It’s not surprising that founders looking for early-stage funding turn to their alumni networks. After all, information in the private markets is scarce, so people turn to who they know.
But researchers who analyzed almost two decades of data on early-stage venture capital activity have found evidence of just how powerful these alumni networks are to the ultimate viability of start-ups.
In fact, the size of a founder’s own alumni network may be the deciding factor in the entrepreneur’s early-stage fundraising success. Investors are more likely to position their portfolio to invest in startups created by founders from their alma mater and to make bigger bets on these firms. For investors and founders alike, the effect is paying off, according to a new research paper, called “Alumni Networks in Entrepreneurial Financing.”
In one-third of all early-stage venture capital investments over a 19-year period, the founder and the investor attended the same college or university. Early-stage investors are more inclined to invest in startups run by founders from their alma mater — even when the new business is “relatively similar” to other companies in the same industry at the time, according to authors Jon Garfinkel, professor of finance at the business school of the University of Iowa, Erik Mayer, assistant professor of finance at Southern Methodist University, and Emmanuel Yimfor, assistant professor of finance, at the University of Michigan’s Ross School of Business.
“Alumni networks are an important channel for start-up-investor matching. That’s not a surprise,” Yimfor told Institutional Investor. “What came as a surprise was the magnitude of this in our data.” For the study, the researchers compiled PitchBook data on all deal activity from 2002 to 2020 in which either the founders of the start up or the venture capital firm attended one of the 550 largest U.S. universities.
The researchers focused on early-stage equity investments, because “alumni networks are likely to play a larger role in this space given the general lack of information on” fledgling companies. In the public markets, companies file regulatory documents with the Securities and Exchange Commission, signaling to the universe of investors that it is trying to raise capital. In contrast, in the private markets, Yimfor said, it’s often difficult for investors to find out who is looking for funds and even more difficult to access detailed information about a startup’s business model, potential competitors, size of the potential market, and other data.
“It’s very hard to get the list of companies that are raising funding. And even if you do get the list, it’s not easy to screen,” Yimfor said.
But, if an investor went to the same school as the founder, he or she may have better access to “soft information” about the company. For example, Yimfor said, “Now [as an investor], I have the list, and I know [a founder] is raising funds. I know the founder went to the University of Iowa and got an A in math. But how difficult are the math classes? If I went to Iowa, I know they’re tough. If I didn’t, I would only know the general reputation of the University of Iowa.”
The findings of the study come at a time when allocators and asset managers, including venture capital firms, are working to diversify the ranks of their employees as well as senior management. With VC-backed firms also representing more than 40 percent of initial public offerings in the U.S., the startups are a huge part of the economy. Networks can both reinforce the status quo and be an untapped route to reach new communities.
The research study offered a more nuanced view of networks, showing “that founders’ connections to early-stage investors through shared education networks [were] more important” than either the academic quality of the school or shared geography, according to the authors.
The education connection between founder and investor is more critical than the quality of the school, the study said. For instance, the same alma-mater effect is even stronger when the founder and the investor went to a less prestigious school, the research found. To determine “prestige” or the investors’ perception of the founders’ alma maters, Garfinkel, Mayer, and Yimfor calculated the mean SAT scores — the average SAT scores of incoming students at the university the founder of the portfolio companies attended. They did this for each university included in the sample set. For schools with higher SAT scores, the positive effect of a shared alma mater is smaller than for founders from schools with average and lower SAT scores. In fact, an inflated average SAT score brings the effect on the likelihood of investing down by 0.06 percentage points, the report said.
“This result suggests that connections matter less when founders have strong public signals of their quality, implying connections’ importance may stem from their ability to resolve information asymmetries,” the authors wrote.
This shows, the authors argue, that it’s not a preference thing; it’s about information. The research results seem to suggest one of two things, said Yimfor: Either investors have a preference toward investing in startups with connections to their alma mater or they are able to learn strong information about the startups. If the matching was simply a result of preference, Yimfor argued, it would be reflected in the company’s performance.
“If it were just a preference, when you look at the outcomes of the investments, they might not do as well,” Yimfor said. “Because, instead of searching hard, [the investors] are doing it based on their preferences.”
Investors’ stock in founders with common educational backgrounds tend to perform better than their other investments. In fact, the startups are 33 percent more likely to conduct an IPO post-funding and are 10 percent more likely to receive patents.
“If I’m an investor, maybe I have some bar — or standard — an investor needs to cross before I invest in them,” Mayer told II. “If I’m exhibiting favoritism toward investing in people from my alma mater, I might lower the bar a little bit for them.”
But, as reflected in the outperformance of the alumni-connected start-ups, the lowering of the bar isn’t happening, Mayer said. Instead, as a result of their university connection, investors are accessing more robust information about the company they’re investing in.
“It’s an information story, not a lowering-of-the-bar story,” Mayer said.
The effect is also stronger when the investor does not have “alternate ties” to the startup, meaning they don’t have connections to other investors who are involved with the founder’s company.
“If you look at a group of investors that are investing in a start-up for the first time and they don't know each other — so they have never collaborated on any prior deal — the alumni network appears to be especially important,” Yimfor said.
Researchers also found that a shared alma mater has a greater effect on early-stage fundraising than geographical location of the company. When accounting for all the factors that may enhance early-stage fundraising, the authors found that a shared alma mater, on average, results in 19 percent more funding in the early stage.
As a result, founders who went to schools with large alumni networks are able to raise more capital than other founders, the report said. In fact, the size of the alumni network may be the most important factor in early stage financing. The authors controlled for other factors that commonly affect early-stage financing, including the distance between entrepreneur and investor, the age of the VC firm, the founder’s university size, the university’s academic quality, and the number of alumni that are early-stage investors.
“None absorbed the importance of alumni connections within investor-founder dyads,” the authors wrote.