How business angels influence each other’s investment decisions – the pitfalls to watch out for

Business angels often look at each other when making investment decisions. But it takes experience to distinguish between valuable and misleading signals.

Business angels investing in early stages face a lot of uncertainty and lack of information. To reduce risk, many join together in angel networks, where they can share knowledge and capital. But the sheer volume of possible investments quickly becomes overwhelming, leading investors to seek shortcuts. One such shortcut is social proof – using other investors’ decisions as a signal of an investment’s attractiveness.

But researchers who have analyzed over 77,000 investment decisions from 469 members of a US business angel network, complemented by an experimental study with 367 investors, can now show that not all signals are equally informative.

Herd behavior that leads to failure

The researchers distinguish between external social proof, which occurs when new investors choose to enter a company, and internal social proof, which is when existing investors in a particular start-up choose to invest again. The latter signal, based on transparency and experience, proved to be significantly more valuable.

The analysis shows that inexperienced angels tend to follow the most visible – but least informative – external signals. They are strongly influenced by other new investors jumping on an offer, which can lead to herd behaviour and decisions based on availability rather than quality. Experienced angels, on the other hand, use social proof more selectively. They pay more attention to internal signals from investors who already know the company and have access to actual information.

Differences in yields

The differences are also reflected in the returns. Internal social proof is linked to higher financial performance, while external social proof showed no positive relationship. So experience doesn’t just reduce the propensity to imitate others – it increases the ability to imitate the right people.

The study points to a challenge for angel networks: internal social proof is often less visible than external discussions among new investors. This can cause inexperienced members to overestimate superficial signals. By making it clearer which companies existing investors choose to re-enter, and why, networks can reduce the risk of unreflective herd behavior and improve decision-making for all members.

More about the article and the authors
The article Following in the Footsteps of Others: Social Proof in Angel Groups is published in the scientific journal Entrepreneurship Theory and Practice.

Authors are Henrik Wesemann Lekkas, IE Business School, Spain, Dean Shepherd, University of Notre Dame, USA, Torben Antretter University of St. Gallen, Switzerland and Joakim Wincent at University of St. Gallen and Hanken School of Economics, Finland.