Value of Social Capital
The value of social capital in starting new ventures
Patricia H. Thornton ©
Entrepreneurs need to acquire three types of capital to achieve success in starting a new venture—social, human, and financial.
Social capital is a quality derived from the structure of an individual’s network relationships—it is not an intrinsic characteristic of an individual. Ownership of the network relationship is jointly held among the members of a network and is not solely the property of the individual. Social capital provides the relationships through which an entrepreneur receives opportunities to use human and financial capital. How an individual entrepreneur structures his or her network can determine the value of their social capital and thus their ability to act in an entrepreneurial manner.
Human capital refers to individual attributes, such as personality, education, intelligence, and job experience. A central challenge for seed stage founders and investors of new ventures is how to create value by the acquisition of human capital, in particular the building of a management team. A start up with an experienced and appropriately growth staged management team will receive a higher valuation by investors. Because new ventures have many “liabilities of newness,” the attraction of a talented management team is one of the most important seed stage assets. It takes social capital to be able to recruit the best human capital. Attracting human capital may be obtained in a number of ways for example in developing an advisory board whose social capital the entrepreneur may draw upon, by leveraging external resources as in collaborative alliances with strategic partners, and investor networks, among others.
You may ask—what are networks and what are opportunities. Networks are relations with individuals that provide access to resources such as investors, customers, experts, strategic alliances, influence makers of any kind. Opportunities are innovative ideas, information benefits that derive from access, timing, referrals, control benefits, ability to broker, and competitive advantage. For example an entrepreneur that can generate competing terms sheets will receive a higher valuation for their start-up. In this example an entrepreneur is more likely to be successful if he or she has sufficient structural holes, rather than too much cohesion in their network. This is because structural holes dampen investors’ ability to collude among themselves against the entrepreneur. On the other hand, the nascent entrepreneur with little social capital may benefit from cohesive networks in which he or she can leverage the social capital of a highly experienced, well respected member of their network. In theory, not being able to broker competition directly for oneself will result in less return to the entrepreneur, but may be the only suitable option when the entrepreneur’s social capital is not well developed.
The following stylized model illustrates the relationship between the three capitals.
Source: Patricia H. Thornton ©
Two different networks structures produce two types of social capital which serve different purposes in the entrepreneurial process, for example 1) the discovery of entrepreneurial ideas and 2) the resources to commercialize those ideas. An increased ability to discover entrepreneurial ideas is associated with a network structure with “structural holes,” (Burt 2004). A structural hole in a network is when there is separation between nonredundant contacts. A network characterized by structural holes has an absence of cohesion and structural equivalence (see figure 1.1, Burt 1992). Structural equivalence is when primary contacts do not have direct ties to one another, but each contact leads to the same cluster of more distant contacts that share the same information (see figure 1.2, Burt 1992). Under certain circumstances explained below, an increased ability to garner the resources to commercialize entrepreneurial ideas, e.g., human capital and finance capital, is associated with a network structure with “cohesion.” However, the exception is the experienced entrepreneur with sufficient social capital to broker competition for a term sheet. Cohesion in a network occurs when primary contacts are connected to one another and in theory share the same information. (Burt 1992). The following over simplified diagrams illustrate these two different network structures.
Networks A,B, and C in figure 1.1. each have 4 major structural holes. In theory network A is most efficient to maintain in terms of the time needed to stay in touch with contacts, network C is the least efficient, yet the three networks essentially provide the same information and control benefits. The lesson here is to not engage in network expansion that is too redundant as it will be too demanding of your time and have diminishing returns.
The two networks in figure 1.2 do not have structural holes, but high cohesion.
The start-up community of investors and their associates tends to be characterized by cohesive networks for several reasons. New ventures are highly risky and network cohesion mitigates risk because it signals reputation. For example, an entrepreneur is more likely to successfully get the attention of investors if they make contact with the investor through a trusted referral such as a well known attorney specializing in start-up law, your professors at Fuqua, help from staff at the Fuqua Centre for Innovation and Entrepreneurship, your membership in the Council for Entrepreneurial Development, among others. Cold calls and emailing your business plan are highly unlikely to result in making a successful contact in the venturing community either with Angels or venture capitalists. Under conditions of high cohesion in the investor community, one way for an entrepreneur to mitigate investor cohesion in brokering terms and conditions is to seek term sheets from geographically different regions such as Research Triangle Park (RTP) and Silicon Valley (SV). While cross region syndications are becoming more common, in theory regional differences in all likelihood will dampen the probability of network cohesion. However, such brokering strategies may result in relocating as investors typically require geographically local control.
Large sample studies support social capital theory. For example they indicate that entrepreneurs with well developed social capital are more likely to receive funding (Shane and Cable 2002) and those with higher status social capital as indicated by prominent partners, e.g. VC investor in the top quartile of firms, will achieve greater success at exit as measured by acquisition premiums and IPO status (Stuart, Hoang, and Hybels 1999).