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How much should an investor trust the startup entrepreneur? A network model

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Abstract

Trust is an important determinant of start-up financing. In a simple agent-based model it is determined what the best trusting strategy is for a collective of investors and whether it is rational for an individual investor to deviate from this collective optimum. Trust depends on a measure of social distance and is the precondition for investment. Trust increases and decreases based on whether an investor is satisfied with the interest payments received from an entrepreneur. If an investor is dissatisfied, he terminates the relation with the entrepreneur. For assessing the quality of their own investments, investors communicate with other investors in a network-like structure. I find that, as a collective, it is best for investors to compare their returns critically in order to identify unproductive entrepreneurs, but to be tolerant regarding existing links to entrepreneurs in order not to terminate profitable relations because of minor productivity drops. However, it is optimal for an individual investor to deviate from this strategy and to be less easily disappointed, but to decrease trust in larger steps. In a sense, an individual investor can free ride on the others’ critical assessment. If all investors behave according to this latter strategy, too many unproductive firms remain in the market and the average investor’s return is lower than in the collective optimum.

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Notes

  1. See Kelly and Hay (2003) for a fuller treatment of the investor-entrepreneur relationship as a principal-agent relationship.

  2. A full description and the complete code of the model, which was built in NetLogo (Wilensky 1999), is available at http://www.openabm.org/model/3813/version/5/view.

  3. In reality, the investor does usually not receive his initial investment back until the end of the investment relationship. Thus, in reality, what the investor updates each period is the expectation of an eventual return, based on current business growth. Modeling the update of such an expectation would require the model to be considerably more complex, and would destroy the analogy to repeated games with stochastic returns. Furthermore, personal loans - more akin to the present model—are very frequently granted by angels as well (Prowse 1998). Thus, this simplification was chosen to grasp the main idea.

  4. For the sake of simplicity the subscript \(i\) to denote entrepreneur \(i\) was omitted.

  5. He does not know his production function and therefore does not know the size of the stochastic component.

  6. A detailed description of the calibration procedure can be found at http://www.openabm.org/model/3813/version/5/view.

  7. This was also done in Roos and Klabunde (2013); more detailed results can be found there.

  8. The author would like to thank Shu-Heng Chen for this suggestion.

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  1. Max Planck Institute for Demographic Research, Konrad-Zuse-Str. 1, 18057, Rostock, Germany

    Anna Klabunde

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  1. Anna Klabunde
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Klabunde, A. How much should an investor trust the startup entrepreneur? A network model. J Econ Interact Coord 11, 293–312 (2016). https://doi.org/10.1007/s11403-015-0147-7

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