The art of persuasion in startup funding

When dealing with a group of potential investors, entrepreneurs may leverage conflicts or align interests to encourage persuasion or truthful communication

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

Silicon Valley has created an obsession with turning startups into unicorns, and now, with the era of machine learning and artificial intelligence, markets are again rushing to turn a vision into valuation. At the back of it are venture capitalists, angel investors, investment banks, and other financiers looking for emerging businesses to fund.

As entrepreneurs thirst for capital, investors assemble temporary alliances or syndicates to meet the need. The most common collaboration to target startup equity investments is venture capital syndicates. Another way is using syndicated loans, debt instruments where lenders or investors come together to provide a loan to a company.

“Syndication could be motivated by many factors, with each investor having their own interest and may only be willing to invest a limited amount of money,” says Luo Dan, Assistant Professor in the Department of Finance at the Chinese University of Hong Kong (CUHK) Business School. “For entrepreneurs, sometimes it is good to raise money from multiple investors instead of one.”

The benefit of fundraising from multiple investors is not merely for the money, Professor Luo explains, but to take advantage of the information sharing. When working on the same venture, investors normally exchange details about the project’s quality and perceptions with one another in informal or formal ways.

For instance, in syndicated loans, a company needing a large loan, typically more than US$1 million, reaches out to an investment bank with confidential information about the project. If the project is deemed profitable, the bank will then accept the mandate to be the lead arranger to invite other lenders to form a syndicate.

At this moment, lenders will discuss the loan terms and how much funding each will contribute based on the risk they’re willing to accept with the lead arranger. Before agreeing to invest, lenders exchange various information while taking data from others into account, simultaneously deciphering others’ strategies to align with their best interests.

“If the investors are not on the same page, entrepreneurs need to consider the diverse interests between them, making things more complicated,” Professor Luo adds. “Communication between investors is very natural and important, and analysing their interaction is not simple because it’s a hard game. Every party is the sender and receiver at the same time.”

Although investment syndicates are quite common, there is a limited understanding of how different investors with different interests communicate. Therefore, Professor Luo uses game theory to build a model to figure out the optimal structures for entrepreneurs to influence communication between investors based on aligned or divergent interests.

“Communication between investors is very natural and important, and analysing their interaction is not simple because it’s a hard game. Every party is the sender and receiver at the same time.”

Professor Luo Dan

How to build persuasion cascades

As explained in his latest paper published in the Journal of Finance, Raising capital from investor syndicates with strategic communication, Professor Luo’s model starts with an entrepreneur owning a project that would generate positive cash flows if it is good and zero if it is bad. The project requires a minimum financial requirement to take off, so the entrepreneur must make offers to one or multiple investors. Investors will communicate strategically with each other before deciding to accept or reject offers.

“Investors’ profits depend on the project outcome, so they want to obtain information about the project from others to enable better investment decisions,” Professor Luo says. “However, investors may not truthfully share information with others if they have conflicts of interest.”

As the project requires a minimum capital, an investor eager to invest will hope others to join. This hidden intention may create conflicts of interest, where one investor’s needs and goals do not align with those of the others. Professor Luo argues that depending on the project’s quality, the entrepreneur’s optimal contract can be flat that promises identical returns to all investors, or a hierarchical contract that offers investors different returns.

A flat contract can involve a single or multiple investors, but a hierarchical one requires a syndicate. With different returns, hierarchical contracts create conflicts of interest between investors, making it harder for them to communicate honestly with others. On the flip side, hierarchical contracts encourage persuasion among investors, as those with higher returns have more incentive to invest and will convince other investors to participate.

If the project is likely to fail based on ex ante information, the optimal contract should be flat to manage investors’ enthusiasm and allow them to share observations with each other. Transparency would sway hesitant investors to participate based on their shared information about the project’s viability.

However, when the project is anticipated to be of good quality, the entrepreneur can secure funding by promising high returns to investors, but the entrepreneur is concerned about the information rents earned by investors. If investors communicate truthfully to each other, bad but not fatal news will be completely shared among investors. That means the entrepreneur needs to promise everyone high returns to secure funding.

In a hierarchical structure, due to the conflicts of interest among investors, those with the higher promised return would actively persuade other investors to participate and withhold bad but not fatal news. Therefore, the entrepreneur only needs to promise a subset of investors high returns, while promising lower returns to others. Such a properly designed hierarchical contract is optimal, as it compromises the communication between investors and reduces their ability to earn information rents.

Persuasion between investors leads to persuasion cascades, meaning that those investing in an uncertain project due to persuasion from others will attempt to persuade more investors. These cascades enable the syndicate to offer differentiated returns to each investor. In practice, an investor’s position in the hierarchy may depend on his influence, reputation, and ability to do due diligence.

Balancing risks and expectations

The findings can explain why most venture capital syndicates are arranged in flat structures, where all investors receive identical returns to accommodate clear communication and screening for lower-quality projects. On the contrary, most syndicated loans are set in hierarchical structures where the lead investors or lead lenders serve as underwriters responsible for managing communication and convincing other investors to join.

The entrepreneur provides high underwriting fees to underwriters for their efforts to organise syndicates, negotiate terms, screen deals, and align with the entrepreneur’s interest. Since only lead lenders in syndicated loans can access the firm’s confidential information, Professor Luo argues that hierarchical structures result in communication problems between lead investors and others, which is supported by many legal cases.

The notable one is the IFE Fund vs. Goldman Sachs International case, where investment bank Goldman Sachs arranged a syndicated loan in 2000 for a company acquisition in Europe with the participation of an investment firm, IFE Fund. The latter alleged Goldman had misrepresented the financial health of the acquired company and failed to disclose critical risks associated with the transaction.

With consequences like reputational damage and lawsuits, lead investors must be cautious in their communications. Taking this into account, Professor Luo finds that a higher risk of misinterpreting information typically encourages honest communication, making flat structures preferable. However, if the risks of misrepresentation are lower, hierarchical contracts will encourage lead investors to ensure the syndicate operates effectively.

Adoption in the broader setting

Although Professor Luo’s theory is formulated in the context of an entrepreneur raising capital from multiple investors, it can be broadly applied to other settings. “Our model is simple and does not rely on very particular things, as it is basically an entrepreneur-proposed contract, where the investors observe the project and then communicate before making a decision. All of these elements are quite standard.”

In a corporate setting, a business owner may use hierarchical contracts tied to additional compensation, like a bonus or promotion, to encourage employees to work on projects based on their knowledge and share it with others through strategic communication.

Professor Luo’s theory suggests that for firms working on projects with low forecasted quality, the organisation structure should be flat to facilitate communication between employees. In contrast, firms with good return projects should build a hierarchy by appointing multiple levels of management, where managers can earn more from the completed tasks and persuade other employees to exert effort.