Does Social Proximity Enhance Business Partnerships? Theory and Evidence from Ethnicity’s Role in US Venture Capital

We develop a formal model to understand the selection and influence effects of social proximity between business partners. Consistent with the model’s predictions, we find that US venture capitalists (VCs) are more likely to select startups with coethnic executives for investment, particularly when the probability of the startups’ success appears low. Ethnic proximity between VCs and the startups they invest in is positively related to performance, measured by the probability of the companies’ successful exit through acquisitions and initial public offerings (IPOs), and net income after IPO. Two-stage regression estimates suggest that these positive performance outcomes are largely due to influence, that is, superior communication and coordination between coethnic VCs and startup executives after the investment. To the extent that VCs expect to work better with coethnic startups, they invest in coethnic ventures that are of lower observable quality than non-coethnic ventures