BEHAVIORAL FINANCE: FACTORS INFLUENCING ANGEL INVESTOR DECISIONS by Robert C. Forrester A Dissertation Presented in Partial Fulfillment of Requirements for the Degree of Doctorate of Business Administration In the Coles College of Business Kennesaw State University Kennesaw, GA 2014 Copyright by Robert C. Forrester 2014 Coles College of Business Doctor of Business Administration Dissertation Defense: July 1, 2014 c. D8A Candidate: Robert Forruter The content and format of the dissertation are appropriate and acceptable for the awarding of the degree of Doctor of Business Administration. lucy Ackert, PhD Committee Chair Professor of Finance Department of Economics, Finance & Quantitative Analysis Coles College of Business Kennesaw State University Signature:-~ Rongbing Huang, PhD Committee Member Professor of Finance Department of Economics, Finance & Quantitative Analysis Coles College of Business Kennesaw State University Signature: Xiao Huang, PhD Reader Associate Professor of Economics Department of Economics, Finance & Quantitative Analysis Coles College of Business t'"\,/' 1 Kennesaw State University Signature: N f..+.o V~ Torsten M. Pieper, PhD Academic Director, KSU DBA Program AssiStant Professor of Management Department of Management and Entrepreneurship Coles College of Business Kennesaw State University Signature: CharlesJ. Amlaner, Jr., DPhil Vice President for Research and Dean of Graduate College cW~ Kennesaw State University Signature: ACKNOWLEDGMENTS This has been an experience of a lifetime, and I am indebted to the many people who supported, encouraged, and inspired this dream. First, my deepest gratitude goes out to the highly supportive and knowledgeable faculty at Kennesaw State University. In particular, thank you to the seminar instructors who fed students’ developing minds from the very beginning (including Lucy Ackert, Rongbing Huang, Xiao Huang, and Divesh Sharma). A special thanks to Gabriel Ramirez for pushing us to be the best we can be. Many of you have since become committee members and friends. I am indebted to you for the opportunity to work alongside brilliant minds. Above all, thank you to my advisors, Joe Hair for bringing me to KSU, Neal Mero, Torsten Pieper, and Juanne Greene for their leadership at this stage of my academic life. You have been my steadfast supporters from the beginning. I appreciate your words of wisdom and the many times you worked on my behalf to provide personal and professional support, advice, and guidance. Second, I am grateful for the many friends at Kennesaw State University who walked this road with me, including George Allen, Shalonda Bradford, Morten Brante, Chuck Casto, Lee Macenczak, Scott Manley, Donna Pearson, Christine Sutton, Frank Thompson, Ralph Williams and all the others in Cohort 3, as well as several in other cohorts. This includes my closest confidants, the members of the accounting and finance majors, Reid Cummings, Lisa Ludlum, and Tonya Smalls, who worked, studied, and played together - as well as spending a small fortune washing away some of a graduate students’ often tortured existence while dining at iv some of the best restaurants in Atlanta. You have been awesome companions; thanks for all the good times and for making the less good ones better. Thank you for your unwavering commitment to work together and tackle every “next project.” Next, to John D. (Pete) Tackett, my friend, business partner, and the angel investor who invested in my ideas and businesses and changed the course of my life. Thank you for the personal, professional, and financial support along with the dedication and encouragement this past 30 years - and for inspiring this dissertation. Then, to my employees, my friends in business at Four Stars, who have managed the businesses and taken care of our customers while I have focused on this journey. Especially my business partner, Jackie Moore, who has taken the reins and guided our companies in a positive direction to insure I could continue on this path. Thank you for all the many hours you all have put in so that I could be here. To my friends and colleagues at Midwestern State University, thank you for taking the time out of your busy schedules to answer my many questions. I value the knowledge and insight you have and your willingness to share it. Thank you for showing me, by example, how to be an excellent colleague, valuable mentor, and friend. But, most of all, thank you for offering me a job so that I can pay for all this! Lastly, I could not have done this without the support of my family. To my mom and dad, thank you for putting me on the path that helped make this possible. My success is a testimony to all the hard work and love you have devoted to your children. To the love of my life and my best friend, we did it! You were with me every step of the way - my rock, my ear, my shoulder. To my children for always remaining optimistic. Thank you for all that you sacrificed, and thank you for always believing. v ABSTRACT BEHAVIORAL FINANCE: FACTORS INFLUENCING ANGEL INVESTOR DECISIONS by Robert C. Forrester Angel investors are individual investors who invest in high-risk projects without the assistance of professional portfolio advisors and are an important source of early-stage entrepreneurial financing. When providing financing, an angel must decide how much time to spend on due diligence, the amount of wealth invested, and the degree of post-investment interaction with entrepreneurs. As they are individual investors, angels may be particularly influenced by behavioral factors. In order to provide insight into the investment decisions of angel investors this dissertation examines angel investor and deal characteristics including demographics, experience, perception of the management team, the source that led the entrepreneur to the angel investor, and syndication status. The dissertation finds that angels’ decisions are influenced by rational and behavioral factors, such as cognitive biases and social influences. While there is strong evidence that experienced angel investors spend more time on due diligence, older investors spend less time on due diligence after controlling for investor experience. These results suggest that experienced angels invest in due diligence because they understand its importance. Gender, risk perception, venture stage, and source of deal identification also influence due diligence. In addition, older angels are found to invest a smaller percentage of their wealth in a deal, perhaps because they seek vi to diversify holdings. More experienced angels, however, are found to invest a larger percentage of their wealth perhaps because experienced angels are more susceptible to cognitive biases such as overconfidence, or because they are able to identify ventures that will do well and choose to invest more in such ventures. Deal syndication also influences the percent of wealth invested in a deal. Other results suggest that after making an investment, angels continue to interact with the companies they invest in. There is strong evidence that more experienced angels are associated with greater post-investment interaction. Gender and risk perception also influence the degree of post-investment interaction. vii TABLE OF CONTENTS Title Page .......................................................................................................................... i Copyright Page................................................................................................................. ii Signature Page ................................................................................................................ iii Acknowledgements ......................................................................................................... iv Abstract ........................................................................................................................... vi Table of Contents .......................................................................................................... viii Chapter 1 ...........................................................................................................................1 Chapter 2 - Literature Review and Hypotheses ................................................................5 Chapter 3 - Methodology ................................................................................................53 Chapter 4 - Results ..........................................................................................................62 Chapter 5 - Discussion and Conclusion ........................................................................101 References .....................................................................................................................112 Appendices ....................................................................................................................131 viii CHAPTER 1 In traditional finance theory, the predominant view is that people behave rationally, making unbiased decisions based on relevant information (Statman, 1995; von Neumann & Morgenstern, 1944). However, individual investors’ decisions that violate principles of traditional finance have bedeviled researchers for years (Baker & Nofsinger, 2010; Barberis & Thaler, 2003; Fama, 1998; Miller, 1986; Shefrin, 2000; Statman, 1995; Statman, 1999; Shiller, 2003; von Neumann & Morgenstern, 1944). Indeed, scholars have concluded that behavioral elements in decision making are likely to be more influential on individual investors compared with large investors or institutional investors who rely on professional portfolio advisors and that knowledge of factors which influence individual investors is incomplete (Barberis & Thaler, 2003; Fama, 1998; Schleifer 2000; Shefrin, 2000; Thaler, 1999). This dissertation provides insight into factors that influence the observed decisions of angel investors which appear to violate the principles of traditional finance, such as investing in high risk projects that contain high information asymmetry while performing relatively little due diligence. Moreover, it explores variables that lead angel investors to invest time in due diligence, as well as to invest capital in projects. An underpinning of this research is behavioral finance. Angel investors are an important source of early-stage financing. Typically, angel investors are individual investors who invest in high-risk, entrepreneurial projects without the assistance of professional portfolio advisors. Angel investors invest billions of dollars in thousands of startup companies and entrepreneurial projects annually 1 2 (DeGennaro & Dwyer, 2013; Mason & Harrison, 2000; Sohl, 1999). Despite significant financial commitment, angel investor decisions sometimes appear to violate the principles of traditional finance. For example, rational investors have been shown to spend time on due diligence to reduce information asymmetry and increase return on investments. Indeed, time spent on due diligence has been shown to be positively related to angel investor returns on investment. Some angels, though, spend no time on due diligence (Morrissette, 2007; Sohl, 2003a; Wiltbank & Boeker, 2007b). Wiltbank and Boeker (2007b) report that amount of time angel investors spend on due diligence ranges between zero and 5,000 hours per investment. Despite angel investors’ growth and significance, very little research has examined factors that lead angel investors to expend time on due diligence as well as to invest in projects. They are one of the most common and least studied sources for financing new ventures (Wong, Bhatia & Freeman, 2009). Data used to examine individual investors not using professional portfolio advisors has been difficult to obtain. Moreover, studies examining the choices made by individual investors have been limited. Increasing availability of data on angel investors, however, provides an ideal opportunity to examine factors influencing individual investor decision making (Gompers & Lerner, 2010; Kaplan & Stromberg, 2003; Kerr, Lerner & Schoar, 2011; Prowse, 1998; Van Osnabrugge & Robinson, 2000). Understanding factors that guide angel decisions should assist in increasing their returns and help ensure their continued contribution to national economic growth. Behavioral finance is a relatively new field that combines behavioral and cognitive psychology with traditional finance to provide explanations for why investors make decisions that appear to be irrational (Ackert & Deaves, 2009; Baker & Nofsinger,