Park of the University of Texas at Dallas and is published in the August 2022 issue of the Academy of Management Journal.
Click here for a video of Welbourne Eleazar discussing this study.
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