How much Should an Investor Trust the Startup Entrepreneur ? A Network Model # 450

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 satisfi ed 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 fi nd 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 profi table 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 fi rms remain in the market and the average investor’s return is lower than in the collective optimum. JEL Classifi cation: C63, G02, G24, L26