Overlooked When Raising Capital: Investor Preferences

If you're an entrepreneur looking for money, you probably have a list of factors that you've heard increase the odds that someone will finance your business. But here's one you might not have considered: homophily.

For those of you who do not spend your spare time reading sociology textbooks, homophily is just a fancy word expressing the birds-of-a-feather-flock-together cliché.

Sociologists have found homophily to be very common. Studies show that rich people want to associate with other rich people. Lawyers like to be with other lawyers. Doctors prefer to hang with other doctors. And people of the same gender, race, and/or ethnic group tend to favor each other's company.

So it shouldn't surprise you that investors prefer to finance entrepreneurs who are similar to them. But you might not have considered the implications of this basic tenet of human behavior.

Evidence Across a Variety of Settings

Academic research has shown that a wide variety of investors prefer to finance entrepreneurs who are similar to them. For example, John Becker-Blease of Washington State University and Jeffrey Sohl of the University of New Hampshire found that business angels are more likely to invest in startups founded by entrepreneurs who are of the same gender.

In a completely different setting—trade credit in Africa—Raymond Fisman of Columbia University concluded that trade creditors are twice as likely to finance entrepreneurs if they are from the same ethnic group than if they are from a different one.

In yet another context, Ola Bengtsson of the University of Illinois and David H. Hsu of the University of Pennsylvania discovered that the founders of venture capital-backed startups and the venture capitalists who serve on their boards are much more likely than random to have the same ethnicity. In fact, they find that having "a shared ethnicity almost doubles the likelihood of a match."

Why Investors Prefer Entrepreneurs Who Look Like Them

Academics have a lot of theories about why people favor those who are similar to them, but two are particularly important to entrepreneurial finance. The first is that similarity breeds trust between entrepreneurs and investors. According to Bengtsson and Hsu, it's easier to develop shared understandings and implicit agreements with people who are like you.

The second is that similarity gives investors more control over the entrepreneurs they back. Being similar increases the odds that the entrepreneur and investor travel in the same social circles. Because ostracizing someone from a common social network is a good way to punish bad behavior, Bengtsson and Hsu explain that investors prefer similar entrepreneurs as a way to get more leverage over them.

The Implications

For an individual entrepreneur, the implications of homophily for financing are fairly benign. Your odds of getting money from someone who is similar to you are greater than the odds of getting it from someone who is different. But homophily exists across a variety of dimensions—race, age, gender, ethnicity, occupation, and so on. So your odds of getting a specific investment might not be that different than those of anyone else because of the way your particular attributes match with those of investors. For instance, you might be twice as old, the opposite gender, and of a different race and ethnicity of an investor, but your common occupation of software engineering might be enough similarity to trigger an investment.

For a society, however, homophily brings with it the problem of unintentional bias. Most people won't condone the direct discrimination of an investor who says, "I won't invest in so-and-so's business because he's black or because she's a woman." But we are more ambivalent about the type of bias that comes from homophily. We tend to take for granted that people will be more comfortable investing in entrepreneurs with whom a common bond exists.

However, if investors are more likely to provide capital to entrepreneurs who are of the same race, age, gender, ethnicity, and/or occupation as them, and investors aren't spread out evenly across these characteristics, then the entrepreneurs who look different from the typical investor are at a disadvantage when looking for money.

While no one said that investors should treat all business owners exactly the same, homophily makes entrepreneurs' access to money uneven when looked at across the whole economy. The seemingly innocuous higher comfort level that male investors have with male entrepreneurs, investors trained in engineering have for engineer-led startups, and Chinese American financiers have with entrepreneurs of Chinese heritage, might mean that black female chemists have little access to capital.

Tricky Solution

That's one of the arguments for the creation of female-only angel groups or black-led venture capital firms. If homophily exists, one way to combat any biases it creates is to offer the benefits of homophily to the disadvantaged groups as well.

But these policies are a tricky business to make work because, in aggregate, homophily works against the disadvantaged group. If all investors put money in businesses run by people who look like them, then entrepreneurs who don't look like most investors will have a harder time getting capital. So if underrepresented groups exploit homophily as a finance tool, and everyone follows suit, those who look least like the typical investor will be worst off.

Moreover, if investors feel more comfortable investing in similar-looking entrepreneurs, then keeping them from operating in their comfort zone might stop them from investing at all.

Policymakers might decide that the costs of homophily outweigh the benefits. But before they take action against it, they need to understand all the ways policies to reduce it could affect financing for entrepreneurs.

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