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How Much Should an Investor Trust the Startup Entrepreneur? - A Network Model

  • Anna Klabunde

    ()

Trust is an important determinant of start-up fi nancing. In a simple agentbased 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 dissatisfi ed, 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 freeride 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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Paper provided by Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen in its series Ruhr Economic Papers with number 0450.

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Length: 17 pages
Date of creation: Nov 2013
Date of revision:
Handle: RePEc:rwi:repape:0450
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  1. Guiso, Luigi & Sapienza, Paola & Zingales, Luigi, 2005. "Trusting the Stock Market," CEPR Discussion Papers 5288, C.E.P.R. Discussion Papers.
  2. Lauren Cohen & Andrea Frazzini & Christopher Malloy, 2008. "The Small World of Investing: Board Connections and Mutual Fund Returns," Journal of Political Economy, University of Chicago Press, vol. 116(5), pages 951-979, October.
  3. Berger, Allen N. & Kick, Thomas & Koetter, Michael & Schaeck, Klaus, 2013. "Does it pay to have friends? Social ties and executive appointments in banking," Journal of Banking & Finance, Elsevier, vol. 37(6), pages 2087-2105.
  4. Mariassunta Giannetti & Yishay Yafeh, 2012. "Do Cultural Differences Between Contracting Parties Matter? Evidence from Syndicated Bank Loans," Management Science, INFORMS, vol. 58(2), pages 365-383, February.
  5. Guiso, Luigi & Sapienza, Paola & Zingales, Luigi, 2005. "Cultural Biases in Economic Exchange," CEPR Discussion Papers 4837, C.E.P.R. Discussion Papers.
  6. Colin Mayer, 2008. "Trust in Financial Markets," European Financial Management, European Financial Management Association, vol. 14(4), pages 617-632.
  7. Mayer, Adalbert & Puller, Steven L., 2008. "The old boy (and girl) network: Social network formation on university campuses," Journal of Public Economics, Elsevier, vol. 92(1-2), pages 329-347, February.
  8. Zak, Paul J & Knack, Stephen, 2001. "Trust and Growth," Economic Journal, Royal Economic Society, vol. 111(470), pages 295-321, April.
  9. Bedassa Tadesse & Roger White, 2010. "Does Cultural Distance Hinder Trade in Goods? A Comparative Study of Nine OECD Member Nations," Open Economies Review, Springer, vol. 21(2), pages 237-261, April.
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