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Chapter 1 Introduction
1.1 The origin of a new business
New startups play an important role in the process of economic growth. According to White Paper On Small And Medium Enterprises In Taiwan 2014, there were more than a million Small and Medium Enterprises (SMEs) in Taiwan in 20131, employing 8.588 million or 78.30 percent of the total number of employees in Taiwan at that time.
Although these numbers seem quite large and might be an important factor of economic growth, more than one half of them disappear before they mature and contribute to GDP.
Only around 48.69% of new ventures last over 10 years. This high failure rate shows the harsh environment investors in Taiwan confront. Investors like VCs or other funds face unforeseen future because of uncertainties of earnings and sustainable cash flows.
Figure 1: Trend of New Ventures in Taiwan
1 According to the Ministry of Economic Affairs, the actual number of SMEs is 1,331,182 in Taiwan in 2013.
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Startup companies grow amazingly fast and play the role of boosting the economy, no doubt. But what kind of difficulties do they face that induce a high failure rate. Most of them actually face the problem of funding. They are unable to raise funds at the early stages2 of a new venture. Young startups with no creditworthiness have little possibility of getting mortgages from banks, and also have little chance to raise funds from specific financial institutions or general public. They hold abundant ideas and advanced technologies in vain, without proper investors. Thus, funding support from specialized sources like venture capital firms or a public sector institution like the sovereign wealth fund is important for their long-run development.
Figure 2: Stages of New Ventures
Table 1: Definition of New Venture Stages Stage Definition
Stage 1 Seed Stage Stage 2 Startup Stage Stage 3 Expansion Stage Stage 4 Mezzanine Stage Stage 5 Turnaround Stage
2 Early stage means seed stage, startup stage and expansion stage here
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While startups do not always succeed in delivering the promised returns which are based on uncertain future growth, decisions to choose promising startups are full of uncertainty and information asymmetry. Investors like VCs or SWF have to put efforts in gathering information and evaluating each investment. Thus, what is needed is the ability to decide which target to invest in and to distinguish the probability of different returns materializing. To solve the information asymmetry problem and to avoid the agency problem, a series of platforms try to balance and exchange information from the two sides of the sectors. We call this kind of platform the social network.
Social network links provide an effective way to deal with information asymmetry.
There are two main branches having their own explanations. First is the social network linkages between the investing and invested companies. Literature has covered educational, background and political linkages, all of which are based on the relationships among the members of parties engaged. The second issue is the distinctive power that the managers or board of directors hold. Different kinds of power are held, like specialty managers, a unique human capital, or a company’s outstanding reputation.
These result in different levels of return to investments.
1.2 The Social network linkages to solve information asymmetry problem
The social network linkages reveal the relationships between the managers and board of directors within investing and invested companies. Some of them have the same educational background, some have the same intersection of past working experience in private sector and others may have some time overlapped in public sector.
No matter which kind of linkages exist, we classify them in the category of social network links.
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educational links among managers and board of directors of both sides of companies.The idea first came up in 2007 with a benchmark paper, Cohen (2007).3 Cohen (2007) proposed the idea that educational link serves as a bridge to investing and invested companies, and defined four types of linkages between managers within investing and invested companies. He proved that the same educational background leads to higher investments in invested companies and leads to a higher return. And of course, a stronger connection or linkage may bring out a relatively significant result. Thus, the educational link becomes a good explanation to eliminate the information asymmetry.
It does help the investing company to find out investment-worthy targets. Here we decide to replicate a similar method to measure the educational link in Taiwan’s new venture market and expect to obtain a convincing outcome.
The second kind of the linkages follow the concept of background link. As Saxenian (2002) has proved, managers’ past experience may bring some effect to the current position. For example, Saxenian (2002) proved that a common experience in Silicon Valley is positive to start a new venture in Hsinchu and Shanghai. Also, if there’s some connection between managers or board directors in terms of past experience, the information asymmetry problem may be solved. Taiwanese market is actually a good target to measure the background link. Unlike the giant market, it contains fewer companies and managers. Besides, most of the technology companies are located in the same cities, such as Hsinchu. All the people, companies, news and issues seem related to each other in this condition.
3 Cohen 2007, 9. Cohen L., Frazzini A., Malloy C. (2008). The small world of investing: Board connections and mutual fund returns. Journal of Political Economy 116 (5), 951-979.
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The third kind of linkages is political links, which is definitely the most important and powerful link. Once an enterprise has some linkages with the authorities, it might probably has a great chance of providing abnormal returns because it may obtain some profitable news which others don’t know. And most of the time, those who are privy to firsthand information before others tend to execute specific actions in advance and react to the industry policy ahead of their competitors. Since every industrial policy and any government related projects involve giant sums of money, its implications are worth inquiry and research. The main purpose here is to judge the unreasonable profit earned because of the social network system, and further uncover the veil of the complicated social network relationships.
1.3 The distinctive power to solve information asymmetry problem
Linkages among managers of investing and invested companies can effectively eliminate a portion of information asymmetry problem. But what if there are no links between them? To choose invested companies which reveal some positive signals would be the closest approach. These positive signals not only contain firms’ features but also the human capital’s characteristics. We classify them into three categories. First, the specialty of human capital. Second, the reputation of the invested companies, the underwriters and the VC. Third, the political patronage enjoyed by specific invested companies.
Under the human capital studies, educational background and past experience are the main ideas to discuss. Whether managers of the invested companies have MBA or a professional degree may cause different leading styles. Also, if the managers have some special professional expertise, it may signal some positive messages to potential investors. For example, managers with past experience of VCs or startup may signal a
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profession in new venture. Managers with special financial backgrounds may take a specialized view of financial operations or management. Above all, the characteristics of managers not only reveal signals to investors but are also directly related to the standing of the company and its corresponding industries.
Besides human characteristics, reputation may also be a good measure of a firm’s characteristics. The invested companies’ own reputation may release some signals to its investors. A good reputation may generate a high goodwill and make it easier to raise funds. VCs’ characteristics also have some impact on the companies’ performance. In past literature, some variables like VC market share may lead to a positive effect to invested companies’ long run performance. Other variables such as VC age, VC capital or IPO frequency may not have discernible effects on performance but are still widely discussed. Apart from the VC, reputation of underwriters also affects performance. A good underwriter perfectly audits a firm’s financial condition and then decide to underwrite a capital issue. Reputations of different parties provide a signal to parties who lack information.
In addition to these two categories, political power might be the most powerful and valuable. Managers or members of board of directors may sometimes hold a concurrent post in public sector. In that sense, companies who hold some political power may gain the possibility to set some “rules” which are profitable for themselves.
In this case, there is no doubt that generating a corresponding return is a piece of cake for those who hold political power on their own.
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1.4 The level of Linkages and distinctive power
To deal with the information asymmetry problem, we define two ways of finding solutions. First is the own distinctive power that a particular invested company has. It may reflect in characteristics the company has, including human capital, reputation of all parties concerned and the political power. But if there’s no power, then the second one, social network linkage is used to deal with the problem. The linkages include educational links, background links and political links. The closer the linkages appear, the more significant is the effect. The figure below shows the classification of these linkages and power.
Figure 3: Solutions to solving information asymmetric problem
From past experience, we suppose the investing parties choose the investment targets following rationality which means the decisions are mainly based on invested companies’ performance. But if the performance cannot be seen or considered, the managers have to make investment decisions based on educational link or even overdrive the effect of the performance. It means that managers choose investment targets based upon linkages with others rather than performance. Furthermore, the effect of political link may be the strongest. It drives not only the effect of educational links but also the performance-oriented behavior. In order to clarify the level of these linkages, we draw a level figure to show them. As the figures below, there are three situations showing the effectiveness of the linkages.
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Figure 4: The effectiveness area of linkages
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1.5 The political related issue in Taiwan
The political issue is always an unknown factor in literature, because many of the details and references are not available to the general public. But inside the black box of the government sector, we often hear of an amazing performance in National Development Funds. For example, the asset management of National Development Fund has had a 3700% growth in 25 years. How do they pick the investment targets and how to efficiently manage their huge positions? Is the profitability reasonable or just fit in the minimum requirement of legal compliance? It is an important issue to dig out how National Development Fund is managed, which is originally from the tax that the general public paid. We here consider the National Development Fund as the political sector because it holds the right to affect and maintain the operation of the market.
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