Referrals and Blind Trust in Venture Capital Due Diligence

While researchers have made important strides into explaining why venture capitalists fail to help companies to become better, the question of why they select poor quality start-ups to invest in the first place has received scant attention. In this paper, we offer a behavioral account of the origins and the nature of biases in due diligence, which is the most critical pre-investment phase, by focusing on referrals from other venture capitalists. We analyze the duration of due diligence performed by a large pool of investment managers for 535 early stage start-ups and correct for potential selection errors. We show that compared to cold arrivals, strong-tie referrals serve as heuristics and lead to a less exhaustive due diligence whereas weak-tie referrals prompt a more exhaustive due diligence. The heuristic effect of strong-tie referrals is accentuated the greater is the recent number of successful exits from the investment manger’s portfolio or the investment manager’s founder experience. For weak-tie r...