Handbook of Research on Venture Capital

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HANDBOOK OF RESEARCH ON VENTURE CAPITAL

Handbook of Research on Venture Capital

Edited by

Hans Landström Institute of Economic Research, Lund University, Sweden

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Hans Landström 2007 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2007921138

ISBN 978 1 84542 312 4 (cased) Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

Contents vii ix x

List of contributors Foreword Acknowledgements PART I 1 2 3 4

Pioneers in venture capital research Hans Landström Conceptual and theoretical reflections on venture capital research Harry J. Sapienza and Jaume Villanueva Venture capital: A geographical perspective Colin Mason Venture capital and government policy Gordon C. Murray

PART II 5 6 7

8

9 10

11

13

3 66 86 113

INSTITUTIONAL VENTURE CAPITAL

The structure of venture capital funds Douglas Cumming, Grant Fleming and Armin Schwienbacher The pre-investment process: Venture capitalists’ decision policies Andrew Zacharakis and Dean A. Shepherd The venture capital post-investment phase: Opening the black box of involvement Dirk De Clercq and Sophie Manigart Innovation and performance implications of venture capital involvement in the ventures they fund Lowell W. Busenitz The performance of venture capital investments Benoit F. Leleux An overview of research on early stage venture capital: Current status and future directions Annaleena Parhankangas Private equity and management buy-outs Mike Wright

PART III 12

VENTURE CAPITAL AS A RESEARCH FIELD

155 177

193

219 236

253 281

INFORMAL VENTURE CAPITAL

Business angel research: The road traveled and the journey ahead Peter Kelly Investment decision making by business angels Allan L. Riding, Judith J. Madill and George H. Haines, Jr v

315 332

vi

Handbook of research on venture capital

14

The organization of the informal venture capital market Jeﬀrey E. Sohl

PART IV 15 16

17

CORPORATE VENTURE CAPITAL

Corporate venture capital as a strategic tool for corporations Markku V.J. Maula Entrepreneurs’ perspective on corporate venture capital (CVC): A relational capital perspective Shaker A. Zahra and Stephen A. Allen

PART V

371

393

IMPLICATIONS

Implications for practice, policy-making and research Hans Landström

Index

347

415

427

Contributors Stephen A. Allen, Babson College, USA Lowell W. Busenitz, Michael F. Price College of Business, University of Oklahoma, USA Douglas Cumming, Schulich School of Business, York University, Canada Dirk De Clercq, Faculty of Business, Brock University, Canada Grant Fleming, Wilshire Private Markets Group and Australian National University, Australia George H. Haines, Jr, Eric Sprott School of Business, Carleton University, Canada Peter Kelly, Helsinki School of Creative Entrepreneurship and Helsinki University of Technology, Finland Hans Landström, Institute of Economic Research, Lund University, Sweden Benoit F. Leleux, IMD International, Lausanne, Switzerland Judith J. Madill, Eric Sprott School of Business, Carleton University, Canada Sophie Manigart, Vlerick Leuven Gent Management School and Department of Accounting and Finance, Ghent University, Belgium Colin Mason, Hunter Centre for Entrepreneurship, University of Strathclyde, UK Markku V.J. Maula, Institute of Strategy and International Business, Helsinki University of Technology, Finland Gordon C. Murray, School of Business & Economics, University of Exeter, UK Annaleena Parhankangas, Institute of Strategy and International Business, Helsinki University of Technology, Finland Allan L. Riding, University of Ottawa, Canada Harry J. Sapienza, Center for Entrepreneurial Studies, Carlson School of Management, University of Minnesota, USA Armin Schwienbacher, Finance Group, University of Amsterdam, the Netherlands and Université catholique de Louvain, Belgium Dean A. Shepherd, Kelley School of Business, Indiana University, USA Jeﬀrey E. Sohl, Center for Venture Research, Whittemore School of Business and Economics, University of New Hampshire, USA Jaume Villanueva, Center for Entrepreneurial Studies, Carlson School of Management, University of Minnesota, USA

vii

viii

Handbook of research on venture capital

Mike Wright, Nottingham University Business School, UK Andrew Zacharakis, Babson College, USA Shaker A. Zahra, Center for Entrepreneurial Studies, Carlson School of Management, University of Minnesota, USA

Foreword In today’s modern economy a country’s or region’s competitiveness lies in its capability to innovate. Whilst earlier old and established companies were reliable producers of innovation as well as jobs, that is changing. The big corporations are outsourcing and downsizing, and the new technologies are emerging from companies that did not exist 20 years ago. Governments have come to realize that in order to sustain economic growth and create jobs they must have a policy that facilitates entrepreneurship. One of the important components in this policy is the supply of venture capital. Nowadays there are few fastgrowing high technology companies that have not been financed by venture capital at some stage. If they haven’t obtained venture capital, they probably tried to obtain it. Governments all around the world are creating schemes and policies that will facilitate the supply of venture capital. The increased attention given to venture capital from policy makers is also evident within the research. The amount of research and literature on venture capital is enormous. There are several academic journals devoted solely to venture capital, and venture capital research is occurring in a large number of journals; numerous books on venture capital are published yearly. Though the venture capital phenomenon is not new, it generates an increasingly large amount of research. We are at a stage when it is suitable to synthesize the research findings and see what we know and what we do not know about venture capital. This volume presents the state of the art in venture capital research. It includes writing from the elite of the venture capital researchers around the world and covers the most central aspects of venture capital research. This volume gives the reader a unique opportunity to understand what venture capital is and how it works. The Swedish Institute for Growth Policy Studies (ITPS), Swedish Foundation of Small Business Research (FSF), and Swedish Agency for Economic and Regional Growth (NUTEK) have as their mission to improve the entrepreneurial climate and the economic growth in Sweden. We see the supply of venture capital as one of the crucial factors to unleash the growth potential in the economy. We are proud to sponsor this handbook, and we are convinced that it will be a frequently read resource for anyone interested in venture capital and in fostering economic growth – as well as those who want to understand the modern economy. Sture Öberg Swedish Institute for Growth Policy Studies (ITPS) Anders Lundström Swedish Foundation of Small Business Research (FSF) Sune Halvarsson Swedish Agency for Economic and Regional Growth (NUTEK)

ix

Acknowledgements I first became interested in venture capital in the mid-1980s when writing my thesis on the development and growth of new technology-based firms in Sweden. At that point in time there was not much research available on the subject of venture capital – with the exception of some seminal studies by researchers who are today regarded as pioneers within the field. Venture capital has always fascinated me, and I have written a large number of articles and reports on diﬀerent aspects of it. At the same time we have witnessed an enormous increase in academic research within the field internationally, thus we know a great deal more about venture capital today than we did a mere decade ago. When I was asked by Edward Elgar Publishing to be the editor of a state-of-the-art book on venture capital I was naturally very honoured, but I also found it timely in the sense that we have been researching venture capital for about 25 years, and in my view, it is important to reflect now and then on the knowledge acquired in order to establish a basis for further development of the field. The first phase of the process involved in the production of the Handbook of Research on Venture Capital was to invite the most prominent international researchers within the field to participate in the project and write a chapter on a specific topic. I was encouraged to find that their reactions were very positive – the need to summarize and synthesize our knowledge after almost three decades of venture capital research was obvious. The writing and reviewing process has been intensive, and the chapters have gone through three rounds of revision. At the end of the process (29–31 May, 2006) the authors met in Lund, Sweden, in order to discuss and provide feedback on each other’s chapters. I sincerely thank all the authors for their willingness to generously share their knowledge on venture capital and for all the work they have devoted to this project. In connection with the meeting in Lund we also organized a ‘Workshop on Venture Capital Policy’ with more than 80 participants including a good mix of researchers and policy makers interested in venture capital, and during these days we achieved a very intense and interesting dialogue between leading researchers and policy makers within the field. As such events do not organize themselves I wish to thank Gertie Holmgren and Elsbeth Andersson of Lund University School of Economics and Management as well as the whole group of researchers and doctoral students within the research programme on Entrepreneurship and Venture Finance at the Institute of Economic Research and CIRCLE for their great eﬀorts in organizing the workshop in Lund. I am very grateful to the Swedish Agency for Economic and Regional Growth (NUTEK), the Swedish Institute for Growth Policy Studies (ITPS) and the Swedish Foundation for Small Business Research (FSF) for their financial support of the project. Sincere thanks to the project committee made up of Birgitta Österberg and Karin Östberg from NUTEK, Marcus Zachrisson of ITPS, and Anders Lundström and Helena Ericsson from FSF for their valuable help and comments throughout the project. I have written the first and last chapter in this handbook, and I thank Doctor Jonas Gabrielsson, Doctor Diamanto Politis and Doctor Joakim Winborg for their valuable x

Acknowledgements

xi

comments on my chapters. In addition, I am grateful to Professor Olle Persson at Umeå University for helping me with the bibliographical analysis of the research field. Finally, a special thanks to Francine O’Sullivan at Edward Elgar Publishing for inviting me to be the editor of the handbook, and for her excellent support throughout the process. Hans Landström Institute of Economic Research School of Economics and Management Lund University, Sweden

PART I VENTURE CAPITAL AS A RESEARCH FIELD

1

Pioneers in venture capital research Hans Landström

Introduction The importance of venture capital We need growth-oriented entrepreneurial ventures in society. These ventures represent an important power in an economy – they create innovations and dynamics, new jobs, income and, not least, wealth. Although growth-oriented entrepreneurial ventures, or what Birch (1987) calls ‘gazelles’, can be found in all industry sectors and locations (urban as well as rural), there are some indications that the ventures with the highest growth potential are often characterized as knowledge-based and technologically driven – primarily based on intangible assets, operating in rapidly developing fields and with no documented history. One of the main problems facing these growth-oriented entrepreneurial ventures is raising capital for the growth of the business and gaining access to the competence, experience and networks necessary for growth which most entrepreneurs lack (Brophy, 1997). It is in this domain of growth-oriented entrepreneurial activities that we need an eﬃcient venture capital market that can provide adequate capital and management skills. For example, it has often been argued that the scope and sophistication of the US venture capital industry is one reason for the exceptional ability of the US economy to turn innovative ideas from universities and R&D laboratories into high growth companies such as the Intel Corporation, Cisco Systems, Microsoft, Oracle, Amazon.com, Yahoo!, etc. (Maula et al., 2005). Thus, growth-oriented ventures are important in society, and venture capital is a significant vehicle for promoting their growth. The importance of venture capital makes it essential to understand the way the venture capital market operates, and how business angels and venture capitalists manage their investments. In this book we will summarize and synthesize the knowledge in the area of venture capital: what do we know? what do we not know? And what can we learn from existing knowledge (or lack of knowledge)? The aims of the book The scholarly interest in venture capital began in the 1970s and expanded substantially in the following two decades. This interest was especially strong among researchers in the US, which is also the home of the most dynamic venture capital market. Thus, systematic venture capital research is less than 25 years old, or a little more than half of an academic career. But during those 25 years our knowledge has grown exponentially, and we know a great deal more today about the venture capital market, business angels, venture capitalists’ investment decision, and so on than we did 10 to 15 years ago. For example, an analysis of the Social Citation Index reveals an increase in the number of scientific articles written on venture capital since the 1980s – from about 10 articles per year at the end of the 1980s to 25 articles in the mid-1990s, while today the annual number of articles on venture capital is between 60 and 70 (see Figure 1.1), and the last five years (2001–2005) account for 48 per cent of venture capital related research. 3

4

Handbook of research on venture capital 80 70 60 50 40 30 20 10 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Figure 1.1

Number of articles on venture capital

In this state-of-the-art book we will try to summarize and synthesize 25 years of venture capital research. In addition, our aim is to communicate new and future directions of our knowledge to scholars, venture capitalists, entrepreneurs and policy-makers, in order to increase the understanding of the venture capital phenomenon. Some comments regarding the content of the book will first be made to help the reader. If we look at our knowledge on venture capital, we can conclude that most venture capital research concerns the supply side of the market (from the investor perspective) whereas little work can be found on the demand side – related to the decision-making processes of ventures seeking venture capital. Obviously, this state-of-the-art book – which attempts to summarize and synthesize existing knowledge within the field – reflects this bias. Second, in a citation analysis performed by Cornelius and Persson (2004; 2006) it was revealed that the venture capital research community was divided into two separate clusters of researchers. With the exception of some very important core authors within the field who are generally cited (such as William Sahlman, Paul Gompers and William Bygrave), there seems to be surprisingly little intellectual cross-fertilization between the two clusters. One cluster of researchers has a background in finance and economics and mainly analyses venture capital on a macro level, using, for example, agency theory, capital market theory, and so on as theoretical frameworks in their studies, which are published in financial and economics journals. Another cluster of researchers has its roots in management and entrepreneurship research and thus has a stronger managerial focus on venture capital with more heterogeneity in the research paradigms employed. These researchers publish their works in entrepreneurship management journals. The present book focuses on the managerial aspects of venture capital – although several chapters in the book also cover more aggregated discussions concerning the development of the market, regional aspects of venture capital, and policy implications. Finally, there is a geographical bias in our knowledge about venture capital. Since the emergence of the research field in the 1980s, venture capital has been regarded as a US phenomenon dominated by Anglo-Saxon (mainly US) researchers – and this has continued, in spite of increased interest on the part of scholars all over the world since the 1990s.

Pioneers in venture capital research

5

As a consequence, our knowledge is heavily influenced by the US context and model of venture capital. However, not only is US research dominant; as venture capital has a tendency to concentrate in certain geographical regions such as metropolitan areas and hightechnology clusters, our knowledge on venture capital does likewise and is mainly derived from dynamic regions such as Silicon Valley and Boston. As this is a state-of-the-art book, these geographical biases will be reflected. However, we have tried to select authors from diﬀerent parts of the world and have asked them to consider venture capital as a global phenomenon. Venture capital – what are we talking about? Venture capital is a specific form of industrial finance – part of a more broadly based private equity market, that is investments (with private equity) made by institutions, firms and wealthy individuals in ventures that are not quoted on a stock market, and which have the potential to grow and become significant players on the international market (Mason and Harrison, 1999a; Isaksson, 2006). The private equity market can be divided into two diﬀerent parts (although the distinction is not always easy to make): 1. 2.

Venture capital, which is primarily devoted to equity or equity-linked investments in young growth-oriented ventures; and Private equity, which is devoted to investments that go beyond venture capital – covering a range of other stages and established businesses including, for example, management buy-outs, replacement capital and turnarounds.

Venture capital will usually be regarded as an active and temporary (5 to 10 years) partner in the ventures in which they invest, and they are normally minority shareholders. They achieve their rate of returns mainly in the form of capital gain through exit rather than by means of dividend income. The venture capital market consists of diﬀerent submarkets, and in this book we will focus on three of them: institutional venture capital, corporate venture capital, and informal venture capital. Institutional venture capital It is not an easy task to provide a generally accepted definition of institutional venture capital (also called ‘formal venture capital’) – the number of definitions is almost as great as the number of authors writing articles on the subject. Institutional venture capital firms act as intermediaries between financial institutions (such as large companies, pension funds, wealthy families, and so on) and unquoted companies, raising finance from the former to invest in the latter (Lumme et al., 1998). Wright and Robbie (1998) defined institutional venture capital as professional investments of long-term, unquoted, risk equity finance in new firms where the primary reward is eventual capital gain supplemented by dividends. Elaborating on this definition, Mason and Harrison (1999a, p. 16) stated that ‘the institutional VC industry comprises full-time professionals who raise finance from pension funds, insurance companies, banks and other financial institutions to invest in entrepreneurial ventures. Institutional venture capital firms take various forms: publicly traded companies, “captive” subsidiaries of large banks and other financial institutions, and independent limited partnerships.’

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Handbook of research on venture capital

As indicated in the definition by Mason and Harrison, an institutional venture capital firm can take diﬀerent organizational forms, depending on the ownership structure, but usually consists of: ●

●

●

Independent limited partnerships, in which the venture capital firm serves as the general partner, raising capital from limited partners such as institutional investors (for example, pension funds, insurance companies and banks). Captive venture capital firms, which are mainly funded by the internal resources of a parent organization – often a financial institution, such as a bank or insurance company, but sometimes by a larger non-financial company (so-called ‘corporate venture capital’). Government venture capital organizations, which are financed and controlled by government institutions.

Since the 1980s the limited partnership has emerged as the dominant organizational form in venture capital. In a limited partnership, the venture capitalists are general partners and control the fund’s activities, whereas the investors act as limited partners who are not involved in the everyday management of the fund (see Figure 1.2). A fact that makes the definition of institutional venture capital even more complicated is that the understanding of institutional venture capital diﬀers from country to country. In addition, the characteristics of the venture capital industries in Europe and the US are not the same, indicating that the view and definition of venture capital diﬀer substantially between them. Bygrave and Timmons (1992) distinction between two types of venture capital may be helpful to illustrate the diﬀerences: ●

●

Classical venture capital funds – where the capital is raised from patient investors, for example, wealthy individuals and families. The funds are managed by investors with entrepreneurial experience and industrial knowledge, who invest in early stage ventures and who actively operate in the companies in which they invest. Merchant venture capital funds, which raise capital from institutional sources with short-term investment horizons, where the funds are managed by individuals with a background in investment banking or other financial organizations, who invest at

INVESTOR Returns

Fundraising VENTURE CAPITALIST

Equity

Cash VENTURE

Figure 1.2

The venture capital process

Pioneers in venture capital research

7

a later stage or undertake management buy-outs (MBOs) and who focus strongly on analytical and financial engineering, deal-making and transaction crafting. Bygrave and Timmons argue that, due to the growing dominance of institutional investments in venture capital funds in the US, and not least in Europe, merchant venture capital funds have taken over at the expense of classic venture capital. Accordingly, the definitions of institutional venture capital in Europe are somewhat diﬀerent and venture capital is usually considered synonymous with ‘private equity’ in a more general sense and includes investments in terms of early and expansion stage financing as well as those covering a range of other stages such as funding of management buy-outs, consolidations, turnarounds, and so on. On the other hand, in the US, the term ‘venture capital’ is narrower and refers to early stage investments in growth-oriented companies, or what Bygrave and Timmons term ‘classic’ venture capital. Corporate venture capital One distinguishable part of the institutional venture capital markets is ‘corporate venture capital’ as a ‘captive’ venture capital organization. Maula (2001) defines corporate venture capital as ‘equity or equity-linked investments in young, privately held companies, where the investor is a financial intermediary of a non-financial corporation’ (p. 9). Thus, the main diﬀerence between institutional venture capital and corporate venture capital is the fund sponsor – in corporate venture capital the only limited partner is a corporation, or a subsidiary of a corporation. Corporate venture capital should be seen as a specific strategic tool in the corporate venture toolbox. There are many other tools that can be used in order to develop new business, and Maula (2001) distinguishes between (i) internal corporate venture, in which innovations and new businesses are developed at various levels within the boundaries of the firm, and (ii) external corporate venture, which results in the creation of semiautonomous or autonomous organizational entities that reside outside the existing firm. It is within the frame of external corporate venture that corporate venture capital is used as a tool for strategic considerations and business development, together with other tools such as venture alliances and acquisitions. Following this reasoning and using a rather broad definition, McNally (1994) states that corporate venture capital can take two main forms: externally managed investments, Table 1.1

Corporate venture capital Corporate Venture Capital

Type of investment

Investment vehicle

Externally managed

Internally managed

Investment via independently managed venture capital fund.

Direct subscription for minority equity stake.

Independently managed fund

In-house corporate managed fund

Independently managed captive fund

Source: Adapted from McNally (1994, p. 276)

Ad hoc/one-oﬀ investments, e.g. strategic alliances/ ‘spin-oﬀs’ from company

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Handbook of research on venture capital

in which large corporations finance new firms alongside independently managed venture capital funds, and internally managed investment, that is making investments through their own internal organization (see Table 1.1). Informal venture capital This book will also discuss the informal venture capital market, which for many years has been associated with and regarded as equivalent to ‘business angels’. Originally, the term ‘angel’ was used to describe individuals who helped to finance theatre productions on Broadway (‘theatre angels’). The ‘angels’ invested in these productions mainly for the pleasure of rubbing shoulders with their favourite actors. It was a question of high-risk investment – the individuals lost their money if the production was a flop but shared the profits if it was successful (Benjamin and Margulis, 2001; Mason, 2007). Later on, William Wetzel (1983) was one of the first to coin the term ‘business angels’ for people providing the same kind of risk investments in young entrepreneurial ventures. Following this line of thought, Lerner (2000) defines a business angel as ‘a wealthy individual who invests in entrepreneurial firms. Although angels perform many of the same functions as venture capitalists, they invest their own capital rather than that of institutional or other individual investors’ (p. 515). In empirical studies we have successively seen a broadening of the study of object, from focusing entirely on ‘business angels’ to include a broader range of private investors making equity investments in entrepreneurial ventures (Landström, 1992; Avdeitchikova, 2005), with more and more emphasis on ‘informal investors’ (see Figure 1.3). A common definition in this respect is based on Mason and Harrison (2000a) ‘private individuals who make investments directly in unlisted companies in which they have no family Narrow definition

Broad definition

Figure 1.3

Business angels

High net worth individuals who invest a proportion of their assets in high-risk, high-return entrepreneurial ventures (Freear et al., 1994). Apart from investing money, business angels contribute their commercial skills, experience, business know-how and contacts taking a hands-on role in the company (Mason and Harrison, 1995).

Informal investors

Comprised of private individuals who invest risk capital directly in unquoted companies in which they have no family connection (Mason and Harrison, 2000a). Thus, informal investors include business angels as well as private investors who contribute relatively small amounts of money and do not take an active part in the object of investment.

Informal investors, including family and friends

Defined as any investments made in start-ups other than the investors’ own businesses, i.e. including family investments, investments by friends, colleagues, etc., but excluding investments in stocks and mutual funds (Reynolds et al., 2003).

Definitions of ‘business angels’ and ‘informal investors’

Pioneers in venture capital research

9

connections’ (p. 137). This definition of informal investors includes not only investments by business angels but also those made by private investors who are less active in the ventures in which they invest as well as private investors who invest smaller amounts of capital in unlisted companies. On the other hand, the definition excludes investments made by ‘family and friends’, and this perspective is not uncontroversial. For example, in the large international research project Global Entrepreneurship Monitor, investments made by ‘family and friends’ are included in the study of informal investments in diﬀerent countries (Reynolds et al., 2003). However, a central argument in the definition by Mason and Harrison (2000a) is that investments made by close relatives and friends are based on other considerations and investment criteria than those of external investors and, therefore, family-related investments should be excluded from the definition. Without taking a definite position, we can conclude that there are many diﬀerent definitions of informal venture capital: from (i) ‘business angels’ in a narrow sense, to (ii) the broader definition of ‘informal investors’, and (iii) also including investments made by family and friends. In empirical studies, the terms ‘business angels’ and ‘informal investors’ are sometimes used to distinguish one from the other, but more often are interchangeable. Needless to say, this lack of rigour makes empirical studies on informal venture capital diﬃcult to interpret and compare. Business angels and other types of informal investors diﬀer significantly – in the way they make decisions, their ability to add value, and so on, and there is a need to divide the informal venture capital market into relevant segments. A comparison between three sources of venture capital An overview of the similarities and diﬀerences between institutional venture capital, business angels and corporate venture capital is an appropriate way in which to conclude this discussion about the definition and diﬀerent sources of venture capital. The overview (Table 1.2) shows that diﬀerent sources of venture capital seem to represent partially complementary and partially overlapping sources of finance: complementary in the sense of investment in diﬀerent venture development phases and the amount of capital provided; overlapping in that each category of investors makes investments in a broad range of ventures. As can be seen in Table 1.2, institutional venture capital, business angels and corporate venture capital seem to have some distinctive characteristics. Obviously, the source of funds and legal status diﬀer, as do the investment motives – all venture capitalists have some form of financial motive (and even if intrinsic rewards are evident among business angels, there are also financial reasons for the investment), although corporate venture capitalists place greater emphasis on strategic considerations. Investment and monitoring diﬀer, and especially it is the business angels that distinguish themselves in that their investment capacity and time for due diligence are much more limited; also they have a much more informal control process compared to institutional and corporate venture capitalists. A final comment needs to be made regarding the definitions of venture capital. The field of venture capital is characterized by vague definitions and a great deal of confusion regarding central concepts. Of course, unclear definitions make knowledge accumulation more diﬃcult, and many authors who contributed chapters to the handbook call for clearer and consistent definitions within the field. However, we do not consider it the aim of this book – which outlines past and present research on venture capital – to provide such authoritative recommendations on definitional issues, although in order to develop

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Handbook of research on venture capital

Table 1.2 Characteristics of institutional venture capital, business angels and corporate venture capital Institutional venture capital

Business angels

Corporate venture capital

Source of funds

Primarily institutional investors who act as limited partner

Investing their own money

Investing corporate funds

Legal form

Limited partnership

Private individuals

Subsidiary of a large company

Motive for investment

Equity growth

Equity growth Intrinsic rewards

Strategic and equity growth

Investment

Experienced investors

Experience varies

Large investment capacity Extensive due diligence

Limited investment capacity Limited time for due diligence

Experience within industry/technology Large investment capacity Extensive due diligence

Formal control

Informal control

Corporate control

Monitoring

Source: Adapted from Mason and Harrison (1999a), Månsson and Landström (2005) and De Clercq et al. (2006)

the field of venture capital research we should spare no eﬀort to clarify the concepts employed. Reality and research The social sciences are not developed in isolation from the rest of society and, as in many other social sciences, we can find a strong linkage between the development of the venture capital industry (the reality) and the interest among scholars in focusing on venture capital (research), although with a certain time lag due to the ‘natural conservatism’ that characterizes most research. In this section we will describe the development of venture capital in the US as well as in Europe and the rest of the world. We will also show that early research contributions by a number of pioneering researchers, often geographically located near dynamic venture capital markets, took place in the context of an emerging venture capital industry. The birth of venture capital Venture capital as a phenomenon is a very ancient activity. Private individuals have always had a tendency to invest in high-risk projects. Examples of entrepreneurs raising capital from private financiers can be found in the Babylonian era as well as in early medieval Europe. One extraordinary example is the decision by Queen Isabella of Spain to finance the voyage of Christopher Columbus, which can be regarded as a highly profitable (for the Spanish) venture capital investment. It could also be argued that in many countries the investments by private individuals were influential in the development of the industrial revolution during the nineteenth and the early twentieth century. For example, in the US,

Pioneers in venture capital research

11

groups of domestic and European private investors were responsible for financing the development of several new industries, such as railroads, steel, petroleum and glass. One such successful investment, made by a group of wealthy individuals, was the merger and financing of a few less successful companies into what became International Business Machines (IBM) in 1924. These kinds of investments are not unique to the US – we can find similar success stories in many other countries (Rind, 1981; Benjamin and Margulis, 2001; Gompers and Lerner, 2003). In a more institutional sense, the venture capital industry can be regarded as an outgrowth of the informal venture capital market – the industry originated in the management of the wealth of high net worth families in the US such as the Rockefeller (Douglas Aircraft and Eastern Airlines), Phipps (Ingersoll Rand and International Papers), and Whitney (Vanderbilt) families during the early decades of the last century. Gradually, these operations became more and more professional, employing outsiders to select and manage the investments, forming the nuclei for what ultimately became independent venture capital groups (Gompers and Lerner, 2003). The Boston area was perhaps the first region to show some degree of organized venture capital. By 1911, the Boston Chamber of Commerce was providing financial and technical assistance to new ventures and, in 1940, the New England Industrial Development Corporation was launched to provide a similar kind of assistance (Florida and Kenney, 1988). Boston was also the home of the first venture capital company in the US. The idea of venture capital came from Ralph Flanders, president of the Federal Reserve Bank of Boston, who was concerned about the lack of new company formation and the inability of institutional investors to finance new ventures. Flanders proposed fiduciary funds, which would enable institutional investors to invest up to 5 per cent of their assets in equity in new ventures (Bygrave and Timmons, 1992). The proposal was supported by General Georges Doriot (professor at Harvard Business School) and together with Carl Compton (president of MIT) and some local business leaders, Doriot established American Research and Development (ARD) in 1946. ARD made investments in young firms with a basis in technologies developed for World War II, often with close ties to the Harvard and MIT communities. Its first investment was in the High Voltage Engineering Corporation, which was founded by engineers from MIT and which later became the first venture capital-backed firm listed on the New York Stock Exchange. However, not all investments were successful – almost half of ARD’s profit during its 26-year existence came from its $70 000 investment in the Digital Equipment Company in 1957, which had increased in value to $355 million by 1971 (Bygrave and Timmons, 1992; Gompers and Lerner, 2003). In Silicon Valley/San Francisco, another region with a dense cluster of technologybased enterprises, venture capital groups began to emerge during the late 1950s and early 1960s. The first venture capital firm in California – Draper, Gaither and Andersen – was founded in 1958, and the late 1950s became a seminal period witnessing the establishment of more than a dozen venture capital firms in the Silicon Valley and San Francisco area (Florida and Kenney, 1988). The development of venture capital in the US Although the venture capital phenomenon can be regarded as a very ancient activity, the venture capital industry grew slowly. The market was fragmented and geographically

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Handbook of research on venture capital

concentrated (Brophy, 1986). One key point in the development of the industry was the creation of Small Business Investment Companies (SBIC) in 1958 – privately operated investment companies that could receive tax benefits and borrowing rights from the Small Business Administration (from 1992 it was also possible to obtain equity capital from the US Treasury at attractive rates), which meant that private investors could benefit from advantageous federal loans as well as favourable tax rules. However, despite these measures to improve the venture capital industry in the US, the amount of venture capital was rather limited. The flow of money into venture capital funds between 1946 and 1977 never exceeded a few hundred million dollars annually (often much less). At the beginning of the 1970s, the venture capital market stagnated even more, mainly due to a sharp rise in capital gains tax – from 25 to 49 per cent – which reduced the potential profit on investments. At the same time, the industry experienced several failures and the venture capital companies did not succeed in managing the situation that arose; thus general mistrust of the venture capital industry emerged. At the end of the 1970s, the venture capital industry was very small, homogeneous in strategy and practice, and competition for deals was weak. Few investors and entrepreneurs considered the venture capital market particularly important for new and growing ventures, and the interest from scholars in academia was limited. However, in the early 1980s, the venture capital industry grew dramatically, due to an increase in investment opportunities and the introduction of tax-related incentives. The market increased from approximately 200 venture capital firms and a pool of venture capital of $2.9 billion in 1979 to almost 700 firms and a pool of more than $30 billion in 1989 (Timmons and Sapienza, 1992). There are several reasons behind this growth (Bygrave and Timmons, 1992; Gompers and Lerner, 1996; 2003): ●

●

●

●

Before 1979 the possibility for pension funds to invest in venture capital was limited, but following clarification by the Department of Labor (the Employers’ Retirement Investment Security Act, ERISA) the rules explicitly allowed pension funds to invest in high-risk assets such as venture capital funds – known as ERISA’s ‘Prudent Man Rule’. An associated change was the increased role of investment advisors. As venture capital represented a very small proportion of pension fund portfolios, almost all pension funds invested directly in venture funds, and the monitoring and evaluation of these investments were rather limited. In the mid-1980s, advisors (so-called ‘gatekeepers’) entered the market to advise institutional investors in the area of venture investments and pooled the resources from their clients, monitored existing investments and evaluated potential new funds. Capital gains tax was successively reduced from 49 to 28 per cent – a measure that was not only important for the supply of capital, but also had positive eﬀects on the entrepreneurial activity which created more investment opportunities. The emergence of new technologies in the economy (microprocessor and recombinant DNA) provided a fertile ground for venture capital investments.

The tremendous growth of the venture capital industry in the 1980s caused fundamental changes in the structure and function of the industry. Venture capital firms increased both in number and size and, as a consequence, the market showed increased heterogeneity

Pioneers in venture capital research

13

across firms, and greater specialization in investment stage, industry and region. Venture capitalists changed their strategy – and moved towards later stage and larger investments (Bygrave and Timmons, 1992; Timmons and Sapienza, 1992). After this period of growth in the US venture capital industry, the development during the 1980s and 1990s was characterized by ‘ups’ and ‘downs’. In the mid-1980s, the returns on venture capital funds started to decrease, basically due to over-investment in various industries and the entry of inexperienced venture capitalists, thus investors became disappointed with lower returns and fund raising as a consequence. The end of the 1980s was characterized by a drop in venture capital and a ‘shake-out’ in the industry, and the number of venture capital firms declined. Venture capitalists tended to invest in later stages, and specialization and diﬀerentiation of investment strategies continued (Timmons and Bygrave, 1997). There was renewed interest at the beginning of the 1990s – due to new possibilities on the initial public oﬀerings (IPO) market and the exit of many experienced venture capitalists (Gompers and Lerner, 2003). The industry ‘shake-out’ consolidated and stabilized the market. Returns had improved – mainly due to a robust IPO market. However, we must bear in mind that the venture capital industry was still heavily concentrated in a few geographical areas in the US and could be regarded as fairly limited. Despite an overall improvement in the US venture capital industry, the total investment made by venture capitalists never exceeded $6 billion until 1996, and it was the end of the 1990s before the market really showed exceptional growth. In the year 2000 the total investment spending reached an astonishing $102 billion, and the average investment was about $18 million per company. Since then, the venture capital market in the US has declined due to the dot.com crash (Megginson and Smart, 2006), where the drop was more significant than in many other countries. The diﬀusion of venture capital to Europe For a long time, venture capital was more or less regarded as an American phenomenon. Even though an emerging venture capital industry in Europe could be found already in the late 1970s – much earlier we could find individual companies that provided equity capital to unquoted firms, for example, 3i in the UK, Investco in Belgium and SVETAB in Sweden. But these companies were rather isolated initiatives, and in general venture capital was virtually non-existing outside the US during the 1970s. The development of a European venture capital market mainly took place in the UK, which had just over 20 venture capital funds at the end of the 1970s with a total investment of £20 million. A little more than a decade later, in 1992, the venture capital industry in the UK had grown significantly, investing in a total of £1326 million in 1297 ventures (Murray, 1995). However, it was not until the late 1980s that a more significant venture capital industry emerged in Europe, and at that point in time its growth outperformed that of the industry in the US – between 1986 and 1990 venture capital in Europe grew from about $9 billion to $29 billion (Bygrave and Timmons, 1992). This growth was associated with the introduction of secondary stock markets in many countries, which enabled rapidly growing ventures to make IPOs and venture capitalists to obtain returns on their investments. A number of secondary stock markets were created, such as the Alternative Investment Market in the UK, Nouveau Marché in France, and the Neuer Markt in Germany, and later on a pan-European secondary stock market (EASDAQ). However,

14

Handbook of research on venture capital

most of these markets were unsuccessful due to low levels of trading and liquidity (Lumme et al., 1998). When describing the venture capital markets in diﬀerent countries, it is important to emphasize that venture capital can diﬀer from one country to another, depending on the characteristics of the financial markets. For example, Black and Gilson (1998) distinguish between bank-centred markets such as in Japan and Germany, and stock-market-oriented markets as in the US. The authors argue that a well-developed stock market and initial public oﬀerings as well as a high level of private pension fund investments (Jeng and Wells, 2000) are of significant importance for venture capital financing. Diﬀerences in the characteristics of the financial market in various countries make venture capital more or less important, and venture capital operates in diﬀerent ways. Following this line of reasoning, we can find several similarities between the venture capital industries in the US and Europe (Manigart, 1994; Sapienza et al., 1996; Jeng and Wells, 2000) but also many important diﬀerences. For example: (i) venture capitalists in Europe seem to rely more heavily on investment from financial institutions (banks and insurance companies) compared to the US, where a great deal of capital comes from pension funds; (ii) venture capital firms are organized in diﬀerent ways, for example, in the US and the UK firms are usually limited partnerships whereas in other European countries we can find diﬀerent organizational structures; (iii) historically, European venture capital has been less focused on early-stage investments compared to venture capitalists in the US; (iv) active involvement diﬀers across countries – venture capitalists in Europe are not always as actively involved in managing their investment as their counterparts in the US; and (v) due to the lack of liquid stock markets for entrepreneurial ventures in many European countries, the exit strategies have diﬀered and the returns on investments were lower compared to the US (Jeng and Wells, 2000; Megginson and Smart, 2006). Venture capital worldwide It was not until the end of the 1990s, and the boom in the dot.com industry, that we could really talk about the growth of the venture capital industry worldwide. The total investments in the US exceeded $100 billion in the year 2000, and the corresponding figure for Europe is €35 billion (Megginson and Smart, 2006). In addition, the venture capital industry in Asia grew significantly between 1995 and 2000, although less rapidly than in the US and Europe – mainly due to the moribund venture capital industry in Japan. The most promising venture capital market in Asia was in India, and to some extent China, although the latter seemed to lack the basic legal infrastructure needed to support a venture capital market, and Chinese stock markets have remained ineﬃcient (ibid.). The Asian market is highly heterogeneous – at one end of the spectrum there are countries like Japan and Australia with long-established market economies as well as newly industrialized countries while, at the other, there are countries such as China, India, Malaysia and Vietnam with emerging market economies (Lockett and Wright, 2002). However, a general characteristic of the venture capital market in Asia is that the institutional framework – regulatory and legal as well as the venture capital culture – is not yet established to support venture capital. In addition, several NASDAQ-type stock markets have been established, such as the ‘growth markets’ in Hong Kong, Singapore and Taiwan, but so far they have shown only limited success in funding fast growth firms. The lack of an institutional framework on many Asian venture capital markets means

Pioneers in venture capital research

15

that venture capitalists have to place more emphasis on employing personal networks to carry out venture capital operations – indicating that venture capital practice in emerging markets in Asia diverges somewhat from the Anglo-Saxon model (Ahlstrom and Bruton, 2006). Since the 1990s venture capital markets have emerged all over the world. However, the growth has not been unproblematic – the bursting of the Internet and dot.com bubble at the end of the 1990s marked a historical peak in terms of capital volume and valuations, but the market collapse that followed had a major eﬀect on the venture capital market, not least in the US. As a consequence, the number of venture capital firms declined and the amount of capital invested decreased dramatically. The dot.com bubble also aﬀected the behaviour of venture capitalists, who became ‘entrapped in the psychic prison of the internet bubble’ (Isaksson, 2006). The market recovered gradually, and in 2006 the size and activities of the US venture capital market returned to the pre-dot.com level of 1998. The European market is not much smaller than the US venture capital market, and there are growing venture capital markets in many Asian countries. We can conclude that venture capital has emerged from being a source of finance for high growth ventures in the US to a worldwide phenomenon. At the same time, the markets in diﬀerent parts of the world exhibit a great variation in their degree of maturation, for example, US venture capital is regarded as a significant source of finance for entrepreneurs in high growth ventures whereas other countries have less well developed markets in which venture capital still has to prove their contributions to entrepreneurial ventures. The pioneers who created the research field In all emerging fields of research there are always some researchers who appear to have a greater influence than others – researchers who make a new phenomenon visible, who ask the interesting questions, who encourage other researchers to explore new and promising fields – pioneers who open up new areas of research. These pioneers seem to play a major role in giving direction to the emerging field of research (Crane, 1972). Venture capital is an old phenomenon and, as shown earlier in this chapter, the institutional venture capital market was established by the end of the 1940s. However, it was not until the growth of the venture capital industry in the 1980s that it aroused interest among scholars. The reason behind this time lag may be the fact that for many years venture capital was a relatively small industry and, even at the end of the 1980s, the venture capital industry in the US never exceeded a couple of billion dollars. By all standards, it was a very small market, and few researchers realized that it would be an important phenomenon for the development of entrepreneurial ventures. However, during the 1980s, pioneers within the field of venture capital research appeared, such as William Bygrave at Babson College, William Sahlman at Harvard Business School, Ian MacMillan at New York University/Wharton School of Business, and Tyzoon Tyebjee and Albert Bruno at University of Santa Clara, who took an interest in the institutional venture capital market. There was also Kenneth Rind with experience as an active corporate venture capitalist in New York, and William Wetzel at the University of New Hampshire who researched the business angels market, and all these researchers were geographically located near the dynamic venture capital markets around Silicon Valley/San Francisco, Boston and New York.

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Handbook of research on venture capital

The subsequent emergence of the venture capital industry in Europe aroused interest among scholars during the early 1990s, especially in countries with an early and dynamic venture capital industry. For example, early research contributions were made by Mike Wright, Richard Harrison and Colin Mason in the UK, Sophie Manigart in Belgium, and Christer Olofsson in Sweden. The exponential growth of venture capital worldwide at the end of the 1990s and beginning of the 2000s – measured in terms of the number of researchers, published articles, and so on – was underlined by the launch of Venture Capital – an International Journal of Entrepreneurial Finance in 1999 – which was mainly dedicated to venture capital research. There was also an increased number of contributions on venture capital from Asia. In many cases, these studies were conducted by Anglo-Saxon researchers in collaboration with domestic partners. The remainder of the chapter will highlight the contributions of the pioneers within the field of venture capital. My objective is not only to provide an insight into the key contributions of these pioneers, but also to familiarize the reader with them as researchers. There are many researchers, who can be regarded as pioneers of venture capital research, and I do not claim to provide a complete picture – the selection is, to a large extent, based on my own subjective view. However, the scope of research on institutional, corporate and informal venture capital diﬀers, which is reflected in the space each part of the venture capital market is given regarding the pioneers as well as in the book in general. Research on institutional venture capital Some early contributions In 1981 Jeﬀry Timmons wrote that research on venture capital by academics was practically non-existent, which was true at that point in time for rather self-evident reasons – the venture capital industry was still small and rather insignificant for the majority of high growth firms as well as for economic development in a more general sense. However, we can find some pioneering contributions to the research on venture capital as early as the 1950s. The first PhD thesis on the topic of venture capital, entitled ‘Corporate profits and venture capital in the post-war period’, was written by Hussayni in 1959 and published at the University of Michigan. However, it was during the 1960s and 1970s that new topics emerged in venture capital research (Brophy, 1982; 1986; Timmons and Bygrave, 1986). One of the earliest interests in venture capital in the 1960s came from scholars in the field of management through works on entrepreneurship who became interested in the characteristics of new technology-based firms, and the problem of external financing in these ventures (see for example early contributions by Shapero, 1965; Roberts, 1969; Cooper, 1971; von Hippel, 1973). In addition, these management scholars stimulated a series of studies on the financing of growth-oriented companies seen from the entrepreneur’s point of view – demand perspective (see for example Baty, 1963; Aguren, 1965; Briskman, 1966; Rogers, 1966; Hall, 1967). Several of the latter studies were published as MS theses at MIT in Boston and can in many cases be regarded as ‘one shot’ studies, whose authors did not develop a sustained body of work in the field. Another research strand came from scholars in the field of finance who, especially in the 1970s, became interested in venture capital. For many years, knowledge of equity markets in finance theory has been well developed. These theories were typically oriented

Pioneers in venture capital research

17

towards equity finance of large publicly traded companies. However, venture capital was diﬀerent in several respects; venture capital invested in young firms with little performance history, the relationship between investor and investee was characterized by a higher degree of involvement and the investments were often illiquid in the short term due to the lack of eﬃcient exit markets. As a consequence, there was an open field for theory development – trying to apply financial models to venture capital, and researchers also addressed the issue of market eﬃciency on the venture capital market with early contributions by, for example, Donahue (1972), Bean et al. (1975), Charles River Associates (1976), Leland and Pyle (1977), Cooper and Carleton (1979), and Chen (1983). A third area of early interest was the venture capital process, from the investment decision to the exit of the investment. Throughout the 1970s attention was devoted to examining the investment and screening process from the venture capitalist’s point of view – a supply perspective (see for example Briskman, 1966; Aggarwal, 1973; Wells, 1974) – and most of the studies confirmed the general belief that the quality of the entrepreneur/founding team and the marketability of the idea are central for success. Another issue of interest in venture capital research was the performance of venture capital investments, and in several studies the annual rate of returns on these investments was calculated (see for example Faucett, 1971; Wells, 1974; Hoban, 1976; Poindexter, 1976; Dorsey, 1977; Huntsman and Hoban, 1980; DeHudy et al., 1981). The conclusions that can be drawn from these studies were that it was diﬃcult to find reliable data and the results of the studies were highly varied. Methodologically, most of the research at this time was based on anecdotal data and/or survey studies using small samples, and venture capitalists were not always willing to provide information that could be made public – factors that made the research less reliable. The emergence of research on institutional venture capital As the venture capital industry grew in scope and importance during the 1980s, interest among scholars increased. A main point of departure was that venture capital concerned ‘building businesses’ and no single discipline could claim to possess suﬃcient knowledge to provide complete understanding of this process. Therefore, a number of scholars, from diﬀerent disciplines – mainly management and entrepreneurship as well as from the field of finance and economics – ‘rushed’ into this emerging topic – providing diﬀerent concepts and methodological approaches in order to understand venture capital finance. Thus, one such group had a background in management and entrepreneurship and focused their attention on the venture capital process (from fund raising, pre-investment activities, to exit of the investment) from a managerial point of view – a micro-level focus – or what we will call ‘managerial-oriented venture capital research’. Several pioneering studies were presented in the 1980s, and some examples are given in Table 1.3. It should be emphasized that the selection of studies is based on my own subjective view, not on any bibliographical analysis. Another group of researchers with roots in finance and economics concentrated on the venture capital market – a macro-level focus – trying to analyse and understand the flow of venture capital, its role in the development of new industries, regional aspects of venture capital, and so on – or what we will term ‘market-oriented venture capital research’. Some of the pioneering studies of the 1980s are presented in Table 1.4. As noted by Sapienza and Villanueva in Chapter 2 of this book, the early contributions to venture capital research can be characterized as highly descriptive, where the researchers primarily aimed to document a more or less unknown phenomenon. As such, early research

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Handbook of research on venture capital

Table 1.3

Topics in managerial venture capital research

Topics of research

Pioneering studies

Pre-investment activities and investment decision criteria

Tyebjee and Bruno (1984), ‘A model of venture capitalist investment activity’, Management Science, 30 (9), 1051–66. MacMillan et al. (1985), ‘Criteria used by venture capitalists to evaluate new venture proposals’, Journal of Business Venturing, 1, 119–28. MacMillan et al. (1987), ‘Criteria distinguishing successful from unsuccessful ventures in the venture screening process’, Journal of Business Venturing, 2, 123–37.

Venture capital investment strategies

Robinson (1987), ‘Emerging strategies in the venture capital industry’, Journal of Business Venturing, 2, 53–77.

Syndication/Co-investing

Bygrave (1987), ‘Syndicated investments by venture capital firms: A networking perspective’, Journal of Business Venturing, 2, 139–54. Bygrave (1988), ‘The structure of the investment networks of venture capital firms’, Journal of Business Venturing, 3, 137–57.

Governance and contracting

Sahlman (1990), ‘The structure and governance of venture-capital organizations’, Journal of Financial Economics, 27, 473–521.

Post-investment activities/board of directors/value added

Gorman and Sahlman (1989), ‘What do venture capitalists do?’, Journal of Business Venturing, 4, 231–48. Rosenstein (1989), ‘The board and strategy: Venture capital and high technology’, Journal of Business Venturing, 3, 159–70. MacMillan et al. (1988), ‘Venture capitalists’ involvement in their investments: Extent and performance’, Journal of Business Venturing, 4, 27–47. Sapienza and Timmons (1989), ‘Launching and building entrepreneurial companies: Do the venture capitalist add value?’, in Brockhaus et al. (eds), Frontiers of Entrepreneurship Research, Wellesley, MA: Babson College, 245–57.

Success factors, returns and performance

Bygrave et al. (1989), ‘Early rates of returns of 131 venture capital funds started 1978–1984’, Journal of Business Venturing, 4 (2), 93–105.

has been extremely useful in that it has not only contributed to a deep understanding of the industry and the way in which venture capitalists operate, but also provided a sound base for further theory building. The ‘descriptive’ period of venture capital research during the 1980s was followed by a growing interest in more theory-driven venture capital research. Before discussing the development of venture capital research during the 1990s, I will comment on the importance of databases in this regard. A contributing factor in the emerging interest in venture capital among researchers was the fact that data on venture capital became available not least from sources such as Venture Economics. Venture Economics gathered data from venture capital firms regarding their investment activities, and the information was published monthly in the Venture Capital Journal. But there were

Pioneers in venture capital research Table 1.4

19

Topics in market-oriented venture capital research

Topics of research

Pioneering studies

Flow of venture capital

Brophy (1986), ‘Venture capital research’, in Sexton and Smilor (eds), The Art and Science of Entrepreneurship, Cambridge, MA: Ballinger.

Venture capital as a financial intermediator

Cooper and Carleton (1979), ‘Dynamics of borrower–lender interaction: Partitioning final pay oﬀ in venture capital finance’, Journal of Finance, 34, 517–33. Chen (1983), ‘On the positive role of financial intermediation in allocation of venture capital in a market with imperfect information’, Journal of Finance, 38 (5), 1543–61.

Venture capital and the development of industries

Sahlman and Stevenson (1985), ‘Capital market myopia’, Journal of Business Venturing, 1 (1), 7–30. Kenney (1986), ‘Schumpeterian innovation and entrepreneurs in capitalism: A case study of the US biotechnology industry’, Research Policy, 15, 21–31.

Regional aspects of venture capital

Florida and Kenney (1988), ‘Venture capital and high technology entrepreneurship’, Journal of Business Venturing, 3, 301–19. Martin (1989), ‘The growth and geographical anatomy of venture capitalism in the United Kingdom’, Regional Studies, 23, 389–403.

Policy-oriented venture capital research

Timmons and Bygrave (1986), ‘Venture capital’s role in financing innovation for economic growth’, Journal of Business Venturing, 1, 161–76.

also other databases available such as the Investment Dealer’s Digest on initial public oﬀerings of securities, and the Center for Research in Securities Prices with daily return data on IPOs. The increased availability of data made the research on venture capital more methodologically sophisticated, and it became possible to test theories, thus leading to more reliable and valid research. As indicated above, during the 1990s we could increasingly identify a theoretical development in venture capital research. An interesting observation in this respect by Sapienza and Villanueva (Chapter 2) is that the emergence of venture capital research coincided with the development of the entire field of management science, and it was natural that early contributions in venture capital research followed the prevailing trends of theoretical development in management science in general, with a reliance on rational economic models and use of agency theory as a dominant theoretical framework. The number of researchers and published articles on venture capital grew significantly during the 1990s (see Figure 1.1). At the same time the research became more theoretically oriented and, as shown by Cornelius and Persson (2004; 2006), the field became partly divided into two separate clusters of researchers – one with a background in finance and economics and the other rooted in management and entrepreneurship theory. For a review of earlier research on institutional venture capital, see for example Wright and Robbie (1998), Mason and Harrison (1999a) and the three-volume compilation of key articles on venture capital research by Wright, Sapienza and Busenitz (2003).

20

Handbook of research on venture capital Theoretical background Management and Finance and Entrepreneurship Economics

Macro

Level of analysis

Micro

Figure 1.4

Examples: Jeffry Timmons, William Bygrave, Gordon Murray

Main focus Examples: William Bygrave, Harry Sapienza, Lowell Busenitz, Jeffry Timmons, Anil Gupta, Andrew Zacharakis, Dean Shepherd, Sophie Manigart, Vance Fried, Robert Hisrich

Main focus Examples: Paul Gompers, Josh Lerner, Raphael Amit, Thomas Hellman, Bernard Black, Ronald Gilson, Leslie Jeng, Philippe Wells Examples: Paul Gompers, Josh Lerner, Mike Wright, Raphael Amit, James Fiet, Anat Admati, Paul Pfleiderer

Researchers on institutional venture capital

Many important contributions to venture capital research were made during the 1990s, and it would be impossible to choose two or three that could be regarded as more important than the others. However, in Figure 1.4 I will present some of the leading scholars within the field during the 1990s – researchers who showed a growing interest in theoretical understanding of the venture capital phenomenon and used more sophisticated methodological approaches. One conclusion that can be drawn from the study by Cornelius and Persson (2004; 2006) is that there are two diﬀerent clusters that seldom meet or cite each other’s work. In order to develop our knowledge of institutional venture capital, I believe it is necessary to encourage cross-fertilization between these two clusters of researchers. The building of a social structure among researchers within the field goes hand in hand with the cognitive development of the research. For example, it is important to develop a ‘cognitive style’ that includes a professional language and clear definitions of central concepts within the field of venture capital. In order to establish this cognitive style, it is essential to develop a ‘social culture’ within the field, which requires regular and intensive forums for discussions, where informal communication between researchers is of central importance. Informal networks are a prerequisite for the exchange of ‘tacit’ knowledge, consensus regarding definitions, discussions on methodological approaches, and so on. Such ‘research circles’ (Landström, 2005) can be achieved through the establishment of research centres and well-developed informal international networks – promoting cross-fertilization within venture capital research. Pioneers of institutional venture capital research In this section I will present some of the pioneers of institutional venture capital research: Tyzoon Tyebjee, Ian MacMillan, William Bygrave and William Sahlman. I will provide a short summary of the seminal articles of each pioneer, followed by an interview with each

Pioneers in venture capital research

21

of them in order to present their reflections on their own contribution to knowledge, as well as their views on the venture capital industry and venture capital research. I will start with Professor Tyzoon Tyebjee and the article he wrote together with Albert Bruno in Management Science – which is one of the most cited articles in venture capital research.

Picture 1.1

Tyzoon Tyebjee, Professor of Marketing, University of Santa Clara, USA

BOX 1.1

TYZOON TYEBJEE

Born: 1945 Career 1977 –

Leavey School of Business, Santa Clara University, USA Professor of Marketing 1975–1977 Wharton School, University of Pennsylvania Education 1976 1972 1969 1967

PhD in Marketing University of California, Berkeley MBA in Marketing University of California, Berkeley MS in Chemical Engineering Illinois Institute of Technology, Chicago B Tech in Chemical Engineering Indian Institute of Technology, Bombay

Seminal article The article by Tyzoon Tyebjee and Albert Bruno ‘A model of venture capitalist investment activity’ published in Management Science in 1984 can be regarded as a truly seminal work within venture capital research. It was based on two empirical studies. The first

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Handbook of research on venture capital

comprised a telephone survey of 46 venture capitalists in California, Massachusetts and Texas, while in the second, Tyebjee and Bruno used Pratt’s directory of venture capital (1981) to identify 156 venture capital firms, 41 of which participated in the study. The venture capitalists were sent a questionnaire for the purpose of evaluating deals under consideration by the firm, and 90 completed evaluations were returned. On the basis of the studies a venture capital process model was developed, in which the investment process was described as consisting of five phases: (1) deal origination; (2) screening; (3) evaluation; (4) deal structuring; and (5) post-investment activities. The authors particularly focused on the evaluation phase in which venture capitalists assess a new venture proposal based on a multidimensional set of characteristics. The venture capitalists who participated in the study were asked to rate deals that had passed their initial screening according to 23 decision criteria. Based upon a factor analysis Tyebjee and Bruno concluded that venture capitalists evaluate deals in terms of five basic characteristics: (i) market attractiveness; (ii) product diﬀerentiation; (iii) management capabilities; (iv) environmental threat resistance; and (v) cash-out potential. The score of each deal estimated on the basis of the five dimensions was related to subjective estimates of the level of expected return and perceived risk using a linear regression model. The results indicated that two aspects seemed to have a significant impact on the risk associated with the deal – a lack of managerial capabilities significantly increases the perceived risk followed by ‘environmental threat resistance’, whereas the attractiveness of the market and the product’s diﬀerentiation are related to the expected return. In the sample of 90 deals, 43 were regarded as acceptable investments while 25 were rejected. A discriminant analysis was used to examine whether the level of perceived risk and return could be used as a means of distinguishing between rejected and accepted deals. According to the results of the study, the decision to invest is determined by the risk versus return expectations, and venture capitalists seem to be profit oriented and averse to risk, although they are willing to invest in risky deals if the risk involved is oﬀset by the profit potential. As indicated above, this seminal work by Tyzoon Tyebjee and Albert Bruno is one of the most cited articles within venture capital research and forms the basis for many of the studies that constituted a strong research stream within venture capital research during the 1990s on the criteria used by venture capitalists when assessing new deals. Interview with Tyzoon Tyebjee What attracted your interest in venture capital and venture capital decision-making? I studied engineering and came to the US from India in the late 1960s to take my graduate degree. Following some work as an engineer, I decided to go to business school, and in pursuing a PhD I specialized in the area of marketing, in particular consumer choice behaviour. After a brief stay in the faculty at Wharton Business School I joined Santa Clara University. At Santa Clara University, in the heart of Silicon Valley, my interests in business, and my former interest in engineering and technology really came together, because I was now in an environment where the commercialization of technology played a very significant role. So, it was not a big issue for me to go into the area of venture capital, but my interest was really sparked by some funding which was made available by the National Science Foundation in order to carry out research on what was then a

Pioneers in venture capital research

23

relatively young industry. My co-author Albert Bruno and I received a fairly large amount of funding for the project. The interest of the National Science Foundation was actually a little diﬀerent from our interests. The government wanted to know what happened to ventures that received no funding . . . in other words, was the venture capital market eﬃcient in terms of recognizing strong opportunities, or were some commercially viable opportunities ignored by the venture capital industry, and if so, did these ventures find alternative sources of funding? My personal interest was to try to introduce consumer choice behaviour and apply choice behaviour models to how venture capitalists made choices. Your study was published in Management Science and became one of the truly seminal articles within the field of venture capital research . . . At that time there was very little published work on venture capital in mainstream academic literature. Most of the venture capital research was very descriptive . . . size of deals, amount of equity investments, profile of venture capital firms and ventures, and so on. And those kinds of studies were not very often published in the academic literature. I think one of our significant contributions was the legitimization of both area and topic by modelling them in a way that gave them academic credibility and, in this regard, the aspect of the study that focused on venture capital decision-making and venture capital choice behaviour was a piece that really lent itself best to serious modelling. You have followed the development of the venture capital industry for a long time. What changes in venture capital have taken place since the 1980s? I think a couple of things have happened in the venture capital market in the US. One is that there is a much greater number of venture capitalists today who were actually entrepreneurs themselves . . . people who have been through the start-up process themselves and, as a result, they are not just financiers, they are people who bring operational expertise. Having said that, the venture capital industry has become more professional with less reliance on pure instinct, far more analysis, far more financial models applied to valuation, resulting in a significant improvement in technical skills within the venture capital decision-making process. In addition, the geographic scope of investments has widened considerably. The focus is no longer local. There was a saying 25 years ago that people invest so that they can visit the venture and sleep in their own bed that same night . . . that is not so any more . . . venture capital has become a global industry and that represents a big change. Globalization is also apparent if you look at what the venture capital network is composed of . . . in the 1980s, the members of the venture capital associations were all basically American white males. Today, the membership is global . . . firms employ the skills of people who have either lived or were born outside of the US and who have very strong networks over there. Another big change is that there is a distinction now between funding products and funding businesses. I think there is a discussion which did not take place 25 years ago that if an entrepreneur has an innovative product – that is no longer enough . . . the venture capitalist asks: Is this product the foundation . . . has it got the potential to spin oﬀ a wider range of portfolio products or opportunities? A good example is Google. Google which basically started out as a search engine, but its business today has far exceeded that . . . basically, a product has to be a platform for building a wider range of businesses.

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Handbook of research on venture capital

Looking at the venture capital industry today, is there anything that can be learned from your study in the early 1980s? One of the things that I think we contributed to, besides the decision-making criteria model, was to model a process that identified the stages of the venture capitalists’ decision-making process. A good venture capitalist, today as well as in the past, is strong in each of these areas, they have good networking in order to be able to locate and identify deals, they have strong evaluation methodologies to be able to focus on deals to which they can bring the highest level of added value as a venture capital firm as well as those which are most likely to succeed. Third, they have strong skills in terms of structuring these venture capital arrangements, and finally, they are very strong in terms of the postinvestment contributions they make in the venture, especially in the area of board representation and in their networking ability. If you were to conduct your study today, what changes would you make? I think that I would have included a wider range of criteria to reflect today’s environment, and certainly the globalization of business and the ability of the venture to respond to the market would have been something that I would have focused on . . . at that time it was not much of an issue. Let us look at venture capital research in a general sense . . . what development can you see in venture capital research? I think it has broadened the questions that have been asked. It has drawn on a wider range of disciplinary interests, which in my opinion has been very useful. For example, the finance community has become a much stronger discipline for venture capital research, and they have brought a methodology and line of inquiry that was lacking 25 years ago. So, questions such as what aﬀects valuation, what aﬀects the value of the firm when it goes public . . . these were not questions which were really pursued 25 years ago . . . focus was more on the venture capitalist and less on the venture, and I think that has changed. However, I still think that there is not enough cross-fertilization between the research which emerges from traditional entrepreneurship surveys and interviews and the more secondary financial database oriented research which has been carried out by the finance community. The second thing that has changed is that there are much stronger quantitative databases today, and these have been made available to members of the academic community, facilitating a line of inquiry much broader than self reports. So, as I see it, it is more that methodology and disciplinary perspectives have changed. In terms of the questions themselves . . . I think that the basic questions have remained the same. These questions are: how do you select a deal, what aﬀects its success, and to what extent does the value added by the venture capitalists influence that success . . . these are the fundamental questions. What advice would you give to new PhD students on venture capital? My advice to them would be to push the issue to another level in terms of trying to bring new approaches by means of new questions rather than simply doing some incremental advances on previous studies . . . I think a great deal of the research is based on that. For example, referring to our own study . . . five criteria became six (or maybe seven), and the

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labels changed . . . but there has really been no significant advance in terms of looking at it in a new way. A second piece of advice is to recognize that this is an area in which obtaining good data is very diﬃcult, particularly if you are relying on venture capitalists and surveys of them as the source of such data. So, I think that an advance should come from new research in the area of methodology concerning how to obtain insightful data on venture capital. A third area that I would emphasize, and this is a far narrower observation than the previous two, is to try to understand the role that the portfolio of the venture capital firm plays in the success of an individual venture. We have looked a great deal at the relationship between the venture capitalist and the venture, while the relationship between a particular venture and the others in the portfolio has not received as much attention in spite of the fact that it would facilitate an understanding of how the network of relationships within a venture capitalist’s portfolio leverages individual ventures. Fourth, I think it would have been useful to ask: has the structure of the venture capital industry changed? For a long time we have talked about two legs: institutional and angel, and corporate venture capital has been added as a third. But are there other emerging forms of venture capital? I think it is very useful to look at the context . . . diﬀerent kinds of venture capital emerge in diﬀerent contexts. For example, if we look at the Asian markets where family business structures are very strong; how does the idea of venture capital and family business overlap and intersect? Finally, if we look more specifically at venture capitalists’ decision-making, one area that requires some improvement is that when we study venture capital decision-making we pretend that there is a single decision-maker . . . which is rarely the case. In a venture capital firm there are multi-parties who jointly make a decision, so I think that it is important to try to understand how multiple inputs in a multi-decision-maker environment end up in an investment decision as well as how these decisions flow over the multi rounds of investment in the same firm. So, a longitudinal decision-making approach over a single venture . . . that is something that I haven’t seen. Policy aspects of venture capital are always a ‘hot topic’: what can we learn from the US in order to improve the venture capital market in other countries, for example in Europe? About 15–20 years ago I wrote a paper called ‘Venture capital in Western Europe’ in an attempt to understand what aspects of the US environment diﬀer from Europe. I think several things have changed. At that time tax policy in Europe was very restrictive, but I think it is much less restrictive today. There are no strong cultural heroes, and there was less of a tendency to pursue something outside of the established business institutional structure by striking out on your own. I think that has also changed . . . not as strongly as in the US but there has nevertheless been a change. One of the areas in which US venture capital has been extremely successful is the flow of knowledge . . . historically, much of that has been due to the US immigration laws. If you look at many of the venture capital successes you will find that there is an immigrant somewhere in the venture, and I think Europe has been very restrictive in that regard – in terms of allowing people to bring knowledge capital. So, an eﬃcient venture capital market requires not only the free flow of capital, but the free flow of knowledge . . . and I think that policy-makers will have to encourage that.

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In general, from a policy point of view, I think the basic idea is to get out of the way . . . and that means allowing people to be successful and become wealthy which obviously involves tax policy, allowing knowledge to flow freely, while at the same time protecting that knowledge by means of patents. Thus, I think that rather than focusing on venture capital per se, it is necessary to focus on the overall environment in which venture capital operates.

Picture 1.2 Ian MacMillan, Professor of Management, Wharton School of Business, USA

BOX 1.2 Born: 1940 Career 1986–

1984–1986 1976–1983 1975 1965–1970 1963–1964 Education 1975 1972 1963

IAN MACMILLAN

Wharton School, University of Pennsylvania 1986– Director, Sol C. Snider Entrepreneurial Research Center 1986–1999 George W.Taylor Professor of Entrepreneurial Studies 1999– Fred R. Sullivan Professor New York University Professor and Director of the Center for Entrepreneurship Research Associate Professor, Columbia University Visiting Researcher, Northwestern University Chief Chemical Engineer, Consolidated Oil Products, South Africa Scientist, Atomic Energy Board, Government Metallurgical Labs, South Africa DBA, University of South Africa MBA, University of South Africa BS, University of Witwatersrand, South Africa

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Seminal articles Following on Tyebjee and Bruno, Ian MacMillan together with colleagues wrote some very important articles on decision-making in venture capital in the mid-1980s. The first article was ‘Criteria used by venture capitalists to evaluate new venture proposals’ in 1985, and it was intended as a follow-up and a replication of an earlier study by Tyebjee and Bruno presented at the Babson Conference in 1981. In the article, Ian MacMillan and his colleagues elaborated on the question: what criteria do venture capitalists use when evaluating venture proposals? Based on interviews with 14 venture capitalists in the New York area and a questionnaire sent to 150 venture capitalists, the results indicated that venture capitalists evaluated ventures in terms of six risk categories (which correspond closely with the findings of Tyebjee and Bruno, 1981): 1. 2. 3. 4. 5. 6.

Competitive risk, i.e. little threat of competition and an existing competitively insulated market. Risk of being unable to bail out if necessary. Risk of losing the entire investment. Risk of management failure, i.e. whether the entrepreneur is capable of sustained eﬀort and knows the market thoroughly. Risk of failure to implement the venture idea, i.e. whether the entrepreneur has a clear idea of what s/he is doing and whether the product has demonstrated market potential. Risk of leadership failure, i.e. whether the entrepreneur has leadership qualities.

The main conclusion in the study was that the most important criteria had to do with the entrepreneur’s experience and personality, which MacMillan expressed in the following way: ‘There is no question that irrespective of the horse (product), horse race (market), or odds (financial criteria) it is the jockey (entrepreneur) who fundamentally determines whether the venture capitalist will place a bet at all’ (p. 128). However, the fact that venture capitalists use certain criteria does not mean that such criteria can distinguish between successful and unsuccessful ventures. In a later article, in 1987, entitled ‘Criteria distinguishing successful from unsuccessful ventures in the venture screening process’, MacMillan and his colleagues tried to determine the extent to which criteria are useful predictors of performance. A questionnaire was designed in which 220 venture capitalists were asked to rate one of the most successful ventures and one of the least successful ventures they had funded, based on 25 decision criteria. In addition, the venture capitalists were asked to rate the venture’s performance on seven performance variables. In total, 150 evaluations were usable in the study. The results indicated that the major diﬀerence between a winner and a loser seemed to be some ‘diﬃcult-to-define’ entrepreneurial team characteristics, and MacMillan concluded that ‘. . . it is not surprising that venture evaluation remains an art, a long way from becoming a science’ (p. 129). Another interesting finding was the identification of two major criteria as predictors of venture success: (1) the extent to which the venture is initially insulated from competition; and (2) the degree to which there is demonstrated market acceptance of the product. It is interesting to note that these two criteria are market- rather than product- or entrepreneur-related and neither was considered essential in the 1985 study. The question was: why were criteria related to the entrepreneurial team and the entrepreneur, which

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were emphasized in earlier studies, not regarded as predictors of success? In this respect, MacMillan made a distinction between necessary and suﬃcient conditions for success. Venture capitalists will not back ventures with a bad entrepreneurial team. Success or failure has to do with those ventures that receive funding. The evaluation of the entrepreneurial team is essential in order to obtain financial backing from venture capitalists whereas the two criteria – threat of competition and market acceptance of the product – are predictors of success for firms already financed by venture capitalists. Another topic in MacMillan’s early contributions on venture capital was the interest in the added value brought by the venture capitalists to the ventures in which they invest. The article ‘Venture capital involvement in their investments’ (1988) followed some earlier studies on venture capitalists’ involvement and value-adding (see for example Gorman and Sahlman, 1989; Timmons and Bygrave, 1986) indicating that, in addition to providing capital, venture capitalists also play many other roles in their portfolio firms. However, none of these studies correlated the venture capitalists’ involvement with the ventures’ performance – which MacMillan and his colleagues attempted to do in this study. The study is based on a questionnaire distributed to a sample of 350 venture capitalists (response rate 18 per cent or 62 usable responses), in which the venture capitalists were asked to indicate their involvement in each of 20 activities for a specific venture. The results show that serving as a sounding board for the entrepreneurial team and diﬀerent financially oriented activities had the highest rating, whereas the lowest degree of involvement occurred in activities related to ongoing operations. However, the most interesting results concern the identification of three distinct levels of involvement adopted by venture capitalists: ● ● ●

Laissez-faire involvement – the venture capitalists exhibited limited involvement. Moderate involvement. Close tracker involvement – the venture capitalists in this group exhibited more involvement in virtually every activity than their peers.

Some interesting conclusions emerged from the study. For example, it appeared that venture capitalists exhibit diﬀerent involvement levels as a matter of choice, and not due to diﬀerent characteristics of the ventures. When the performance of the ventures was examined, it was evident that there were no significant performance diﬀerences among ventures in the three clusters – each involvement strategy is about equally eﬀective, that is ‘close tracker venture capitalists’ were no more or less successful than the other groups. Interview with Ian MacMillan Let’s start with the seminal studies on venture capital decision criteria that you conducted in the mid-1980s, and which were published in the Journal of Business Venturing in 1985 and 1987. Why did you become interested in this topic? In 1975 I came from South Africa to the Northwestern University in Boston, but after a few years I moved to Columbia University in New York. In the early 1980s a decision had been taken by New York University to launch a Center for Entrepreneurship, and in 1984 I was oﬀered the position as professor and director of the Center for Entrepreneurship Research. I remained in that position until 1986, when I moved to Wharton School of Business in Philadelphia.

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In New York we had a fair amount of contact with venture capitalists in the area. We found out that there seemed to be some criteria that all venture capitalists looked for when evaluating a new deal, but the thing that struck me was that there were also some idiosyncratic criteria that diﬀerentiated venture capitalists from each other – some venture capitalists seemed to use a diﬀerent set of decision criteria – but although most venture capital investments are highly risky and have a high failure rate, the venture capitalists were still able to deliver a significant rate of return to their investors – that attracted my interest: what criteria do venture capitalists use when evaluating new investment proposals? And, does it matter? In the first study we found that the quality of the entrepreneur and the entrepreneurial team was of great importance in the venture capitalists’ evaluation, but we didn’t know anything about performance in relation to the criteria used by the venture capitalists – as the criteria emphasized by the venture capitalists were not necessarily correlated with the success of the ventures. The big surprise in the second study was that the emphasis the venture capitalists attached to the quality of the entrepreneur and the entrepreneurial team didn’t correlate with performance. So, there was a huge emphasis on the entrepreneur, but when we looked at the impact of these criteria on outcomes it turned out that it was not the entrepreneur that mattered so much but rather the demand for the product in the market place and protection against competitive attacks . . . and this was a puzzle. We went back to the venture capitalists and said: ‘Here is an anomaly . . . you place a tremendous amount of emphasis on the entrepreneur, but the reality is that when we looked at performance, it is the product characteristics in the market place that seem to matter!?’ The explanation was that we were overlooking the fact that the characteristics of the entrepreneur and the entrepreneurial team were used to screen out the certain losers . . . people that the venture capitalist would not invest in . . . and what was left over is a bunch of people who, despite their qualities, provide no indication of whether or not they will be successful. And what may determine the success of a project is an established demand in the market and that the product is protected from competitive attacks. Thus, while the entrepreneur is a necessary condition, s/he is not suﬃcient for success. What basically happened was that we went beyond simply accepting the results and said: ‘Let’s try to find the reasons why these results do not line up with our observations of the real world.’ You also looked at the venture capitalists’ involvement in the ventures in which they invest . . . a study that was published in the Journal of Business Venturing in 1988. Many venture capitalists that we met claimed that they did more than just invest in a company . . . that they brought an added value beyond capital . . . but at that point in time we had very little hard data on this added value. I became intrigued by the ways in which venture capitalists could add value. To me it was obvious that venture capitalists could add value – they had experience and expertise from active involvement in many ventures. To bring one of the leading venture capitalists into the venture meant not only money, but access to the venture capitalist’s experts and legitimizing the venture, which has a domino eﬀect. What we found in the study was that venture capitalists seemed to work in various ways based on their own decisions, but there was no significant diﬀerence in performance related to their involvement strategy. This was interesting, but you have to remember that,

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as in many earlier studies, we had some problems measuring input as well as output variables. So, when you have judgemental data as well as messy dependent and independent variables, it should come as no surprise that the relationships are ‘messy’. This is probably a very complex relationship. It might be a good thing for the entrepreneur to involve a venture capitalist in the venture, but such involvement also means a host of issues that could be very harmful . . . it is the mix of good and bad that leads to inconsistencies in the results of the study, and we were unable to sort that out . . . a problem that researchers still have. How would you describe the research on venture capital that followed from your and others’ pioneering studies? I think what we needed back in the 1980s was to get some scope and terrain identification. Much of the early work that I did on entrepreneurship and venture capital was more in the nature of documentation of phenomena that had not been described before, and categorizations of phenomena, rather than the development of new theories . . . going into emergent fields or topics and seeing if we could identify the decisive key variables, to pass them on to other researchers to explore in greater depth . . . it made further work possible . . . in that respect I think our early work was important. Once you have done your explorative work somebody must bring some theory into it, and that is what I think happened in the 1990s. Researchers started to think about the phenomenon of venture capital in the context of theory and in particular brought economic concepts and theories, not least agency theory, into venture capital research . . . that is a natural progression. The concern is of course if you let these theories totally dominate the research . . . then you increasingly have the kind of research that we find in a lot of management research today. We are not there yet, but there is a danger that it will happen – an incredibly sophisticated analysis of basically trivial problems . . . and less emphasis on what we can learn that provides us with insights for people operating in the ‘real world’ – we need to develop meaningful knowledge. Looking to the future. What kind of research questions would you like to see in the years to come? I will give you two examples of venture capital research that I would very much like to see in the future: first, as you know, I have been involved, together with Rita McGrath, in the development of what we call ‘option reasoning’, and I would very much like to see venture capital research based on option reasoning. Second, I would like to see more room for researchers who study venture capital investments as a sociological phenomenon . . . more attention to understanding how networks of venture capitalists make decisions . . . maybe to see the venture capital community as a neural net – a bunch of nodes making decisions and being aware of the decisions that are made by others. You are a very experienced mentor and supervisor of doctoral students. What advice would you give to a new doctoral student who wants to start research on venture capital? This is perhaps one of the most diﬃcult questions to answer. I have spent many years trying to tell my doctoral students to think in terms of relevance . . . the research must be relevant and important to society, and you need a great deal of confidence and intellec-

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tual capabilities to produce ground-breaking work that is relevant to and important for society. This is a challenging task and you never know if you will make it and be able to develop a number of papers that set you up for the tenure race . . . and, it is diﬃcult to encourage young researchers to take this path. As a doctoral student you need to get published . . . have enough articles published to obtain tenure. Therefore, most doctoral students will work on more incremental studies, extending knowledge with a few minor variations, with greater chances of getting published . . . because journals are more interested in statistical, robust results than in relevance to society. This is a strategic decision for a doctoral student – it is a trade oﬀ between relevance, newness and big risks, compared to replication, incremental development of knowledge, and less risk of failure. My heart indicates the first path, but not many people make it. The problem is that the research easily becomes trivial. So, all doctoral students who I work with today must go through my ‘six-people-test’. If you are going to do research you need to do something that couldn’t be solved by six smart people in a two-hour discussion. If they come to the same conclusion as you do from research, then why do the research? Why not talk to six smart people? Research must go beyond what is self-evident.

Picture 1.3

William Bygrave, Professor of Entrepreneurship, Babson College, USA

BOX 1.3 Born: 1937 Career 1985–

1982–1985 1984 1979–1982 1970–1978 1963–1978

WILLIAM BYGRAVE

Babson College 1991– Frederic C. Hamilton Chair for Free Enterprise Studies 1993–1999 Director, Arthur M. Blank Center for Entrepreneurship Associate Professor, Bryant College Associate Professor, Boston University Associate Professor, Southeastern Massachusetts University Deltaray Corporation High Voltage Engineering Corporation

32

Handbook of research on venture capital Education 1989 1979 1963 1963 1959

DBA in Management (Policy), Boston University MBA (Executive Program), Northeastern University D.Phil. in Physics, Oxford University MA (Physics), Oxford University BA (Physics), Oxford University

Seminal articles One of the most influential pioneers of venture capital research, and a researcher who has dedicated his life to our knowledge of venture capital, is William Bygrave. During the 1980s Bygrave presented several pioneering contributions in venture capital research. One study that deserves mention is ‘Venture capital’s role in financing innovation for economic growth’ together with Jeﬀry Timmons (1986). The aims of the study were to (i) determine the characteristics of technology-oriented venture capitalists and entrepreneurs in these high-tech firms, (ii) examine the factors that influence the supply of venture capital for the development of small high-tech companies, and (iii) elaborate on whether or not publicpolicy instruments could be used eﬀectively in this process. In the study, the authors used the Venture Economics database and classified 464 venture capital firms according to their investments in ‘highly innovative technological ventures’ (HITV) and ‘least innovative technological ventures’ (LITV). The study shed new light on the flow of venture capital to highly innovative ventures at that point in time. The reduction of the capital gains tax at the end of the 1970s had led to an unprecedented growth in the venture capital industry, and not least in HITV investments. However, HITV investment requires less capital than initial investments in LITV – what is required is quite specialized management, not capital, and there was a core group of highly skilled and experienced venture capitalists that accounted for a disproportionate share of HITV investments. In terms of policy implications, the general view in the article was that government should take a ‘hands-oﬀ’ approach to the venture capital market – active government involvement could well do more harm than good. A second study that received a great deal of attention was on the subject of the co-investment networks of venture capital firms, and Bygrave elaborated on this issue in several seminal articles. The first article that appeared in the Journal of Business Venturing (1987), ‘Syndicated investments by venture capital firms’, is an examination of linkages of venture capital firms through syndication investments. In this article Bygrave posed the following questions: why do venture capitalists network? Do the reasons diﬀer for various types of venture firms? Bygrave used a sample of 1501 portfolio firms for the period from 1966 to 1982 and analysed the joint investments of 464 venture capital firms. The results show that co-investments were more common among venture capitalists in high than low innovative technology ventures, and in early-stage compared to later-stage investments. Thus, the innovativeness and technology of the portfolio companies were crucial in explaining networking among venture capital firms. Bygrave argues that more co-investments are made where there is greater uncertainty and that the primary reason for

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co-investing is the sharing of knowledge rather than the spreading of financial risk – venture capital firms gain access to the network by having knowledge that other firms need. The second article on venture capitalists’ co-investment networks, ‘The structure of investment networks of venture capital firms’ (1988), builds on his previous work and uses his classification of ‘high innovative’ (HIVC) and ‘low innovative’ (LIVC) venture capitalists, depending on their investment profile. He employed this categorization to analyse the diﬀerences between HIVC and LIVC, but also to identify regional diﬀerences in network patterns. The venture capital firms from the Venture Economics database were classified into three groups: (i) the top 61 firms – in terms of most investment in portfolio firms; (ii) the top 21 HIVCs – subset of the 61 firms that mainly invested in high-tech companies; and (iii) the top 21 LIVCs – venture capital firms among the top 61 that mainly invested in low innovative firms. The conclusion was that the venture capital industry in general could be regarded as a rather ‘loosely coupled system’, but the coupling of HIVCs, and especially those in California, was quite tight. In this kind of tight system, external influence can aﬀect the entire system, as information can flow through many channels and make the behaviour in these systems more uniform – which may also explain why herds of HIVCs stampede into or out of new industries. Finally, in another seminal work by Bygrave, together with some collaborators at Venture Economics, ‘Early rates of return of 131 venture capital funds started 1978–1984’, published in the Journal of Business Venturing (1989), the authors noted the lack of reliable data and systematic analysis of the rates of return on venture capital investments. On the other hand, there was no shortage of anecdotal accounts and folklore about the rate of return in the venture capital industry – often indicating returns of 30 per cent or more. Bygrave compiled a database of 131 venture capital funds reporting their rate of return on investments – covering about 50 per cent of the new capital committed to private funds at the beginning of the 1980s. The contribution of this study is mainly the compilation of the database – for the first time ever it was possible to analyse the rates of return in the venture capital industry in a systematic way – although the analysis reported in the article was rather premature and it was too early to draw any clear conclusions (for example the oldest fund in the database was 7 years old and the youngest not more than 15 months old). However, the preliminary analysis of the annual compound rates of return in the period 1978 to 1985 was disappointing compared to the myths that flourished about them in the industry, which, in general, declined at the beginning of the 1980s, although the oldest funds in the database showed a great performance – far in excess of the oft-quoted expectation of 25–30 per cent. Interview with William Bygrave You have an interesting background with a PhD in physics and many years as a manager. Can you give a short summary of your career? Yes, I did my PhD in Physics at Oxford in 1963. But I always had an interest in the commercial world – I grew up in a micro-business context, most of my relatives were entrepreneurs. So, when I graduated from Oxford in Physics I was recruited by an American firm, the High Voltage Engineering Company. I was employed as sales manager for three

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years, and after which I moved to America in 1966 and took charge of the commercialization of new products. Interestingly, the High Voltage Engineering Company was a public company on the New York Stock Exchange, and it turned out to be the first ever venture capital backed company, funded by Georg Doriot and his venture capital company American Research and Development back in the 1940s. After a couple of years I became more and more frustrated by the fact that the company didn’t put enough resources into products that I thought had huge potential, and I left in a friendly fashion. In 1969, together with an MIT professor, I started the Deltaray Corporation, a high tech company that manufactured ultra-stable, high voltage power supplies. We raised money from venture capitalists – at that time the venture capital market was very small and the market almost unknown, but we succeeded. In 1974 we sold the company to the High Voltage Engineering Company . . . my former employer . . . and I stayed with them for a couple of years and became marketing manager – but I didn’t enjoy it. I took an executive MBA at Northeastern University in 1979. Jeﬀ Timmons was the leader of the programme. I met Jeﬀ and it turned out that we had many things in common. At one meeting Jeﬀ said to me ‘I think you are a pretty good teacher. Have you ever thought about an academic career?’ I said ‘why not?’ . . . my family wasn’t keen on me starting another business. So, I became a teacher and I enjoyed it. However, I soon realized that I couldn’t go further than teaching at a rather average university without doing research within the field. I went to Boston University and started on their doctoral programme on a part-time basis in 1981. I contacted Jeﬀ Timmons and Jeﬀ replied immediately and told me that he had a project on venture capital for which he tried to get funding from the National Science Foundation. At that time, the beginning of the 1980s, there were many myths about the venture capital industry, for example, that the rate of return was at least 40 per cent, the most critical factor for the flow of capital was a reduction in the capital gains tax, and venture capital was more than money – venture capitalist brought value-added. But very little was really known about the industry. Some work had been carried out in the 1960s, mainly from a financial perspective, and there were some studies done at MIT . . . mostly as master theses . . . but that was all. Very few knew about the industry, about the flow of capital, and where the industry was going. We obtained funding for the project, and the National Science Foundation wanted to know a great deal, but primarily to understand the flow of venture capital to innovative companies. I started to look at this issue together with Venture Economics . . . which was a company just a mile from Babson College, and they had a database with about 450 venture capital firms and 4000 portfolio firms. At that time everything was stored in a mini-computer with 20 Mbyte, and it was a real limitation in terms of the amount of data that could be stored electronically as opposed to physically. The first thing we did was to characterize the industry based upon technological innovativeness, the flow of capital in the market and, most especially, capital for high-tech companies. We developed a scale for classifying the portfolio firms depending on their degree of innovativeness. Some rather interesting results came out of the study, and it became my first paper for the Babson Conference in 1983, after which some of the results were presented in my Journal of Business Venturing article with Jeﬀ Timmons in 1986.

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But did that study not produce even more results? Yes, we had a good database from Venture Economics, and we had developed a categorization in which we could distinguish between ‘highly innovative technological ventures’ and ‘least innovative technological ventures’, which we could use to look at the networks among venture capitalists through their syndication investments. We divided the venture capitalists into 21 ‘top high-tech venture capital firms’, 21 ‘lowtech venture capital firms’, and 61 firms that didn’t have any preferences. We contrasted the high-tech firms with the low-tech firms, and what we found was that there were diﬀerences between venture capitalist networks on the east coast and the west coast – the California network was much tighter than its counterpart on the east coast, which also influenced the flow of information. But, what we couldn’t disclose in the articles that were published in the Journal of Business Venturing in 1987 and 1988 were the names of the most central venture capital firms in the network – the most central one being Kleiner Perkins. You also performed a study on the rate of returns in the venture capital industry? Shortly after the first study, Venture Economics called me up and asked me to put a database together, which included the rates of return in the venture capital industry. That must have been in 1985. The problem was that the venture capital funds wouldn’t let us have the information, but we could obtain it from the limited partners. Most of the limited partners, such as pension funds, didn’t even know about their rate of return from their venture capital investments because they didn’t have any software to measure it . . . but we said that we could put together a data set if they only allowed us access to their records. In that way we put together a data set including the rate of return for more than 200 funds in America. I’ll never forget the first time that we printed out the results. It took about 20 minutes to run . . . we could see it printing, but after a couple of minutes it stopped. In order to make the programme run eﬃciently, I designed the rate of return algorithm to have a maximum 84 per cent rate of return . . . I never dreamt that anyone could achieve that, so that wouldn’t be a problem . . . but, the printer stopped, and finally, I had to double the upper limit in my algorithm, and the printer started to run again. So, guess what . . . it was Kleiner Perkins once again, not only were they the most central in the venture capital network, their rate of return was so high that it broke my algorithm. That is wonderful . . . seeing something nobody else knows on your computer screen. However, Kleiner Perkins was one of the few winners. Looking at the industry in general, the average rate of return was only 15 per cent in 1985, not the 40 per cent that everyone was talking about. Venture Economics wouldn’t publish the figures, but the results leaked out to journalists. The reactions from industry were mixed – some venture capitalists were furious, others more grateful that correct figures now had been made public. But I couldn’t use the results in my research because the information was bound to secrecy until 1988 when Venture Economics agreed that we could publish it, and it became a Babson Conference paper in 1988 and then an article in the Journal of Business Venturing in 1989. I was also doing my dissertation, and all these studies were included in my doctoral thesis entitled ‘Venture capital investing: a resource exchange perspective’, which I presented in 1989 at Boston University.

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How would you characterize the development of the research field since your pioneering studies in the 1980s? In the 1980s the venture capital industry was shrouded in mystery . . . it was an industry full of myths, but it is fair to say that, by the beginning of the 1990s, venture capital was an ‘open book’ and the research very much from a practitioner’s point of view . . . such as venture capitalists, policy-makers, and entrepreneurs. Today, a great deal of research on venture capital is more rooted in the theory of sociology, psychology and economics. Nothing wrong with theory, but research doesn’t have much impact on practice anymore. Frankly, I think there is too much research being done on venture capital. If venture capital disappeared tomorrow in America, we wouldn’t see any eﬀects on entrepreneurship . . . a few years down the road there would be consequences because the growth of technological innovations would be slower, but venture capital does not develop new ventures, it merely takes existing ventures and accelerates their growth. I have realized more and more that venture capital is so rare in start-ups that it is negligible – only 1 in 10 000 start-ups will have venture capital when they start their business – and in fact, when I lecture my MBA students, I say; ‘forget about venture capital . . . try to get informal investors instead’. So, that is your advice to your MBA students, but what would your advice be to a new PhD student interested in venture capital? Don’t research venture capital! Since I started my research in the 1980s the proportion of money going to early stage ventures has just kept declining, but if we look at the informal investors market – it is enormous. When we did the GEM study, the biggest surprise for me was to see the amounts of money from informal investors, in a broader sense than ‘business angels’. I estimated that about 100 billion dollars a year comes from informal investors in America, and a great deal goes into early stage ventures. And from the entrepreneurs’ perspective the action is in the informal investors’ market, and it is there that we as researchers should make an eﬀort. The risk is that we are doing ‘easy’ research . . . where we can obtain easy data, as opposed to research that is relevant to policy-makers and entrepreneurs. If we study the informal investors’ market, it isn’t easy to obtain data, we have to work with messy data and less elegant databases, and we have to give credit to young researchers who are willing to work with this kind of data. Such research will be far more influential in terms of advice to entrepreneurs and policy-makers. Finally, if we look at policy implications, what should government do to promote an active venture capital market? Looking back, we can conclude that the changes in the pension fund rules at the end of the 1970s were most influential for the flow of venture capital in America. However, the changes in capital gains tax only seem to have had minor eﬀects. Capital gains tax only aﬀects individuals and over the years the proportion of individuals investing in the venture capital industry has dropped. A majority of the money for venture capital is supplied by non-taxable sources such as pension funds, endowments and foreign investors. In addition, I have also learned that there is only one thing that really aﬀects the flow of venture capital and that is the strengths of the public oﬀering market – forget anything else – you need to have a strong second tier market.

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Picture 1.4 William Sahlman, Professor of Business Administration, Harvard Business School, USA

BOX 1.4

WILLIAM SAHLMAN

Born: 1951 Career 1980 – Entrepreneurial Management, Harvard Business School 1999–2002 Co-chair Entrepreneurial Management Unit 1991–1999, 2006– Senior Associate Dean 1990– Dimitri V. D’Arbeloff Professor of Business Administration Education PhD in Business Economics, Harvard University MBA, Harvard University A.B. degree (Economics), Princeton University

Seminal articles With his roots in financial economics, William Sahlman has been extremely influential in venture capital research. His early studies are still among the most cited works within the field. His article ‘Capital market myopia’ in 1985 was the lead article in the first issue of the Journal of Business Venturing. In the article, William Sahlman and Howard Stevenson focused their attention on a phenomenon that they call ‘capital market myopia’ in which participants in the capital market ignore the logical implications of their individual investment decisions – each decision seems to make sense, but when taken together they are a recipe for disaster and lead to over-funding of industries. The article uses the Winchester Disk Drive industry as an example of this phenomenon.

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The Winchester Disk Drive industry, that is high-speed data storage devices for computers, grew rapidly in the late 1970s and early 1980s. The technology was first introduced by IBM in 1973, and many new entrants followed, resulting in an inexorable increase in the performance of computers as well as disk drives. The expectations of the industry were high, and there were many spin-oﬀs where executives in firms that were active in the data storage industry decided to go after a share of the growing market and started their own companies. Finding venture capital for start-ups in the disk drive industry was easy. The industry was perceived as attractive, there was a large group of high quality management, and the equity capital market was increasing. The late 1970s and early 1980s were characterized by a rapid growth in the venture capital industry in the US as well as robust stock market performance. Many of the firms in the disk drive industry received money from venture capitalists – from 1977 to 1983 just over $300 million was invested in the industry by venture capitalists – and a number of firms began to raise capital through the public stock market rather than continuing to rely on venture capital funding. However, something began to happen in the industry and many companies ran into diﬃculties; new technologies were introduced and competition increased, many companies were unable to produce acceptable quality drives, and the market for computers (the customers of the disk drive companies) showed a significant downturn in the rate of growth. Sahlman and Stevenson argued that the venture capitalists could have been aware of these changes if they had used available information on the market, the technology and competition – ‘the data necessary to anticipate the problem were readily available before the industry shakeout began and stock prices collapsed’ (p. 7). In another seminal article, ‘The structure and governance of venture-capital organizations’ (1990), William Sahlman was one of the first to describe and analyse the structure of venture capital organizations. In the article Sahlman provides an analysis of the relationship between the venture capital firm and its fund providers as well as between the venture capitalist and their portfolio firms. The article provides an in-depth understanding of how venture capital organizations are governed and managed. Regarding the relationship between venture capital firms and their fund providers, Sahlman devotes particular attention to the financial contract that governs the relationship and highlights the agency problems involved in the relationship. He argues that venture capitalists have many opportunities to take advantage of the fund providers and that agency problems are exacerbated by the legal structure of the limited partnerships in which limited partners are prevented from playing a role in the management of the venture capital firms. In order to protect the limited partners the contract needs to be designed in such a way that the venture capitalists will not make decisions against the interests of the limited partners, for example, by the inclusion of a limitation on the life of the venture capital fund, a compensation system that gives the venture capitalists appropriate incentives, and a contract that addresses obvious areas of conflict between the venture capitalist and the limited partner. The article also includes a discussion about the relationship between the venture capitalist and his/her portfolio firms. Sahlman drew particular attention to the information asymmetry between the venture capitalist and entrepreneur, which may cause monitoring problems. In this respect, Sahlman provided a rationale for venture capitalists to stage their commitment of capital, devise compensation schemes that provide the entrepreneur

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with appropriate incentives through active involvement in the portfolio firms, and preserve mechanisms to make investments liquid. Finally, in the article ‘What do venture capitalists do?’ (1989) Michael Gorman and William Sahlman shed some light on how venture capitalists spend their time. Based on the results derived from 49 responses to a questionnaire distributed to venture capitalists in 1984 they concluded that: ● ● ●

Venture capitalists spend about 60 per cent of their time monitoring nine portfolio firms, in five of which they are the lead-investor. As lead-investors they devote 80 hours of on-site time and 30 hours of phone time per year to each portfolio firm. The most common services for the portfolio firms were to help build the investor group (raise additional funds), formulate their business strategy and fill the management team (management recruitment).

Even though the article is very descriptive, it has been heavily cited and can be regarded as very influential in terms of understanding venture capitalists’ involvement in the firms in which they invest – the venture capitalist–entrepreneur relationship, monitoring activities and value-adding eﬀects. Interview with William Sahlman In the 1980s you wrote several seminal articles on the venture capital industry. What awakened your interest in venture capital and the venture capital industry? My background was that I had a degree in economics from Princeton, and for a short period I worked in the area of finance in New York. I came to Harvard Business School (HBS) in 1973. As I was graduating from the MBA programme I applied to the PhD programme in Business Economics at HBS . . . I was accepted for the programme, but spent a year in Europe writing cases for Harvard Business School. I wrote my thesis in economics on the interaction between investment and financial decisions in companies and joined the faculty of the Department of Finance at HBS in 1980. In 1982 we started to plan for a conference on entrepreneurship at HBS, for which I wrote a paper ‘The financial perspective: what should entrepreneurs know’. In the paper I tried to understand entrepreneurship, what financial decisions were like for entrepreneurs, who the players in the financial market were, and whether or not finance for entrepreneurial firms was diﬀerent from what could be called ‘traditional finance’. We had a very interesting conference, which included a number of practitioners, including quite a few from the venture capital industry as well as some entrepreneurs. The purpose was to set an agenda for HBS – what should HBS do to understand these kinds of activities? You have to remember that ten years after graduation just under 50 per cent of all HBS graduates describe themselves as ‘entrepreneurs’, a large proportion of all venture capitalists have their roots at the Harvard Business School, and the group of people who started the venture capital industry in the US . . . Doriot, Perkins, to mention a few . . . all came from HBS. So, the school is deeply rooted in entrepreneurship and the venture capital industry. I began to write cases about entrepreneurship and about people in the venture capital industry – in total I have written almost 160 cases for HBS. In the mid-1980s I decided to

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launch a new course in ‘Entrepreneurial Finance’ which was introduced in the spring of 1985. I also decided to write all my own material and cases for the course . . . as I developed course materials, I observed several interesting questions in the venture capital industry, like why did they use securities that seem inappropriate for risky ventures; why did they stage the commitment of capital; what decision rights do they retain; what happens down the road depending on the performance of the venture, etc.? So, there were many interesting questions to be explored. Based on this experience I wrote a note called ‘Note on financial contracting’ that resulted in an article entitled ‘Aspects of financial contracting in venture capital’ in the Journal of Applied Corporate Finance, in 1988, which then evolved into the article ‘The structure and governance of venture-capital organizations’ in the Journal of Financial Economics, in 1990. Yes, the article ‘The structure and governance of venture capital organisations’ is probably your most cited article in venture capital research. What do you see as its major findings? At that point in time, no-one had really laid out the main issues in the venture capital industry – there was not much written about the venture capital industry – and the article was an attempt to take a financial economist’s lens and apply it to a field-based research project. I think the most important part of the article was to show the interconnectedness between the governance of the funds and the investments in individual ventures – the interconnectedness of those two systems. Researchers often study one system but not the other, but you cannot understand why venture capitalists make bets and how they structure the deals with individual entrepreneurs, without understanding how the funds are structured. Another important contribution in my opinion was to provide some rationale for staged capital commitment, and I also tried to compare that with how capital is allocated in larger companies. Does fund structure matter? Well . . . on the one hand, you can say that limited partnerships are no better or worse than other fund structures but, on the other hand, I believe there are several aspects that make limited partnership an important way of governing the venture capital funds. I consider that the structure of staging the capital committed to venture capital funds is extremely important . . . making the venture capital funds pay all the money back before giving them more money is a remarkably powerful control mechanism . . . that kind of structure works much better than providing a permanent pool of capital. Looking at performance it seems as if US funds always outperform European VC funds . . .? Yes, historically you are correct . . . due to a stronger ‘right hand tail’ of successful companies in the US as well as a more active exit market – most exits have been IPOs in the US, as opposed to mergers, and IPOs yield higher returns. But as the economy becomes more global, we will see more successful ventures all over the world and stronger exit markets – and the diﬀerences between countries or continents will level out. This leads us to some policy issues. What do you think policy-makers can do in order to create an eﬃcient venture capital market? Well, I think there is essentially very little that governments can do to encourage venture capital. My view is that venture capital follows people and ideas . . . venture

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capital doesn’t lead them . . . in many cases policies are based on the notion that money attracts entrepreneurs, but I think it has a tendency to attract the wrong entrepreneurs and the wrong ideas. So, what you have to do is to encourage entrepreneurship. However, one thing has to do with failures and bankruptcies. In many countries, it is a dishonour to fail, and if you go bankrupt there are a host of personal legal implications as well as high costs – that context is damaging to entrepreneurship and you will have fewer people starting new ventures. But it is not only a question of the downside of failures, the question is also: what is the upside of entrepreneurship – the right hand tail . . . to be successful – is far less attractive in many countries than it is in the US. In another early article that you wrote together with Howard Stevenson, ‘Capital market myopia’, you were very critical of the venture capital industry. Yes, I noticed that all venture capitalists seemed to rush into the same industry at the same time. Why did that happen, and what can be learned? Historically, it turns out that every industry ever created seems to have the same course of development. In the beginning, you start with a large number of entrants and many players – it is the same if you look at the railroad industry, the telephone industry, or whatever – and all will be financed in the early days by informal capital, by business angels. There will be some early successes. But, we also know that as the industry matures, many firms will be over-valued and some will disappear from the market, and there will be many losers. So, this is not a new phenomenon. What was new in the Winchester Disk Drive industry in the 1970s and 1980s was the new class of professional investors and a new technology that very few people understood. The entrepreneurs within the industry all had the same origin in companies like IBM, Memorex, etc. and they were all desperately searching for faster, cheaper, smaller products . . . in this case disk drives. Every single venture capitalist who invested in the industry believed that his team and their technology were going to win. As expected, not everyone can obtain a 10 per cent market share – at least not 130 companies – so, inevitably there were a large number of failures. But there were not only losers – in the venture capital industry you know that there is a high likelihood of losses – there are a small number of interesting firms that will generate remarkable profits. So, the question was ‘Did it all make sense?’ and ‘Why were people assuming that their company would win?’ We see this over and over again, in e-commerce, in nanotechnology, etc. Don’t venture capitalists learn anything? You have to remember that this is a diﬃcult game. If we look back 15 years, 50 per cent of all distributions in the venture capital industry came from 30 firms. So, venture capital returns are heavily concentrated . . . the nature of the game is that everybody has to try to find the winners. In this respect, it is not necessarily stupid to invest in companies where there is a high likelihood of failure, as long as you place your bets so that you end up with some companies in the ‘right hand tail’ of the distribution – the great winners. It is a question of understanding the industry. And if we look at the disk drive industry itself, it was not very structurally attractive . . . it had no network eﬀects, low operating margins . . . so, the likelihood of a huge pay-oﬀ in the ‘right hand tail’ is much smaller than in many

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other industries. And, I think, the venture capital community has learned a bit about which industries may create big winners. A third article that has been influential in venture capital research is ‘What do venture capitalists do?’ published in the Journal of Business Venturing in 1989. Yes, I must admit that I am surprised that the article has been cited so often. It was based on a student project and contains very little analysis and interpretations, but to some extent the data speak for themselves and I think researchers had never looked into the work of venture capitalists in a systematic way. Does venture capitalist involvement in the firms in which they invest really matter? I believe that . . . there is a tremendous amount of evidence to suggest that venture capitalists are beneficial in many diﬀerent ways – introducing people to a network that they have cultivated over a long period of time, making it easier to get access to future finance, and there is a certification process that helps to legitimize the venture in the market place. Have you seen any changes in the way venture capitalists work today compared to your study in the 1980s? Yes, there is a change in the sense that venture capitalists today have much more capital to allocate per partner – they are involved in more ventures and spend less time with each company, and accordingly, they are not as helpful as they were before. I think of venture capital as an art in which judgement and wisdom play a critical role. So, therefore, it is not a single attribute that makes a successful venture capitalist. For example, we have seen venture capitalists with quite diﬀerent backgrounds who have been successful . . . venture capitalists with a financial background, in other cases former top managers, etc. . . . and they are not always experts in the industries in which they invest – in this respect the venture capitalist hasn’t changed. Finally, if we look at venture capital research in the future, what are the questions that ought to be asked? I would say that there are some important questions that have not yet been addressed. First, venture capitalists allocate a great deal of money to projects and new ventures, but so do large corporations . . . and, how do we compare the relative eﬃciency of these two models? Thus, I would very much like to see comparative studies of diﬀerent models of venture capital investments. Second, I don’t think researchers have done an adequate job in understanding the dynamics of venture capitalists’ portfolios. Looking at the portfolio of investments as opposed to individual investment I would liked to ask a series of questions, for example; what was the proportion of failures, what was the proportion that recouped more than ten times the money invested, what was the likelihood of obtaining a second round of financing, what was the pay-oﬀ structure for the investments, etc.? A third area of importance in which we haven’t seen a great deal of research is the board of directors in venture capital-backed firms. What is an eﬀective and ineﬀective board structure? One problem with these kinds of questions is that they require information from inside the firms, not from databases . . . this is not an industry you can study without inside knowledge that current databases do not provide. So, there is much hard work to be done.

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Research on corporate venture capital A history of corporate venture capital investments and research on corporate venture capital Probably the first corporate venture capital investor was DuPont back in 1919 when one of its important customers ran out of funds, and DuPont purchased 38 per cent equity interest in the company – General Motors. They brought in a new president, Alfred Sloan, and General Motors grew substantially over the years. After World War I, American Telephone, General Electric and Westinghouse made several investments. Soon after World War II a small company, Haloid Corporation, funded the commercialization of a new technology developed by Chester Carlson and the Battelle Memorial Institute – later the company changed its name to Xerox Corporation (Rind, 1986). In the late 1950s several larger corporations became interested in venture capital activities, and venture capital firms funded by larger corporations or a subsidiary of a corporation, emerged in the mid-1960s, pioneered by companies such as Xerox and AT&T. Since then corporate venture capital has gone through several cycles (Rind, 1981; Gompers and Lerner, 1999; Birkinshaw et al., 2002). The initial wave of corporate venture capital occurred at the end of the 1960s. More and more companies established divisions that acted as venture capitalists and in the early 1970s more than 25 per cent of the Fortune 500 firms implemented corporate venture capital programmes. However, the market diminished dramatically in 1973, following the oil price crisis, the abrupt decline in the market for new public oﬀerings, and the ensuing recession. The second wave, beginning in the late 1970s and early 1980s, was fuelled by the growth of the computer and electronic sector and reached a peak in 1986 when corporate venture capital funds managed $2 billion, or almost 12 per cent of the total pool of venture capital in the US. However, when the stock market crashed in 1987 and the market for new IPOs dropped, larger corporations scaled down their venture capital investment commitments. Finally, the third wave emerged in the 1990s linked to the technology boom and the dot.com era, and in 1997 corporate investors accounted for about 30 per cent of the commitments to new funds compared to an average of 5 per cent in the period from 1990 to 1992. As in the earlier waves of corporate venture capital, the interest was stimulated by the success of the venture capital industry in general – rapid growth of funds and attractive rates of return. The market peaked in 2000 before the great crash (the collapse of high-technology stocks, the loss of faith in internet-based businesses, and a number of high-profile corporate failures). The conclusion arrived at by Gompers and Lerner (1999) is that, over time, corporate involvement in venture capital has mirrored the cyclical nature of the entire venture capital industry. The emergence of the industry during the 1980s led to some pioneering scholarly work on corporate venture capital, and in Table 1.5 some of the early contributions will be presented. All of these contributions can be regarded as highly descriptive (and normative) in their approach. It was a way of making the ‘new’ corporate venturing tool visible and discussing its advantages and limitations, that is corporate venture capital was considered in the frame of strategic management and the corporate venture process. However, after these pioneering works, the research on corporate venture capital was relatively scarce with a few exceptions (for example, Gompers and Lerner, 1996; McNally, 1994)

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Table 1.5

Early contributions on corporate venture capital

Pioneering studies Fast (1978), The Rise and Fall of Corporate New Venture Divisions, PhD Thesis, Ann Arbor, MI: UMI Research Press. Rind (1981), ‘The role of venture capital in corporate development’, Strategic Management Journal, 2 (2), 169–80. Hardymon et al. (1983), ‘When corporate venture capital doesn’t work’, Harvard Business Review, 61, 114–20. Burgelman (1984), ‘Managing the internal corporate venturing process’, Sloan Management Review, Winter, 33–48. Siegel et al. (1988), ‘Corporate venture capitalists: Autonomy, obstacles and performance’, Journal of Business Venturing, 3 (3), 233–47. Winters and Murfin (1988), ‘Venture capital investing for corporate development objectives’, Journal of Business Venturing, 3 (3), 207–22. Sykes (1990), ‘Corporate venture capital-strategies for success’, Journal of Business Venturing, 5 (1), 37–47.

until the late 1990s and early 2000s (linked to the third wave of corporate venture capital investments) when a large number of studies on corporate venture capital appeared. A stateof-the-art review of recent studies can be found in Chapters 15 and 16. Pioneers of corporate venture capital research As can be seen in Table 1.5, there were several early research contributions on corporate venture capital in the 1980s. One of the pioneers in this respect was Kenneth Rind, who in 1981 published an early article on corporate venture capital in the Strategic Management Journal. Rind can be regarded as an active advocate of venture capital, not only in the US but internationally, being a mentor for new venture capitalists, the author of several articles and a notable speaker on venture capital. He is also regarded as one of the pioneers in introducing venture capital to countries such as Japan, Singapore, Israel, and Russia. In this section I will summarize his SMJ article and present an interview in which he looks back on four decades as an active international venture capitalist. Seminal article Kenneth Rind was one of the first to recognize corporate venture capital as a tool in the corporate development toolbox. His observations were based on his experience of being responsible for acquisitions and venture capital investments at Xerox Development Corporation, but were also influenced by the second wave of corporate venture capital that emerged in the late 1970s as a result of the growth of the computer and electronics sector. In his article ‘The role of venture capital in corporate development’ (an extended version was later published in the Handbook of Strategic Planning in 1986 entitled ‘Venture capital planning’), corporate venture capital is mainly seen as a strategic tool, and in the introduction to the article Rind states (p. 169):

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Picture 1.5

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Kenneth Rind, Venture Capitalist, New York, USA

BOX 1.5 Born: 1935 Career 1961–1962 1963–1964 1964 1968–1969 1970–1976 1973

KENNETH RIND

1998

Post-doctoral Argonne National Laboratory Assistant Professor of Physics, City University of New York Founder, Quantum Science Manager, Samson Fund Associate, Rockefeller Family & Associates Vice President – Corporate Finance at Oppenheimer & Co., Inc. Founding Director of the US National Venture Capital Association (NVCA) Corporate Development Venture Capital Executive – Xerox Development Corporation Co-founder of Oxford Partners – venture capital company Co-founder of the Nitzanim-AVX/Kyocera Venture Capital Fund in Israel Co-founder of the Israel Infinity Venture Capital Fund

Education 1956 1961

BA in Chemistry at Cornell University PhD in Nuclear Chemistry at Columbia University

1976–1981 1981 1993

Strategic managers have a variety of tools available which they may use to gain competitive advantage and to optimise the business portfolios of their corporations. While the use of acquisitions and joint ventures for this purpose is well understood, few corporations are familiar with the benefits or the pitfalls of the various types of venture capital programmes . . .

However, it was not any successes of companies investing in venture capital at the end of the 1970s that fuelled the increased activity. Rind argues that a combination of several

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factors led to the resurgence of interest, for example, the excess corporate liquidity at that point in time, a relentless toughening of anti-trust regulations regarding acquisition, and the entry of foreign companies to the US market. In the article, Rind compared corporate venture capital with conventional institutional venture capital and he also put corporate venture capital in the context of other corporate development strategies. He provided an overview of corporate venture capital activities in the US at the time of the second wave of corporate venture capital, but the main part of the article contains a discussion about the benefits for corporations involved in corporate venture capital activities as well as the problems of and diﬃculties involved in corporate venture capital programmes in diﬀerent companies. Focusing on the benefits of introducing a corporate venture capital programme, Rind reports strategic advantages such as: engaging quickly with companies whose product/technology could play an important role in the future, a better understanding of the management strengths and weaknesses of potential acquisitions, obtaining products at a lower cost and more eﬃciently than could be done in-house, and an early window on new technologies and new markets that show future potential. However, not all corporate venture capital programmes succeeded – in fact only 7 per cent of active corporate venture capital organizations regarded themselves as very successful, and over half did not even rate themselves as marginal successes. In the article Rind emphasizes that the diﬃculties experienced from these less successful cases usually arose from one of the following sources: ● ● ● ●

Lack of people with appropriate skills; contradictory rationales (investee company versus the parent organization); legal problems; and inadequate time horizon (success in early-stage venture capital can take seven to ten years, and corporate venture capital funds are generally terminated before that).

As a consequence, many corporate investors changed their investment approach and started to make investments through venture partnerships. A venture capital partnership provides the opportunity to attract good people, problem investments become less visible, management time is saved, long-term commitment is assured and many legal liabilities are eliminated. Rind formulated his conclusion in the following way (p. 179): ‘venture capital is a useful tool for corporate development. It is diﬃcult but possible to do internally, and an outside partnership investment can be either an alternative first step or a beneficial supplement to a direct corporate venture capital programme.’ Interview with Kenneth Rind You had a long career as a venture capitalist. Could you say something about your background? I obtained my PhD in nuclear chemistry at Columbia University, and after a couple of years as a post-doc at Argonne National Laboratory I returned to New York in 1963 as an Assistant Professor at the City University of New York teaching nuclear physics. However, the promises made to me were not kept, and although I was oﬀered tenure, I

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stayed there for only two years. My room mate at the university, whose father was in the finance business, encouraged me to start consulting on technology evaluations for the financial community. So, I first did part-time consulting and after a couple of years it became a full-time business, and I co-founded Quantum Science/Samson Fund. We were retained by 8 out of the 10 largest mutual funds in the US, 5 out of 6 then operating venture capital firms, and 3 out of 5 of the largest banks. One of my clients was the Rockefeller family, and they recruited me to be their technology analyst but I also became involved in their venture activities. You can say that I served my first apprenticeship there. While I was at Rockefeller we made a couple of very interesting investments, for example, we were an initial investor in Intel – in the then new integrated circuit business. After a few years with the Rockefeller family I was recruited by Oppenheimer, a very large money manager in those days. I was responsible for a venture capital fund in which I became the senior partner – you could say that I continued my apprenticeship at Oppenheimer. In 1973 I also became active in forming the National Venture Capital Association, and I was one of the initial Directors. Our main concern was to lobby for making venture capital investments more attractive, and we were successful in so far as many changes were made in the US regulations and tax system in the late 1970s – of which the ‘Prudent Man Rule’, allowing pension funds to invest in venture capital funds, was the most important. In 1976 I joined the Xerox Corporation and became responsible for their venture capital and acquisition programme. You could say that this was a bad decision for me, but maybe a good decision for the world. One consequential thing that I did was to go back to my colleagues at Rockefeller and ask what they were investing in. They told me about a personal computer manufacturer which sounded like an ideal supplier for Xerox. We put a million dollars into Apple Computer, so that Apple would develop a computer that Xerox had exclusive rights to – but Xerox rejected the design, and Apple produced it more cheaply and called it MacIntosh. In general, I must admit that I was very sad about Xerox – as the management made some rather peculiar decisions after I had left. After Xerox I formed my own venture capital firm – Oxford Partners . . . after the street where I lived, and not the university in the UK . . . I started to look for investors in 1980 and the fund was ‘closed’ in 1981. As I had been active in corporate venture capital at Xerox, I brought in a large number of corporations, and within several years we had companies like Xerox, IBM, ATT, Siemens and General Motors as investors. You have been referring to my article in the Strategic Management Journal in 1981, and I think you should consider my arguments in the article in the context of my experience at Xerox and my new operation as an independent venture capitalist. In Xerox I had experienced the diﬃculties associated with corporate venture capital, and I had seen a new wave of corporations made venture capital investment. Many of these programmes failed, and corporate venture capitalists were not always well regarded in the venture capital community due to suspicions regarding their motives and doubts about their longevity – and I wanted to teach how they could succeed. I was also on my own . . . launching my own independent venture capital firm, and I went out to search for corporations to invest in my fund. I travelled around making speeches, and the article in the SMJ was more or less a way of selling my new fund – it was successful in encouraging over 25 corporations to give us money instead of trying to invest in corporate venture capital by themselves.

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But you have also been very active as an international venture capitalist and regarded as one of the pioneering venture capitalists in Japan and Israel, and now you are actively working to introduce venture capital in Russia . . . Yes, I first became involved in international venture capital when I was at Oppenheimer. My senior partner called me up and said that there was a Japanese company that would like to learn about venture capital. I hosted them for a summer, and I introduced them to venture capital situations and showed them what was happening in US technology . . . but on condition that they invite me to Japan and allowed me to look at venture investments in Japan . . . that must have been 1973 or 1974 . . . I went over and lectured about venture capital, but I was turned down by MITI for making investments in Japan. However, at Oppenheimer I hosted a number of people from Japan who had come to learn about venture capital. In 1986 I was asked by the Israeli government to come over and consider starting a venture capital fund in Israel. I went over, but realized rather quickly that it was impossible to make money – the best engineers were working for the military, the government did not like business, the inflation rate was 100 per cent per annum, etc. – and I concluded that there was nothing for me to invest in. However, a few years later I received a phone call from a friend of mine, who had a factory in Jerusalem, and he told me that the Israeli government wanted to increase a venture capital activity and asked if I would be willing to help set up a fund in Israel. Based on my earlier experience, I was doubtful, but he convinced me that things had changed a lot in Israel by the early 1990s. So, in 1993 I founded my first fund in Israel – Nitzanim-AVX/Kyocera Venture Fund – which was a part of the government-supported Yozma programme. In 1997 I was asked to join the board of an organization set up by the US Congress to find useful work for Russian weapon scientists – the United States Civilian Research and Development Foundation – and I became interested in technology developments in Russia. I started to visit Russia, I held speeches on why venture capital should be encouraged, and tutored people to understand venture capital. However, progress has been very slow . . . there is no tradition and no entrepreneurial spirit, and as I see it, it will take time to foster venture capital in Russia. You have been involved in introducing venture capital in many emerging venture capital markets. What is your advice to policy-makers who want to encourage venture capital in a country? Over the years, foreign governments have learned more about venture capital . . . they recognize that venture capital is a good thing . . . and when I make my presentations, which are based on my experience from several diﬀerent countries, I always say that venture capitalists want to have (1) partners with an entrepreneurial spirit – drives and visions; (2) a financial and scientific infrastructure; (3) world-class products and experienced management teams; (4) large world markets with unfulfilled needs; (5) easy exits; and (6) a context characterized by low taxes, low capital gains taxes, and the ability to repatriate funds. I usually advise governments on what has been done elsewhere to promote an active venture capital market (see Table 1.6). I am not suggesting that all these initiatives work in every country, but government should know what possibilities exist, and what has been successful in other countries.

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Table 1.6 Rind’s advice to governments on how to promote an active venture capital market Taxes 1. Reduce capital gains rate – more for long-term capital gains – defer taxes if re-invested in qualified entity 2. Give tax credits to individuals/ corporations for investments in qualified small firms, qualified venture capital funds, and R&D activities 3. Waive corporate income taxes, sales taxes, and property taxes for qualified start-ups 4. Allow investor losses to oﬀset ordinary income 5. Lower taxes on management fees/bonus 6. Permit option grants/ exercise without taxes – tax only when cash received 7. Tax exemption for foreign investors (irrespective of tax treaty)

Other financial programmes

Non-financial programmes

1. Encourage non-taxable entities 1. Encourage military/ to invest (‘Prudent Man Rule’) government labs/universities to spin-out projects 2. Provide leverage through the pro- – help organize venture vision of equity/loans/grants capital funds to finance spin-out ventures 3. Ensure that investors will not – foster co-operation with lose capital start-ups 4. Pay for % of R&D/new facilities costs/labour (training) 5. Fund incubators/companies in incubators 6. Make grants for generic R&D programmes

2. Improve liquidity/capital raising – create exchanges – lessen listing requirements 3. Allow investors to control investees – no cap limit on ownership

7. Establish Bird-F type of activity

4. Require US-compatible reporting (so firms can list on NASDAQ)

8. Finance training abroad for venture capitalists

5. Permit immigration of skilled talent

9. Establish agencies to provide consulting/support

6. Allow LLCs

10. Relax bank lending criteria 11. Coax émigrés to return (e.g. housing)

7. Encourage foreign corporations to: open development centres, invest, and acquire

12. Create industrial parks

8. Make successful entrepreneurs into heroes; encourage networks

13. Allocate part of governmentmanaged pension fund investments

9. Don’t ostracize failures

As I see it, the most important way of encouraging venture capital is to promote an entrepreneurial spirit in the country – people must feel it is a good thing to be an entrepreneur, to build something that the world wants, and to become wealthy. In addition, government should try to keep away from attempting to pick the winners and losers by themselves – it is always a disaster – anything they do to encourage the

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industry should be alongside experienced venture capitalists . . . and/or if the venture capitalists select the companies, the government could say that they will leverage and invest alongside the venture capitalists, but the venture capitalists are responsible for making the company a success. You have been active as a venture capitalist for four decades, you have been a mentor for new venture capitalists, writing articles, making speeches about venture capital . . . what is necessary to be a successful venture capitalist? This is a very diﬃcult question to answer . . . a venture capitalist succeeds by making good investment, but you never know in advance which investments will be good – many companies fail and venture capitalists lose money on most of their investments. But at least you should, as a venture capitalist, have the skills to help the companies in which you invest. The diﬀerence between venture capital and predicting stock market prices is that venture capitalists can help to change the odds. In this respect, I strongly believe that venture capital is a business that requires an apprenticeship . . . you can’t teach it, one has to experience venture capital situations and learn from them . . . and we need a trained cadre of people who know how to operate in the world of venture capital. And I can see a problem . . . the people who founded the venture capital industry in the US are now retiring, and new people who are coming in should apprentice . . . but a whole bunch of people came in during the dot.com boom who didn’t know what they were doing. Thus, venture capitalists must have the experience to help the companies in which they invest. One of the most important decisions to make is replacing the founding entrepreneur at the right time and bringing in someone who is capable of running a growing company. At the same time it is important to keep the founder on board, so that he/she can continue to contribute from a technical point of view, as a spokesperson, etc. Unless they have done that several times . . . people can’t learn that – they have to experience it by themselves. I also teach entrepreneurs how to make exits and always tell them not to make the company dependent on having an IPO, but to run the company at all times as if either an IPO or takeover is imminent and to make contact with corporate venture capitalists who could be potential acquirers – even if they have no interest in investing in your company at that point in time they should get to know you. It is also important to emphasize that venture capital is a rather heterogeneous phenomenon. I would say that there is no single way in which venture capitalists operate. There are venture capitalists doing seed investments, others wait until there is a developed business plan, some only invest in particular technologies, etc. And diﬀerent venture capitalists are successful in diﬀerent ways. In your view, what will the venture capital market look like in the future? I am sorry, but it is impossible to answer that . . . the only thing I know is that the market goes through cycles and will always go through cycles – for the same reasons as the stock market – people are greedy and will invest when the market goes up, and that is good for venture capital. However, when a lot of money goes into the venture capital market, venture capitalists invest in too many companies that are doing the same things, so many go out of business. Thus, investors lose money, then there will be too little money, and we will start all over again . . .

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Historically I can also say that most of the returns have come from the top quartile of venture capitalists – the most experienced venture capitalists – and I expect the future will be no diﬀerent. Finally, some advice for the research community. What would you say will be the most important questions for researchers on venture capital to answer in the future? The one question that I have never been able to answer is how to keep a corporate venture capital activity going. For example: how do you oﬀer incentives to people in a way that it doesn’t make corporate management and the internal people working with the corporate venture capital group jealous? In addition, I have given advice to many governments about what is needed to encourage venture capital in a country, and of course, I would be very happy to see research that could confirm and sort out the initiatives that are successful – probably certain initiatives would be more or less successful in diﬀerent cultures and contexts. Research on informal venture capital Some early contributions The interest in the informal venture capital market among policy-makers and researchers started in the 1950s and 1960s. In particular, the financial problems experienced by many young technology-based firms provided a starting point for studies on informal venture capital. For example, in the late 1950s the Federal Reserve performed a couple of investigations regarding the initial financing of new technology-based firms – studies that preceded the Small Business Investment Act of 1958, which led to the creation of the Small Business Investment Company (SBIC) programme in the US. The interest in early financing of young technology-based firms originated in an emerging interest in business angels as an important external source of finance for entrepreneurial ventures with a basis in new technologies. Some of these early contributions during the 1950s and 1960s are summarized in Table 1.7. However, it was the pioneering work by Professor William Wetzel at the University of New Hampshire in the US that led to an increasing interest in the informal venture capital Table 1.7

Early contributions on informal venture capital

Pioneering studies Rubenstein (1958), Problems of Financing and Managing New Research-based Enterprises in New England, Boston, MA: Federal Reserve Bank of Boston. Baty (1964), The Initial Financing of New Research-based Enterprise in New England, Boston, MA: Federal Reserve Bank of Boston. Hoﬀman (1972), The Venture Capital Investment Process: A Particular Aspect of Regional Economic Development, PhD Thesis, University of Texas at Austin. Brophy (1974), Finance, Entrepreneurship and Economic Development, Institute of Science and Technology, University of Michigan, Ann Arbor. Charles River Associates Inc. (1976), ‘An analysis of capital market imperfections’, prepared for the Experimental Technology Incentive Program, National Bureau of Standards, Washington, DC.

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market. Wetzel’s study was based on the widely held perception that new technologybased ventures encountered problems when raising small amounts of early-stage financing. On the other hand, anecdotal evidence indicated that ‘business angels’ played a role in solving this problem. Little was known about the characteristics of business angels and the flow of informal venture capital and in his study Wetzel wanted to ‘put some boundaries on our ignorance’. Some central themes in informal venture capital research Following Wetzel’s seminal study in the early 1980s, interest in the informal venture capital market grew among researchers in the US and around the world. Researchers felt a need to quantify and describe the informal venture capital market, thus the research has been fairly descriptive and focused on three main questions: ● ● ●

How large is the informal venture capital market? – The market scale. What characterizes the informal investors/business angels – ABC of angels (their attitudes, behaviour and characteristics). How can a more eﬃcient venture capital market be created? – Policies and information networks.

The market scale Estimating the size of the informal venture capital market is a diﬃcult task. In one of his first research articles on informal venture capital, William Wetzel (1983) concluded that the informal venture capital market is ‘unknown and probably unknowable’ (p. 26). Despite conceptual and methodological problems in researching the informal venture capital market, a large number of scholars have been trying to estimate its size – mainly defined as business angel investments. The result varies significantly between countries – from about 2.75 per millage of the GDP in the US to about 0.78 per millage in Sweden – partly due to the diﬀerent methodological approaches used to measure the scope of the informal venture capital market (Mason and Harrison, 2000a; Avdeitchikova, 2005). The conclusion that can be drawn from earlier studies is that the estimations of the informal venture capital market are problematic in various ways (Mason and Harrison, 2000a) due to the private and unreported nature of the investment activity and the desire of most informal investors to preserve their privacy. In addition, as indicated earlier, there are severe problems of definition, for example, in some estimations investments by ‘family and friends’ are included, whereas they are excluded in others, while some estimations concentrate on the group of investors known as ‘business angels’. Most of the studies relied on convenience sampling, and it remains unclear whether these samples are representative of the underlying population of informal investors (Riding, 2005). Finally, many earlier studies had very small samples and low response rates (Mason and Harrison, 2000a). Thus, the estimates made in the various studies must be considered very crude calculations of the informal venture capital markets in diﬀerent regions. ABC of angels It was not only essential for researchers to estimate the size of the informal venture capital market – another question of importance was to characterize the individuals making informal investments, mainly the group of informal investors we call ‘business angels’ and to describe the attitudes, behaviour and characteristics of these individuals (ABC of angels). As far back as the 1980s, several studies were conducted in

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diﬀerent parts of the US in order to describe the ABC of angels in diﬀerent regions. However, at the end of the 1980s and early 1990s, academic and public policy interest in the informal venture capital markets started to grow internationally and continued to do so throughout the 1990s (for a review of the characteristics of angels, see Chapter 12 by Peter Kelly). Although the conditions for an active business angel market diﬀer from region to region and country to country, it is worth emphasizing that there seem to be many similarities in business angels’ attitudes, behaviour and characteristics irrespective of context (Lumme et al., 1998) as well as over time (Månsson and Landström, 2005). For example, the ‘typical’ angel investor seems to be a middle-aged male with a reasonable net income and net worth and previous start-up experience, who makes about one investment a year, usually close to home. The primary method of finding new investment opportunities is through friends and business associates, and they prefer high-technology and manufacturing ventures, with an expectation to sell out in three to five years (Mason and Harrison, 1992). However, despite many common characteristics, early research has repeatedly indicated that the informal venture capital market is highly heterogeneous – almost individualistic in character – and in the research we can find various attempts to develop categories of investors that describe the market in more nuanced ways (see for example Gaston, 1989; Coveney and Moore, 1998; Sørheim and Landström, 2001; Avdeitchikova, 2005). One conclusion that can be drawn from these attempts is that there does not appear to be much agreement with respect to the categorization schema developed in the various studies, and the usefulness of the categorizations can be questioned: (i) informal investments are unlikely to be mutually exclusive – informal investors may invest in a variety of diﬀerent ventures, including both ‘love money’ and ‘business angel investments’, and (ii) their investment profile may change over time (Riding, 2005). Thus, the conclusion that can be drawn is that we know a great deal more today about informal investors and business angels but, despite 25 years of research, much more remains to be learned about the characteristics of the investors and the dynamics of the informal venture capital market. Policies and information networks Wetzel’s pioneering work in the early 1980s addressed the fact that the informal venture capital market experienced severe ineﬃciency problems, making policy interventions necessary. In many countries there seem to be two major problems associated with the informal venture capital market: (i) there are too few informal investors active on the market, and (ii) there are market ineﬃciencies that make it diﬃcult for investors and entrepreneurs to find each other (Mason and Harrison, 1997). Tax incentives for private individuals who invest in unquoted companies have been the main strategy for increasing the pool of informal investors on the market. The UK has been the leading exponent of this kind of measure. Since the early 1980s, several strategies that provide investors with diﬀerent kinds of tax relief for informal investments have been introduced. A study by Mason and Harrison (1999b; see also Mason and Harrison, 2000b; 2002) shows that the tax relief available to UK business angels has had a positive impact on informal venture capital investment activity. The availability of tax relief on informal investments – which reduces the risks involved – seems to be the most important encouragement for informal investors to invest more, whereas reducing the rate of capital gains

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tax – increasing the reward – seems to be less influential than front-end tax relief, although both have an impact on promoting informal venture capital activity. However, Lerner (1998) argues that new ventures are inherently risky, and there is considerable uncertainty regarding their survival and growth. Thus, there is always a risk that attempts by government to stimulate the informal venture capital market may ‘encourage amateur individual investors’ which will be counterproductive for society. Lerner concludes that encouraging informal investments could be ill-advised – some investors may lack the skills necessary to protect themselves and to accurately value the opportunity in which they invest. A conclusion that can be drawn is that tax incentives need to be complemented by micro-level initiatives – one such initiative is ‘business introduction services’. One initiative was the Venture Capital Network (VCN), introduced by William Wetzel in New Hampshire in 1984 as a business introduction service to provide an eﬃcient channel of communication between business angels and entrepreneurs. This idea of business angel networks or matching services was later introduced in several places in the US as well as in other countries. In this respect the UK has also been at the forefront in encouraging the establishment of such communication channels. According to Mason and Harrison (1999b), the performance of business angel networks (BANs) has been varied but, in general, evidence suggests that on an aggregate level their impact on informal venture capital activities has been both positive and significant (diﬀerent kinds of business angel networks are discussed by Jeﬀrey Sohl in Chapter 14). Pioneers of informal venture capital research In this section I will present the real exponent of informal venture capital research – Professor William Wetzel – starting with a summary of his pioneering article in the Sloan Management Review – an article that opened up the research field and inspired many studies on business angels. I will also include an interview in which he gives his view on the research on informal investors and business angels. Seminal article Until the end of the 1970s the number of studies on the informal venture capital market was rather limited. However, at the beginning of the 1980s, Professor William Wetzel at the University of New Hampshire put informal venture capital on the ‘research map’. In 1978 Wetzel conducted a pilot study, based on a questionnaire distributed to 100 individuals with a known interest in venture investment situations. A total of 48 completed questionnaires were returned and the results showed, among other things, that the total potential pool of venture capital represented by the respondents exceeded $1 million per year, the required rates of return were lower than those typically required by professional venture capitalists, and so on. Wetzel came to the conclusion that ‘business angels’ probably represent the largest pool of risk capital for entrepreneurial ventures and that the informal venture capital market plays an essential role in the growth of the high-tech sector. Based upon the analysis presented in the pilot study, the Oﬃce of Economic Research of the US Small Business Administration funded an expanded study of the availability of informal risk capital in New England, USA, in the autumn of 1979. Wetzel and his colleagues undertook a nine-month search for business angels, resulting in a sample of 133 investors. The results of the study were presented in one of the most cited articles on

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Picture 1.6 William Wetzel, Professor of Management, University of New Hampshire, USA

BOX 1.6 Born: 1928 Career 1993– 1967–1993

1987–1988 Education 1967 1950

WILLIAM WETZEL

Professor of Management Emeritus University of New Hampshire Whittemore School of Business and Economics, University of New Hampshire 1983 Founder of the Center for Venture Research 1983–1993 Director of the Center for Venture Research 1984 Founder of the Venture Capital Network Inc (VCN) 1987–1993 Forbes Professor of Management Chair Paul T. Babson Visiting Professor of Entrepreneurial Studies, Babson College MBA (Finance and Accounting), University of Chicago BA (Mathematics), Wesleyan University

business angels: ‘Angels and informal risk capital’ published in the Sloan Management Review in 1983. Some of the findings presented in the article can be summarized as follows: ● ●

Business angels are accustomed to sharing investment opportunities with friends and business associates, and make investments together with others. Informal risk capital is an important source of external seed capital. Forty-four per cent of business angel investments were start-ups, and 80 per cent involved ventures less than five years old. In addition, one third of the respondents expressed a ‘strong interest’ in financing technology-based ventures.

56 ● ● ● ●

Handbook of research on venture capital Business angels are active investors, typically having an informal consulting relationship or service on the board of directors. Business angels invest in close geographical proximity to their home – 58 per cent of the firms financed were located within 50 miles of the business angel. Risk capital is ‘patient money’. The median expected holding period among the respondents was five to seven years. Business angels were highly influenced by non-financial rewards, including ‘psychic income’ and social responsibility (for example creating jobs in areas of high unemployment, socially useful technologies, and so on). Between 35 and 45 per cent of the respondents reported that they would accept lower returns if ‘non-financial rewards’ were included.

The conclusions from the study by William Wetzel were that business angels seem to represent a substantial pool of funds for entrepreneurial ventures and to have some unique characteristics as well as being highly influenced by non-financial incentives to make investments, but that the market was relatively ineﬃcient in bringing entrepreneurs and investors together. William Wetzel made the informal venture capital market visible and revealed its importance. The study awoke interest among policy-makers as well as scholars and has been replicated in many diﬀerent contexts (within the US as well as internationally). Interview with William Wetzel Your studies on ‘business angels’ in the late 1970s are truly regarded as a pioneering piece of work in the area of venture capital research. What aroused your interest in the informal venture capital market? I think . . . earlier in my career I worked as a commercial banker in Philadelphia, and in that position I managed a large commercial oﬃce, and many of my clients were family businesses that needed capital. They often went outside of family and friends to search for money, and I started to recognize people out there making investments in ventures with growth potential, which really sparked my interest: how many of these people were there, what kind of ventures do they look for?, etc. Later on, as professor at the University of New Hampshire in the mid-1970s, I was involved in an organization called New England Industrial Resource Development (NEIRD). NEIRD was often approached by inventors who wanted to commercialize their ideas, but had no one to back them. Over a number of years NEIRD had informally assembled names of people with money and experience who could assist the inventors . . . So, I knew that these people existed. In 1979 I approached Milton Stewart, the first Chief Counsel for the Oﬃce of Advocacy in the US Small Business Administration and a former venture capitalist, and applied for a research grant to explore the role played by these invisible private investors in entrepreneurial ventures. I was successful and received a grant of $55–60 000. What were the most interesting results of the study? It goes without saying that there were many interesting results, but one thing that intrigued me greatly was the list of non-financial rewards that the private investors

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reported . . . they either expected a lower return or took a bigger risk if there was some sort of pay-oﬀ that made them feel that they were doing something worthwhile, for example, developing environmental technology or helping minority entrepreneurs. I felt that this non-financial dimension was an important determinant for how these private individuals made decisions. The study was later published in the Sloan Management Review . . . I had many problems getting it published. The paper was rejected by the Harvard Business Review and California Management Review, but I gave it one more try . . . I had sabbatical leave, and I sat down and tried to respond to the criticism in the reviews. Most of it had to do with the problem of convenience sampling and sample bias. In my response I acknowledged that this was a descriptive study without hypotheses to be tested. In addition, my style of writing was rather conversational . . . I didn’t use ‘academic jargon’ in the article . . . because I was not really writing for an academic audience, I wanted to get visibility out there for the phenomenon . . . but, at last the paper was published. The article in the Sloan Management Review is definitely the most influential article that I have published in my career. The study was recognized by scholars interested in entrepreneurship, saying that ‘the informal investors market is certainly something that deserves a lot more attention’, but the study also caught the interest of public policy-makers. I remember that there was an article in Inc Magazine about the study . . . ‘Business angels myths and reality’. The reporter came to my oﬃce with a bundle of dollar bills and spread them out on my desk. It made a great picture for the Magazine, but it was not exactly the message that I wanted to give . . . however, the popular press began to pick up on my work . . . and I preached the role of business angels in the first round of outside equity finance – taking the venture beyond the family and friend stage. The methodological problems experienced in informal venture capital research today seem to be the same as 25 years ago. Are you disappointed about the progress of the research? There are many obstacles, and I think many researchers felt that they were beating their heads against the wall. First, it is diﬃcult and requires a great deal of hard work to locate these people, and if you find them, they are not always interested in participating in a study. Second, the obstacle that I struggled with in my article – and researchers studying informal venture capital still do – is to identify the population from which we can draw a random sample and claim that it is representative of business angels. Third, as a consequence, informal venture capital research has been rather descriptive, with less testing of hypotheses and statistical rigour. As a result, the research on informal venture capital has always been seen as ‘second class’ research, and it didn’t appeal in an academic sense to those who have been traditionally oriented towards research methodologies and statistical rigour. But how can we encourage new researchers, not least doctoral students, into the field? I would tell them that they will meet some very fascinating and creative people, people who are willing to take risks but are not gamblers in a Las Vegas sense. In addition, their research can make a diﬀerence. Today it is much easier for entrepreneurs, who have something promising and with potential, to find the first round of outside equity funding from

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business angels than it was 20 years ago . . . and I think in some way our work has facilitated this whole entrepreneurial phenomenon. In my opinion there is still a great deal more work to be done in the area of informal venture capital research – questions that will end up with important outcomes and make ‘the world a better place to live in’. It was also a pioneering achievement to introduce the first match-making service on the informal venture capital market – a ‘dating bureau’ between entrepreneurs and business angels. The background of this initiative was twofold. It was felt that there was a need on the part of investors to see a flow of new deals . . . to see a broader range of investment opportunities, not only based on random situations, for example, that you mention something at the golf course. The second reason was to ease the frustration of the entrepreneurs who were desperately trying to find external money for the growth of their ventures. Even at that time, the venture capital industry was not really interested in small amounts of money. We founded the Venture Capital Network (VCN) in 1984 in order to create a more eﬀective market for angel finance. In addition to matching entrepreneurs with potential investors, VCN oﬀered seminars in pricing, structuring, and exiting venture investments. VCN was initially sponsored by leading accounting firms, banks, and by Digital Equipment. However, I think we were mistaken in our belief that we could make this process work in a more orderly and less random fashion. After five years of no home-run performance we were unable to obtain additional sponsorship. So, we decided to find another home for it, a home that would have a higher probability of success. We opened up a discussion with MIT in Boston, and in 1990 VCN became the Technology Capital Network (TCN) at MIT. The VCN was used as a model for more than 20 other networks around the US and even in Canada. We designed the software for the matching services and sold it to the networks. We installed the programme, and trained them how to use it. One of the obstacles faced by these networks, as with the VCN, was locating a critical mass of investors as well as entrepreneurs . . . and it is not a question of a static critical mass, because these are people who come in and go out of their entrepreneurial activities. In many countries it is important to stimulate an active informal venture capital market. What policy implication can be drawn from your research? I am very sorry, but I don’t really believe that there is much of a role for public policy in this field, because the market is very individual and personal. Maybe there might be potential for tax incentives. In these kinds of investment there is always a risk/reward ratio, and if you could reduce the risk and/or increase the reward, that would certainly have a positive impact . . . but as to how big the eﬀect would be, I cannot say. However, we know that business angels invest close to home, and unless they have a strong attraction to a specific technology or market, they will typically not invest much more than a few hours’ drive away from where they live. This indicates that policy instruments should be anchored locally or regionally. I also believe that there is a need for some form of learning . . . both for the actors involved as well as with regard to the instruments used . . . we have a great deal of experience of diﬀerent measures, and new initiatives don’t need to start from scratch all the time.

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Finally, what are the major lessons to be learned from your research? I will give you a list: 1. 2.

3.

4.

Business angels exist – there are private individuals with know-how and money who are interested and enthusiastic about backing promising start-up ventures. Business angel investments are very much a personal process and depend heavily on interpersonal contacts between investors, and between the investor and entrepreneur – the angel market does not lend itself to institutionalization. The business angel market has a great economic value at regional level – business angels can be found everywhere, and they invest close to home. At the same time, I think there are regional diﬀerences in taste – for example, investors in Missouri have diﬀerent backgrounds than investors in California and will invest diﬀerently. There is great potential in the market – not only do business angels have an appetite for more deals, but there is also a latent market of potential angels – I think the latent angels out-number their active counterparts by ten to one. Thus, there is a great opportunity to convert latent angels into active ones.

State-of-the-art venture capital research In the Handbook of Research on Venture Capital we will cover diﬀerent aspects of our knowledge on venture capital as the research field. The book is divided into five parts. Part I contains some general discussions about venture capital. In the present chapter (Chapter 1), we present a historical overview of our knowledge within the field and highlight some of the pioneers of venture capital research who made the phenomenon visible in the 1980s and attracted other researchers into this new and promising field. In Chapter 2, Harry Sapienza and Jaume Villanueva will continue the historical journey by considering the extent to which venture capital research has contributed to the understanding of the venture capital phenomenon and to our knowledge of entrepreneurship in a broader sense. The authors also question some of the underlying assumptions made in management research in general and venture capital research in particular and make some suggestions about the future direction of the field as well as arguing for what they call ‘engaged scholarship’ in which research enriches practice and vice versa. Next, in Chapter 3, we will look at venture capital from a geographical point of view, where Colin Mason focuses on the ‘regional gaps’ in the supply of venture capital, that is the underrepresentation of venture capital investment in particular regions relative to their share of national economic activity. Mason argues that there are strong geographical eﬀects characterizing venture capital investment, thus contradicting the economist’s concept of a perfectly mobile capital market. Given the positive impact of venture capitalists on firm creation and growth, the influence of the geographical clustering of their investments contributes to uneven regional economic development. Finally, Part I ends with a chapter on venture capital policy (Chapter 4), written by Gordon Murray. Venture capital is usually widely associated with the free market and an entrepreneurial spirit unrestricted by public interference but, as Murray comments, the state may have an important role in both initiating risk capital programmes and providing a conducive environment for venture capital. Murray argues that academic support for a public role(s) in the venture capital market is, at best, conditional and cautionary. Therefore, policy-makers will have to act with a deft hand, and there is plentiful evidence that governments are at least as likely to

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produce overall negative eﬀects by their involvement in the venture capital market as they are to engineer a lasting improvement in market conditions. In this chapter Murray will seek to summarize what consensus may be found in seeking an appropriate role and mode of action for government in the light of the evidence of both academic studies and policy experience. Part II of the book focuses on the institutional venture capital market. It is within institutional venture capital that we find the longest tradition of scholarly work and the most extensive research volume. As research on informal venture capital and corporate venture capital in many cases takes the institutional venture capital market as a point of reference, it seems reasonable to start our ‘journey’ in this area. In this part of the book, we will follow the ‘venture capital cycle’ from fund raising to the exit of venture capitalists’ investments. We start in Chapter 5, in which Douglas Cumming, Grant Fleming and Armin Schwienbacher discuss how venture capital funds are structured and governed. They not only look at the typical US market fund structure but show how it varies across geographical markets. Their conclusion is that the way the venture capital fund is structured will have an important influence on the way venture capitalists manage their operations, the strategy and type of firms that receive finance, the willingness to add value, and so on. After this focus on the structure of the venture capital fund, a couple of chapters serve to elaborate on our knowledge of the investment process used by institutional venture capitalists, that is the process from the pre-investment phase to post-investment activities and exit as well as the financial performance of the ventures. In Chapter 6 we look at the ‘pre-investment phase’, in which Andrew Zacharakis and Dean Shepherd elaborate on the evaluation process – and especially the decision criteria and process applied when venture capitalists make investments in new venture proposals. Zacharakis and Shepherd take an information processing perspective to increase understanding of the process of selecting new investments. In particular, they examine how biases and heuristics impact on the investment process. In the following chapter (Chapter 7), Dirk De Clercq and Sophie Manigart focus on the ‘post-investment phase’ and provide an overview of the knowledge of venture capitalists’ involvement in monitoring activities vis-à-vis entrepreneurs and value-adding for their investees. De Clercq and Manigart open the ‘black box’ by discussing the question of how value-added is created in the venture capitalist–entrepreneur relationship. In Chapter 8, Lowell Busenitz follows up on this discussion by suggesting new research directions for venture capitalists’ value-adding activities. Busenitz argues that research needs to go beyond the broad questions that have been studied so far – and that in many cases have produced very mixed results – and press forward in looking at governance arrangements, compensation systems and obtaining follow-on rounds of funding as well as exploring the broader impact of venture capital investments on innovation and the development of new industries. The chapter ends with a discussion on what measures to use when evaluating venture capitalists’ performance. In Chapter 9, Benoit Leleux elaborates further on the performance aspect of venture capital, and raises the issue of the drivers behind venture capital performance on diﬀerent levels of analysis. The key message is that the nature of the industry makes it very diﬃcult to measure value creation and hence performance over time, and Leleux provides an in-depth discussion on how to measure financial performance in the venture capital context. In this way the chapter provides the reader with a solid basis for his/her interpretation of the data presented on and by the venture capital industry.

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In the next two chapters on institutional venture capital, we ‘cut the cake’ in a diﬀerent way – instead of looking at venture capital as a process we focus on two extremes of institutional venture capital investments: (1) early stage ventures, and (2) late stage ventures, known as equity capital and management buy-outs (MBOs). Based on our knowledge of early stage venture capital, Annaleena Parhankangas argues in Chapter 10 that early stage venture capitalists are faced with specific problems associated with the combination of long-term commitment in a young venture and a considerable likelihood of failure. She elaborates on the diﬀerences between investments in early and late stage ventures and identifies several management practices available for early stage venture capitalists who expose themselves to a high level of information asymmetries and risk. At the other end of the investment spectrum, there are investments in private equity capital and management buy-outs, and in Chapter 11 Mike Wright provides an overview of the development and trend in the private equity and MBO market. He demonstrates the heterogeneity of the buy-out concept as well as the application of the concept to diﬀerent firm and country contexts. In addition, private equity and MBOs are analysed using a life-cycle perspective: deal generation; screening and negotiation; valuation; structuring; monitoring and adding value; and exit. In Part III we turn our attention to informal venture capital (or business angels) research. As in the case of institutional venture capital, there is a fairly long tradition of research on informal venture capital (although the volume of research is less extensive) and the institutional and informal venture capital markets have been regarded as partly complementary and partly overlapping (see discussion above). Peter Kelly opens in Chapter 12 by acknowledging that it is 25 years since William Wetzel published his seminal study on business angels and summarizes and synthesizes the knowledge within the field: what have we learned about the informal venture capital phenomenon over the past quarter century? Kelly not only looks at ‘the road that has been travelled’ in business angel research, but also ‘the journey ahead’ and highlights some of the key issues that need to be tackled in future research. We then focus our attention on a couple of research themes that are important not only for informal venture capital researchers but also for policy-makers and business angels themselves. In Chapter 13, Allan Riding, Judith Madill and George Haines review recent research literature with regard to how business angels make investment decisions. The authors employ a model of the investment process including: (1) sourcing of potential deals and first impression; (2) evaluations; (3) negotiation and consummation; (4) post-investment involvement; and (5) exit, as well as examining recent knowledge pertaining to these stages and elaborating on the way business angels’ investment decision-making influences each stage of the process. In Chapter 14, Jeﬀrey Sohl argues that the informal venture capital market is fraught with ineﬃciencies which result in two persistent funding gaps: a primary seed gap and a secondary post-seed gap. These market ineﬃciencies and funding gaps have led the market to adopt various organizational mechanisms to increase eﬃciency – angel portals – and in the chapter the author reviews and discusses current experiences of diﬀerent kinds of angel portal. In Part IV we focus our attention on corporate venture capital, that is equity or equitylinked investments where the investor is a financial intermediary of a non-financial corporation. Corporate venture capital is regarded as a distinct part of the institutional venture capital market, but research on corporate venture capital is still in its infancy and the amount of research rather limited. Part IV consists of two chapters. In Chapter 15

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Markku Maula argues that the research on corporate venture capital is still quite fragmented and has not been systematically reviewed – a challenge that Maula attempts to take on, and he synthesizes the literature on corporate venture capital with particular emphasis on research examining corporate venture capital from the corporate investors’ perspective. In Chapter 16 we change perspective, and Shaker Zahra and Stephen Allen look at corporate venture capital from the entrepreneurs’ perspective. Zahra and Allen’s point of departure is that many new ventures need to assemble and use resources fairly quickly in order to develop capabilities that can create and protect a competitive advantage, and corporate venture capital enables them to obtain the financial resources and business contacts necessary for development and growth. The authors discuss the potential financial and non-financial benefits that new ventures can gain from corporate venture capital investments. Finally, in Part V (Chapter 17), Hans Landström presents a summary and synthesis of the discussions in the Handbook by elaborating on the question: what advice can be given based on the knowledge developed in the book? The chapter provides some implications for venture capitalists, entrepreneurs and policy-makers as well as a discussion about the future direction of venture capital research. References Aggarwal, V. (1973), The Selection Criteria and Evaluation Techniques used by Venture Capitalists, Graduate School of Business Administration, University of California, Berkeley. Aguren, W.F. (1965), Large Nonfinancial Corporations as Venture Capital Sources, Cambridge, MA: MIT. Ahlstrom, D. and G.D. Bruton (2006), ‘Venture capital in emerging economies: networks and institutional change’, Entrepreneurship: Theory & Practice, March, 299–320. Avdeitchikova, S. (2005), ‘Typologies of the informal venture capital investors in Sweden’, Conference Proceedings, 50th ICSB World Conference, Washington, DC, 17–19 June. Baty, G.B. (1963), Financing the New Research Based Enterprise in New England, Cambridge, MA: MIT. Baty, G.B. (1964), The Initial Financing of New Research-based Enterprise in New England, Boston, MA: Federal Reserve Bank of Boston. Bean, A.S., D. Schiﬀel and M.E. Mogee (1975), ‘The venture capital market and technological innovation’, Research Policy, 4. Benjamin, G.A. and J. Margulis (2001), The Angel Investor’s Handbook, Princeton, NJ: Bloomberg Press. Birch, D.L. (1987), Job Creation in America, New York: Free Press. Birkinshaw, J., R. van Basten Batenburg and G. Murray (2002), ‘Corporate venturing: the state of the art and the prospects for the future’, Working Paper, London: London Business School. Black, B.S. and R.J. Gilson (1998), ‘Venture capital and the structure of capital markets: banks versus stock markets’, Journal of Financial Economics, 47, 243–77. Briskman, E.F. (1966), Venture Capital: The Decision to Finance Technically-Based Enterprises, Cambridge, MA: MIT. Brophy, D.J. (1974), Finance, Entrepreneurship and Economic Development, Institute of Science and Technology, Ann Arbor: University of Michigan. Brophy, D.J. (1982), ‘Venture capital research’, in C.A. Kent, D.L. Sexton and K.H. Vesper (eds), Encyclopedia of Entrepreneurship, Englewood Cliﬀs, NJ: Prentice-Hall, pp. 165–92. Brophy, D.J. (1986), ‘Venture capital research’, in D.L. Sexton and R.W. Smilor (eds), The Art and Science of Entrepreneurship, Cambridge, MA: Ballinger, pp. 119–43. Brophy, D.J. (1997), ‘Financing the growth of entrepreneurial firms’, in D.L. Sexton and R.W. Smilor (eds), Entrepreneurship 2000, Chicago, IL: Upstart Publishing Company, pp. 5–27. Bygrave, W.D. (1987), ‘Syndicated investments by venture capital firms: a networking perspective’, Journal of Business Venturing, 2, 139–54. Bygrave, W.D. (1988), ‘The structure of investment networks of venture capital firms’, Journal of Business Venturing, 3, 137–57. Bygrave, W.D. (1989), ‘Venture capital investing: Resource exchange perspective’, unpublished DBA thesis, Boston University. Bygrave, W.D. and J.A. Timmons (1992), Venture Capital at the Crossroad, Boston, MA: Harvard Business School.

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Bygrave, W.D., N. Fast, R. Khoylian, L. Vincent and W. Yue (1989), ‘Early rates of return of 131 venture capital funds started 1978–1984’, Journal of Business Venturing, 4, 93–105. Charles River Associates Inc. (1976), ‘An analysis of capital market imperfections’, NTIS Report PB-254996, Washington, DC: National Bureau of Standards. Chen, Y.-S. (1983), ‘On the positive role of financial intermediation in allocation of venture capital in a market with imperfect information’, Journal of Finance, XXXVIII(5), 1543–68. Cooper, A.C. (1971), The Founding of Technology-based Firms, Milwaukee: The Center for Venture Management. Cooper, I.A. and W.T. Carleton (1979), ‘Dynamics of borrower–lender interaction: partitioning final payoﬀ in venture capital finance’, Journal of Finance, 34, 517–29. Cornelius, B. and O. Persson (2004), ‘Who’s listening? The function of small business research’, paper presented at the 13th Nordic Conference on Small Business Research, Tromsö, Norway, June. Cornelius, B. and O. Persson (2006), ‘Who’s who in venture capital research’, Technovation, 26, 142–50. Coveney, P. and K. Moore (1998), Business Angels: Securing Start-Up Finance, Chichester: Wiley. Crane, D. (1972), Invisible Colleagues. Diﬀusion of Knowledge in Scientific Communities, Chicago: University of Chicago Press. De Clercq, D., V.H. Fried, O. Lehtonen and H.J. Sapienza (2006), ‘An entrepreneur’s guide to venture capital galaxy’, Academy of Management Perspectives, 20(3), 90–112. DeHudy, T.D., N.D. Fast and S.E. Pratt (1981), ‘The venture capital industry: opportunities and considerations for investors’, Working Paper, Capital Publishing Corp. Donahue, T.W. (1972), An Application of a Generalized Risk Model to the Analysis of Major Capital Ventures, PhD thesis, University of Southern California. Dorsey, T.K. (1977), The Measurement and Assessment of Capital Requirements, Investment Illiquidity and Risk for the Management of Venture Capital Funds, PhD thesis, Austin: University of Texas. Faucett, R.B. (1971), The Management of Venture Capital Investment Companies, Cambridge, MA: Sloan School of Management, MIT. Florida, R. and M. Kenney (1988), ‘Venture capital and high technology entrepreneurship’, Journal of Business Venturing, 3, 301–319. Freear, J., J.E. Sohl and W.E. Wetzel (1994), ‘Angels and non angels: are there diﬀerences?’, Journal of Business Venturing, 9, 109–23. Gaston, R.J. (1989), Finding Private Venture Capital for Your Firm: A Complete Guide, New York: Wiley. Gompers, P. and J. Lerner (1996), ‘The use of covenants: an empirical analysis of venture partnership agreements’, Journal of Law and Economics, 39, 463–98. Gompers, P. and J. Lerner (1999), The Venture Capital Cycle, Cambridge, MA: MIT Press. Gompers, P. and J. Lerner (2003), ‘Equity financing’, in Z.J. Acs and D.B. Audretsch (eds), Handbook of Entrepreneurship Research, Boston, MA: Kluwer Academic Publishers, pp. 267–98. Gorman, M. and W.A. Sahlman (1989), ‘What do venture capitalists do?’, Journal of Business Venturing, 4, 231–48. Hall, D.R. (1967), A Study of the Capital-Seeking Process of the Technical Entrepreneur, MS thesis, Cambridge, MA: MIT. Hoban, J.P. (1976), Characteristics of Venture Capital Investments, PhD thesis, Provo, University of Utah. Hoﬀman, C.A. (1972), The Venture Capital Investment Process: A Particular Aspect of Regional Economic Development, PhD Thesis, University of Texas at Austin. Huntsman, B. and J.P. Hoban (1980), ‘Investment in new enterprise. Some empirical observations on risk, return and market structure’, Financial Management, Summer, 44–51. Hussayni, H.Y. (1959), Corporate Profits and Venture Capital in the Postwar Period, PhD thesis, University of Michigan. Isaksson, A. (2006), Studies on the Venture Capital Process, PhD thesis, Umeå: Umeå School of Business. Jeng, L.A. and P.C. Wells (2000), ‘The determinants of venture capital funding: evidence across countries’, Journal of Corporate Finance, 6, 241–89. Kenney, M. (1986), ‘Schumpeterian innovation and entrepreneurs in capitalism: a case study of the US biotechnology industry’, Research Policy, 15, 21–31. Landström, H. (1992), ‘The relationship between private investors and small firms: an agency theory approach’, Entrepreneurship and Regional Development, 4(3), 199–223. Landström, H. (2005), Pioneers in Entrepreneurship and Small Business Research, New York: Springer. Leland, H. and D. Pyle (1977), ‘Information asymmetries, financial structure, and financial intermediation’, Journal of Finance, 32, 371–87. Lerner, J. (1998), ‘Angel financing and public policy: an overview’, Journal of Banking & Finance, 22(6–8), 773–84. Lerner, J. (2000), A Brief Review of Venture Capital and Private Equity: A Casebook, Toronto: John Wiley & Sons. Lockett, A. and M. Wright (2002), ‘Editorial. Venture capital in Asia and the Pacific rim’, Venture Capital, 4(3), 183–95. Lumme, A., C. Mason and M. Suomi (1998), Informal Venture Capital: Investors, Investments and Policy Issues in Finland, Dordrecht, the Netherlands: Kluwer.

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MacMillan, I.C., D.M. Kulow and R. Khoylain (1988), ‘Venture capitalists’ involvement in their investments: extent and performance’, Journal of Business Venturing, 4(1), 27–47. MacMillan, I.C., R. Siegel and P.N. Subba Narisimha (1985), ‘Criteria used by venture capitalists to evaluate new venture proposals’, Journal of Business Venturing, 1, 119–28. MacMillan, I.C., L. Zemann and P.N. Subba Narisimha (1987), ‘Criteria distinguishing successful from unsuccessful ventures in the venture screening process’, Journal of Business Venturing, 2(2), 123–37. Manigart, S. (1994), ‘The funding rate of venture capital firms in three European countries (1970–1990)’, Journal of Business Venturing, 11, 439–69. Månsson, N. and H. Landström (2005), ‘Business angels’ investment preferences: early-stage investors – are they diﬀerent?’, paper at the RENT XVIII Conference, Copenhagen, Denmark, 25–26 November. Martin, R. (1989), ‘The growth and geographical anatomy of venture capitalism in the United Kingdom’, Regional Studies, 23, 389–403. Mason, C. (2007), ‘Informal sources of venture finance’, in S. Parker (ed.), The Life Cycle of Entrepreneurial Ventures, Volume 3, New York: Springer. Mason, C.M. and R.T. Harrison (1992), ‘The supply of equity finance in the UK: a strategy for closing the equity gap’, Entrepreneurship and Regional Development, 4, 357–80. Mason, C.M. and R.T. Harrison (1995), ‘Closing the regional equity gap: the role of informal venture capital’, Small Business Economics, 7, 153–72. Mason, C.M. and R.T. Harrison (1997), ‘Supporting the informal venture capital market: what still needs to be done?’, Venture Finance Working Paper No. 15, Southampton: University of Southampton and University of Ulster. Mason, C.M. and R.T. Harrison (1999a), ‘Editorial. Venture capital: rationale, aims and scope’, Venture Capital, 1(1), 1–46. Mason, C.M. and R.T. Harrison (1999b), ‘Public policy and the development of the informal venture capital market’, in K. Cowling (ed.), Industrial Policy in Europe, Routledge: London, pp. 201–23. Mason, C.M. and R.T. Harrison (2000a), ‘Informal venture capital and the financing of emergent growth businesses’, in D.L. Sexton and H. Landström (eds), The Blackwell Handbook of Entrepreneurship, Oxford: Blackwell. Mason, C.M. and R.T. Harrison (2000b), ‘The size of the informal venture capital market in the UK’, Small Business Economics, 15, 137–48. Mason, C.M. and R.T Harrison (2002), ‘Barriers to invest in informal venture capital sector’, Entrepreneurship and Regional Development, 14, 271–87. Maula, M.V.J. (2001), Corporate Venture Capital and the Value-added for Technology-based new Firms, Doctoral Dissertations 2001/1, Institute of Strategy and International Business, Helsinki University of Technology, Espoo, Finland. Maula, M.V.J., E. Autio and G.C. Murray (2005), ‘Corporate venture capitalists and independent venture capitalists: what do they know, who do they know, and should entrepreneurs care?’, Venture Capital, 7(1), 3–21. McNally, K.N. (1994), ‘Sources of finance for UK venture capital funds: the role of corporate investors’, Entrepreneurship and Regional Development, 6, 275–97. Megginson, W.L. and S.B. Smart (2006), Introduction to Corporate Finance, Mason, OH: Thomson SouthWestern. Murray, G.C. (1995), ‘Evalution and change: an analysis of the first decade of the UK venture capital industry’, Journal of Business Finance & Accounting, 22(8), 1077–106. Poindexter, J.B. (1976), The Eﬃciency of Financial Markets. The Venture Capital Case, PhD thesis, New York: New York University. Reynolds, P.D., W.D. Bygrave and E. Autio (2003), Global Entrepreneurship Monitor: Executive Report 2003, Wellesley and London: Babson College and London Business School. Riding, A. (2005), ‘On the size and structure of the informal market’, Working Paper, Faculty of Administration, University of Ottawa, Canada. Rind, K.W. (1981), ‘The role of venture capital in corporate development’, Strategic Management Journal, 2(2), 169–80. Rind, K.W. (1986), ‘Venture capital planning’, in J.R. Gardner, R. Rachlin and A. Sweeny (eds), Handbook of Strategic Planning, New York: Wiley & Sons, pp. 19.1–19.34. Roberts, E.B. (1969), ‘Entrepreneurship and technology’, in W.H. Gruber and D.G. Marquis (eds), Factors in the Transfer of Technology, Cambridge, MA: MIT Press, pp. 219–37. Robinson, R.B. (1987), ‘Emerging strategies in the venture capital industry’, Journal of Business Venturing, 2, 53–77. Rogers, C.E. (1966), The Availability of Venture Capital for New Technically-based Enterprises, Cambridge, MA: MIT. Rosenstein, J. (1989), ‘The board and strategy: venture capital and high technology’, Journal of Business Venturing, 3, 159–70.

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Rubenstein, A.H. (1958), Problems of Financing and Managing New Research-based Enterprises in New England, Boston, MA: Federal Reserve Bank of Boston. Sahlman, W.A. (1988), ‘Aspects of financial contracting in venture capital’, Journal of Applied Corporate Finance, 1(2), 215–30. Sahlman, W.A. (1990), ‘The structure and governance of venture-capital organizations’, Journal of Financial Economics, 27(2), 473–521. Sahlman, W.A. and H.H. Stevenson (1985), ‘Capital market myopia’, Journal of Business Venturing, 1(1), 7–30. Sapienza, H.J. and J.A. Timmons (1989), ‘Launching and building entrepreneurial companies: do the venture capitalist add value?’, in R.H. Brockhaus et al. (eds), Frontiers of Entrepreneurial Research, Wellesley, MA: Babson College, pp. 245–57. Sapienza, H.J., S. Manigart and W. Vermeir (1996), ‘Venture capital governance and value added in four countries’, Journal of Business Venturing, 11, 439–69. Shapero, A. (1965), The Structure and Dynamics of the Defense R&D Industry, Menlo Park, CA: Stanford Research Institute. Sørheim, R. and H. Landström (2001), ‘Informal investors: a categorization with policy implications’, Entrepreneurship and Regional Development, 13(4), 351–70. Timmons, J.A. and W.D. Bygrave (1986), ‘Venture capital’s role in financing innovation for economic growth’, Journal of Business Venturing, 1, 161–76. Timmons, J.A. and W.D. Bygrave (1997), ‘Venture capital: reflections and projections’, in D.L. Sexton and R.W. Smilor (eds), Entrepreneurship 2000, Chicago, IL: Upstart Publishing Company, pp. 29–46. Timmons, J.A. and H.J. Sapienza (1992), ‘Venture capital: the decade ahead’, in D.L. Sexton and J.D. Kasarda (eds), The State of the Art of Entrepreneurship, Boston, MA: PWS-KENT Publishing Company, pp. 402–37. Tyebjee, T.T. and A.V. Bruno (1981), ‘Venture capital decision-making: preliminary results from three empirical studies’, in H. Vesper (ed.), Frontiers of Entrepreneurship Research, Wellesley, MA: Babson College, pp. 281–320. Tyebjee, T.T. and A.V. Bruno (1984), ‘A model of venture capitalist investment activity’, Management Science, 30(9), 1051–1066. Von Hippel, E. (1973), An Explorative Study of Corporate Venturing – a New Product Innovation Strategy, PhD thesis, Carnegie-Mellon University, Pittsburgh. Wells, W. (1974), Venture Capital Decision-Making, PhD Thesis, Carnegie-Mellon University, Pittsburgh. Wetzel, Jr., W.E. (1983), ‘Angels and informal risk capital’, Sloan Management Review, 24(4), 23–34. Wright, M. and K. Robbie (1998), ‘Venture capital and private equity: a review and synthesis’, Journal of Business Finance & Accounting, 25(5/6), 521–70. Wright, M., H.J. Sapienza and L.W. Busenitz (eds) (2003), Venture Capital. Volumes I, II and III, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing.

2

Conceptual and theoretical reflections on venture capital research Harry J. Sapienza and Jaume Villanueva

Introduction Entrepreneurship and early venture capital literature As indicated in Chapter 1 the research on venture capital1 dates back at least to the late 1960s (for example Briskman, 1966; Aggarwal, 1973; Wells, 1974; Poindexter, 1976) when the industry itself was in its infancy. Whereas these early studies in venture capital tended to focus on the eﬃciency of venture capital as an investment vehicle or on the decision criteria used by venture capitalists to assess entrepreneurs and opportunities, other areas of the more general entrepreneurship literature focused on the nature of the entrepreneur and on conditions of founding. Thus, early on, venture capital research contributed primarily in the areas of economic implications of this ‘new’ organizational entity (venture capital) as a financing tool. In truth, the entire field of management or business ‘science’ itself was just forming. Whereas the field of economics was comparatively well-developed, the examination and study of business organizations as atomistic entities worthy of study in their own right was just emerging. Through the 1980s and into the early 1990s, interest in venture capital and its unique problems and contributions expanded. For entrepreneurship research in general, the decade began with a focus on the entrepreneur and ended with a focus on the entrepreneurial process of new venture creation. Venture capital research complemented this development by beginning to unravel the mysteries of the venture capitalist–entrepreneur dyad in this process of venture creation (Sapienza, 1989; Fried and Hisrich, 1995; Landström et al., 1998). Although venture capital research focused solely on highpotential ventures (rather than on the vast majority of new ventures), it nonetheless contributed to the broader development of entrepreneurship theory because the majority of people working diligently in the area were attentive to theory development. Into the twenty-first century, research on venture capital has remained a vibrant and critical part of the more general entrepreneurship literature. Purpose and overview of this chapter In this chapter we share our reflections on the past, present, and, especially, the possible future of managerial venture capital research. What we mean by managerial is that we consider work with a disciplinary focus on management, work produced by management scholars and published in management journals, rather than on other perspectives such as finance or economics. We reflect on (without reviewing in depth) the historical pattern of this domain, considering especially the extent to which this research has contributed to the understanding of the venture capital phenomenon and to the broader entrepreneurship literature. We then turn our attention to suggesting how we would like to see 66

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future study develop. In the spirit of this collection of works, we reflect to some extent on research including private, institutional venture capital firm (VCF), corporate venture capital (CVC), and business angel venture capital (BA). However, our primary focus is on the literature that developed around institutional venture capitalists. Our thinking is influenced by two recent ‘critiques’ of the management literature published by some of its prominent scholars. One critique opines that research has become increasingly remote from phenomena of interest and suggests an approach of ‘Engaged Scholarship’ to redress the problem (Van de Ven and Johnson, 2006). The other critique charges that an exaggerated ‘pretense of knowledge’ in social science combined with the dominance of unrealistically pessimistic assumptions about the character of individuals and institutions has led to ‘bad theory’ resulting in bad practice (Ghoshal, 2005). The former article oﬀers suggestions to guide the engaged scholar to conduct meaningful research. The latter pleads for a ‘Positive Organizational Scholarship’ movement (for example Cameron et al., 2003) that will seek answers to the ‘positive’ problems of management. We tend to share the views expressed in these works. We use them as a framework for suggesting how venture capital research may meaningfully develop in the future. Our overall conclusion in reviewing past work is that managerial venture capital research has accomplished a great deal in the twenty or so years since it began to blossom into a persistent area of study within the developing arena of entrepreneurship research. The ‘glass half-full’ view is that such research has been at the forefront of growing attempts to build serious theoretical underpinnings to the study of entrepreneurship grounded in a variety of disciplines. Important work has been done to apply and extend economic views such as agency theory (for example Robbie et al., 1997), game theory (for example Cable and Shane, 1997), resource-based and knowledge-based views (for example Lockett and Wright, 1999). Further, macro-organizational perspectives such as population ecology (for example Manigart, 1994), institutional theory (for example Bruton et al., 2005), and network theory (for example Bygrave, 1988) have figured prominently. Finally, with an outlook and basis quite diﬀerent from the economic roots of venture capital research, micro-organizational perspectives have provided important behavioral insights via such perspectives as social exchange theory (for example De Clercq and Sapienza, 2001), social capital theory (for example Maula et al., 2003), learning theory (for example De Clercq and Sapienza, 2005), cognition and cognitive bias theories (for example Shepherd and Zacharakis, 1999), psychological contract theory (for example Parhankangas and Landström, 2004) and procedural justice theory (for example Sapienza and Korsgaard, 1996; Busenitz et al., 1997). The ‘glass half-empty’ view is that there is still much we have ignored and much we do not know. We believe that, upon occasion, adopting such a critical view of ourselves will lead to productive new directions. This chapter provides us with the opportunity to stop for a minute, take a deep breath, and take stock of where we are and where we want to go before continuing on our research agendas. We hope to engage you in this exercise with us. We first oﬀer two cautions: (1) our suggestions do reflect our own biases and preferences; and (2) some of our suggestions reflect an ‘ideal’ of scholarship that may be more or less feasible for a researcher to heed, depending upon his or her stage of career and the institutional and departmental norms faced. We believe that as entrepreneurial scholars (double meaning intended), however, we prefer to spend energy envisioning where we would like to go rather than to spend it focusing on the barriers that keep us from getting there.

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In short, the most important question we raise in this chapter is: where should we go as a field? At one extreme, we could become a clinical field, with proliferation of clinical analyses and consulting activities. At the other extreme, we could become theoretically remote from the practice of venture capital but achieve great theoretical elegance. We endorse the concept of ‘Engaged Scholarship’ (Van de Ven and Johnson, 2006) in which research enriches practice and vice versa. We believe that theory that is not informed by practice is neither useful nor interesting; similarly, practice without theory is particularized and uninformative. Rigorous research with a solid theoretical and methodological base is essential to advance the field. For us, the best research will also be meaningful to practitioners. It will not be done ‘for’ practitioners; it will be done ‘with’ them. Perhaps the term ‘practitioner’ is too narrow, for it invokes an incomplete image of those aﬀected by our research. We suggest that stakeholders (beyond researchers and their students themselves) include investors, entrepreneurs, policy makers and broad societal elements such as local communities and regional and national economies. The chapter proceeds as follows: first, we analyze the focus of research in venture capital over time. We identify and discuss the dimensions that have been studied extensively, and we note the ones that have been relatively neglected. We present a stylized figure that depicts key dimensions of past managerial venture capital research: the stage in the venture capital cycle, the perspective of the key focal actor (for example venture capitalist or entrepreneur), the type of venture capital (institutional, angel, corporate), the level of analysis used, and the theoretical framework through which works are designed and interpreted. We also discuss the causes and consequences of the chosen perspectives. Next, we introduce the concept of ‘engaged scholarship’ (Van de Ven and Johnson, 2006), examining its applicability to venture capital research. In the penultimate section, we introduce Ghoshal’s (2005) ‘positive organizational scholarship’ argument and consider its implications for our field. Finally, we use our stylized model and these two perspectives to consider avenues for future research. Causes and consequences of dominant areas of venture capital research In this brief section we trace the development of managerial venture capital literature from the rich, detailed descriptions of the phenomenon that dominated early work to the later theory-driven analyses (see also Chapter 1). We employ a metaphor of the kaleidoscope to represent the varied perspectives, levels of analysis, phases of the venture capital process, and actors that have become part of the rich tapestry of the field.2 This metaphor allows us to introduce a discussion of the dimensions of the field that have received relatively greater attention. Early contributions Much early literature focused on what exactly venture capitalists do (Tyebjee and Bruno, 1984; MacMillan et al., 1985; Gorman and Sahlman, 1989). These highly descriptive works have proven extremely useful for three reasons. First, they helped everyone understand the mechanics of the industry and illuminated the significant ways in which venture capital diﬀers from other sources of capital for entrepreneurial start-ups and from one another (for example Elango et al., 1995). This contribution is in line with the engaged scholar view discussed later.

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Second, by opening the black box of practice, early descriptive studies allowed subsequent researchers to build theory eﬀectively. The venture capital process itself is highly complex, and, without a deep understanding of the mechanics of the industry, theorists would be likely to create incorrect or incomplete theoretical frameworks. That is, a deep understanding of the issues and practices involved in the phenomenon improves the validity, sophistication and power of theoretical models developed. Finance theory work such as Sahlman’s (1990) on the structure of the venture capital industry served to highlight the agency issues and financial structure challenges faced by venture capital firms. This type of study paved the way for managerial work such as Giﬀord’s (1997) that pointed to the serious issue of the venture capitalist as agent and for Cable and Shane’s (1997) work that elucidated the powerful forces for collaboration in venture capitalist–entrepreneur pairs. Third, empirical descriptions chronicle venture capital at various points in time and at various economic epochs in a manner that allows us to understand the phenomenon and to see how types of financing interact over time. For example, the chronicling of corporate venture capital in the aftermath of the economic booms of the late 1980s (for example Block and MacMillan, 1993) and around the turn of the twenty-first century (for example Maula, 2001) has added understanding not only of corporate venture capitalists but also of institutional venture capitalists and business angels. Thus, theory has been aided because the chronicles allow us to derive the meaning of variation (or non-variation) in practice in diﬀerent times and places. As we move into the twenty-first century, we can build sophisticated portraits that look at the entire ecosystem of venture capital and that will provide more complete pictures than are currently available. Expansion of venture capital research along several dimensions After the early ‘descriptive’ period, managerial venture capital research grew more theorydriven and developed along several diﬀerent paths. Figure 2.1 represents the dimensions by which the most common examples of past venture capital research might be viewed and classified. The outer circle surrounding the central dimensions in Figure 2.1 represents the lenses (or theories) that researchers bring to bear on the questions or dimensions being studied. Think of this diagram as a metaphorical kaleidoscope, one whose internal dimensions and external circumference can be rotated, bringing various theoretical views and elements into diﬀerent juxtapositions and focuses. Imagine each theoretical perspective as existing at a specific location on the outer ring of the kaleidoscope; imagine further, then, that we rotate the outer ring. From this new location, the perspective on the dimensions within the internal circle of the kaleidoscope will have changed. Further, think of the inner circles as also being capable of being rotated; they represent levels of analysis, for example, individual, group, venture, community, region, country, and so on.3 In the interior of the kaleidoscope, we see three overlapping dimensions: type of venture capital (for example institutional venture capital – VCF, business angels – BA, or corporate venture capital – CVC), the interests or perspectives being investigated (for example investor4 vs. entrepreneur), and the stage of the venture capital process (for example fund raising, selection). Although each dimension is composed of several elements, most studies center on one element within each dimension. For example, Shepherd and Ettenson (2000) examined how an investor type (the institutional venture capital firm) attempts to maximize returns (investor’s perspective) via decisions made during the selection stage of the venture capital cycle.

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Handbook of research on venture capital Theoretical frameworks

Levels of analysis

Stage in VC cycle Fund raising Screening/selection Negotiation/investing Monitoring/advising Exit

Focal perspective Entrepreneur Investor

VC type BAVC CVC PFVC

Note: Areas highlighted in bold represent the most frequently studied areas in managerial venture capital research

Figure 2.1

Kaleidoscope of research in managerial venture capital

We have chosen the metaphor of the kaleidoscope to convey the idea that changing levels of analysis and/or theoretical lens provides very diﬀerent views of the phenomena. For the Shepherd and Ettenson article, the level of analysis is the venture capital firm and the theoretical framework is the industrial organization perspective. Had they chosen the entrepreneur’s perspective, diﬀerent theoretical questions may have arisen such as how to position their venture to attract capital or how to select venture capitalists if given options. Other choices of frameworks or levels of analysis would also have resulted in quite diﬀerent questions, data and interpretations. The choice of framework aﬀects the likely questions asked, the levels viewed, and the data examined. Conceiving of possibilities in this manner may lead researchers to a variety of questions, some previously studied and some not. Examples of questions suggested if we consider diﬀerent levels of analysis include: at the individual level, why do entrepreneurs seek venture capital, and how are their outcomes aﬀected? At the dyadic level, how do governance structures and mechanisms aﬀect returns, and how do venture capitalist–entrepreneur interactions moderate these? At the firm level, why do venture capital firms exist, and why do some venture capital firms outperform others? At the regional/national levels, how may venture capital activity be fostered, and what is the appropriate role of government in the venture capital process? The appropriateness of

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theories also varies by level: cognitive and behavioral theories are most appropriate at the individual level; social exchange and power theories at dyadic levels; network, social capital, resource-based and knowledge-based at the firm level; and population ecology and institutional theory at the industry/region/nation levels. Figure 2.1 indicates that the most common studies focus on institutional venture capital firm type, from the investor’s perspective, in the selection and/or monitoring stages of the venture capital cycle (for example Tyebjee and Bruno, 1984; MacMillan et al., 1985; Bygrave, 1988; Gorman and Sahlman, 1989; Sapienza and Manigart, 1996; Shepherd and Zacharakis, 1999). Despite the well-known fact that institutional venture capital firm financing is a much smaller phenomenon than is business angel investing (Mason and Harrison, 1996; Landström, 1998; Freear et al., 2002), both in terms of number of deals and in terms of absolute capital invested, several factors explain why institutional venture capitalists have been studied most vigorously. First, the history of the venture capital industry itself is traced back to such famous institutional venture capitalists as ARD (American Research and Development), Kleiner-Perkins, and others. Second, many high profile ventures such as Apple, DEC, Genentech and the like have been linked in the popular press to institutional venture capitalists. Third, in comparison to business angels, institutional venture capitalists are more visible; they are easier for researchers to locate, and they have more resources to devote to helping in research; and, in comparison to corporate venture capitalists, the institutional venture capital industry has been more stable both in terms of number of firms existing at one time and in terms of the longevity of the firms. The focus on examining issues from the investor’s perspective is also understandable for several reasons: first, even though they would not exist without entrepreneurs, venture capitalists, are, after all, the individuals who comprise the industry itself. Second, venture capitalists are the most clear and immediate of stakeholders for venture capital research. Third, as a practical reason, venture capitalists (possibly with the exception of angels) are more visible than entrepreneurs and are able to provide researchers with access to large numbers of ventures. Thus, researchers are apt to use institutional venture capitalists and corporate venture capitalists to locate samples; this allows the possibility, too, of establishing long-term relationships to which researchers may return for future studies. Because business angels are often as invisible and as fragmented as the entrepreneurs themselves, less research is executed in this domain overall. Nevertheless, even work on business angels tends to take the perspective of the investor (for example Mason and Harrison, 1996; Sohl, 2003). The focus on selection and monitoring stages may also have practical roots. First, collecting information on selection criteria is especially amenable to the questionnaire and interview techniques preferred by early researchers (for example Tyebjee and Bruno, 1984; MacMillan et al., 1985). Furthermore, as innovations in methods for studying selection through such techniques as conjoint analysis arose, the selection literature was revitalized and new empirical and theoretical insights were achieved (for example Shepherd and Zacharakis, 1999). This technique allows the generation of large sample sizes and high ability to control contextual factors that may confound typical field work. Second, as researchers became aware of the dominance of post-investment activities in time spent overall by investors, the pressure to understand this stage of the venture capital cycle gained momentum. Thus, a good deal of work attempted to penetrate the issues of exactly

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how venture capitalists added value beyond selecting and providing money to entrepreneurs (for example Sapienza and Gupta, 1994; Fried and Hisrich, 1995). This research could draw on a rich tradition of theory in organizational behavior and decision making to guide research design (for example Sapienza and Korsgaard, 1996; Busenitz et al., 1997). Third, because many aspects of other stages of the venture capital process involve individuals outside the venture capitalist–entrepreneur dyad (for example fund raising involves limited partners, and exit involves several external organizations), research designs on these other phases are especially complicated. Dominant focuses Given the focus on the investor’s perspective, it is unsurprising that the rational economic framework has been the prominent theoretical lens used. In particular, although its eﬃcacy in this context has increasingly been called into question (for example Landström, 1993; Cable and Shane, 1997), agency theory has been the dominant approach to examining the topic. Specifically, the investor has been framed as principal and the entrepreneur as agent. This choice of agency theory is in harmony with focusing on institutional venture capital type and on the investor’s perspective. First of all, among venture capital types, institutional venture capital is the one in which economic return is most unambiguously the sole motivation for venture selection. Second, Jensen and Meckling’s (1976) seminal presentation assessed in detail the likely consequences of conflict between ownermanagers of firms (entrepreneurs) and outside equity holders (investors); furthermore, the publication of this article coincided with the emergence of the institutional venture capital industry and doubtless influenced the emerging research on venture capital. From an agency perspective the key issue is how outside investors can minimize agency costs emanating from adverse selection and opportunism. Seeking both practical solutions and tests of a dominant theory, researchers devoted special attention to applying agency theory to the selection (MacMillan et al., 1985; Harvey and Lusch, 1995; Muzyka and Birley, 1996; Smart, 1999) and monitoring phases (MacMillan et al., 1989; Sapienza and Gupta, 1994; Mitchell et al., 1997) of the venture capital process. While not all of these studies relied fully on agency theory, they all shared with it the assumptions inherent in rational economic models. Most importantly, many prominent researchers, especially within the domain of financial venture capital research, have demonstrated the potency of agency theory in predicting the structure of venture capital firms, the development and employment of financial instruments for investing, the terms of formal agreement, and the nature of syndication among institutional venture capitalists.5 We can speculate on two additional factors that may have played a role in the predominance of this theoretical framework: (1) as an emerging topic, venture capital researchers sought to rely on basic and popular theories within the mainstream disciplines; and (2) because most of the initial venture capital research was developed in the United States, it may be that governance, conflict and control of agency problems were more relevant in that context than in other contexts such as those of Western Europe or Japan.6 In short, the dominant elements studied within our metaphorical kaleidoscope (institutional venture capital firm, investor perspective, selection/monitoring) are logically coherent, especially when viewed through the rational economic lens. Because the underlying agency theoretical framework was a familiar and widely used one even within the

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management literature, venture capital researchers have been able to span boundaries within management literature (for example strategy, and organization theory) and across business research domains. For example, the issue of how agency concerns aﬀect risk–return relationships in organizational decision making interests both finance and organization behavior researchers. On the positive side, then, the particular focus adopted over the past decade and a half has placed venture capital research at the core not only of developments in entrepreneurship but more broadly in the mainstream of disciplinary work outside of entrepreneurship. At the same time, we must recognize the costs of having focused so strongly on this particular configuration of elements (institutional venture capital firm, investor perspective, and selection/monitoring, all through the rational economic lens) in our studies. Importantly, the costs are ones of omission or lack of knowledge development in the other areas such as venture type, actor perspective, and stage of the process. Some have already noted that the level of investment activity in institutional venture capital is dwarfed by the enormous (but hidden) activity in the realm of business angels (Sohl, 2003). Yet the amount of research conducted on business angels is but a fraction of that conducted in the institutional venture capital arena. As is evidenced in the other chapters of this Handbook of Research on Venture Capital, a thriving literature on business angels does exist (see Chapters 12 to 14). Our point, however, is only that more work in this area is needed. Although some of the barriers to conducting empirical research on business angels are much higher than they are for institutional venture capitalists or corporate venture capitalists, we believe that hurdling such barriers is worthwhile. As one example of how moving away from the dominant model may enrich our work, the field of venture capital research would be enhanced by further examinations of the entrepreneur’s perspective. The work that does exist shows the promise of deep investigations of entrepreneurs’ perspectives. For example, Busenitz et al.’s (1997) study of the eﬀects of procedural justice on entrepreneurs’ receptivity to investors has illustrated the value of examining the process from the entrepreneur’s perspective: their work suggests that investors who ignore the rules of respect and fairness may be destined to have critical information distorted or withheld from them. Sapienza et al. (2003) also showed the value of considering the entrepreneur’s motives. They argued that entrepreneurs’ choice of financing type (and the particular investor within the chosen type) involves both considerations of economic rationality and of self-determination. In summary, we have noted above that managerial venture capital research started as simple descriptions of the processes and practices in the industry and eventually evolved into more complex studies that focused on several dominant themes or configurations. In order to represent this complexity and to highlight the areas of emphasis, we used the metaphor of a kaleidoscope. This metaphor helped to illustrate that certain areas received much more emphasis than others. Implicitly, then, many areas have not received much attention. At the end of this chapter we point out which of these areas we believe especially merit additional study. Contributions of venture capital research to entrepreneurship literature Venture capital research directly addresses many of the fundamental issues of interest to entrepreneurship scholars. For example, much of the research has been devoted to how investors assess opportunity (MacMillan et al., 1985; Shepherd, 1999; Smart, 1999). The

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most common approach has been to look at the criteria that venture capitalists use to make investment decisions. Smart (1999) takes the central conclusion from this literature (that is the conclusion that venture capitalists focus most strongly on the quality of the entrepreneurs themselves) and delves into how venture capitalists assess the entrepreneurs and whether some assessment methods are more eﬀective than others. Some work, such as Fiet’s (1995) comparison of institutional venture capitalists and business angels, assesses how investors attempt to deal with risk in entrepreneurial settings; Fiet argues that institutional venture capitalists possess potent remedies against agency risks and thus focus on market risk whereas business angels, lacking such potent contractual leverage, focus on agency problems. Some have even looked at business angels as entrepreneurs themselves (Landström, 1998); such work draws an essential but little recognized parallel between the challenges and issues facing both entrepreneurs and their investors. In some ways contributions of venture capital research to the field of entrepreneurship have been indirect. For example, venture capital portfolio companies are usually considered ‘high potential’ ventures. As such, venture capital provides a convenient sampling space for studying ‘entrepreneurial’ firms. The venture capital setting provides an easy-toidentify, comparable and convenient sampling of high-potential firms. Another benefit of studying in the venture capital setting is that it helps researchers address a common problem plaguing users of survey designs. Here, the issue of common source bias – the validity problem of deriving measures of independent variables from the same source as dependent variables – may be addressed more readily than in other settings. The presence of two sets of individuals (investors and entrepreneurs) highly knowledgeable about one another and about the venture in question provides venture capital researchers with a means to overcome some common source and common method problems that typically plague entrepreneurship research. For example, using venture capitalists’ rating of venture outcomes along with entrepreneurs’ rating of venture activities creates valid ratings and avoids spuriously related measures. The high profile nature of the institutional venture capital industry and the stream of good descriptive early studies have made the industry understandable and accessible to the broader management field. This matters because it makes entrepreneurship itself accessible to other areas of business scholarship. We can also be proud of the fact that a very high percentage of the entrepreneurship studies published in the widely distributed, highly regarded management journals (for example Academy of Management Journal, Academy of Management Review and Journal of Management Studies) have been about venture capital. Clearly, venture capital researchers have been able to execute worthy empirical work and contribute to entrepreneurship and management theory. And, whereas entrepreneurship research in general has been plagued by lack of replication, incomparable samples, variations in measures and constructs, and the like, venture capital researchers have created several relatively coherent streams of inquiry such as venture valuation, investment decision making, partner interaction and governance. Yet, we can do more to advance entrepreneurship literature. Given that venture capital is a multi-stage, multi-actor process, its study can help us understand whether, or in what ways, the ‘myth’ of the solo, heroic entrepreneur is indeed a myth (Aldrich, 1999; Van de Ven et al., 1999). The venture capital setting oﬀers a plethora of circumstances in which teamwork and inter-organizational relations may be carefully studied. We have the opportunity to view how teams of entrepreneurs work together over a long period of time with

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customers, suppliers, government entities, as well as with various sources of informal and formal financing. Further, we have the opportunity to learn how and when venture capitalists operate as lone wolves or as parts of investment syndicates and venture ecosystems that reach far beyond their own organizations (for example Lerner, 1994; Lockett and Wright, 1999). As yet, however, we understand little about the interconnections across the ecological landscape of the entrepreneurial process. To date, we have but begun to mine the potential in this setting to study the value creation and organization creation processes. We can come to understand more not only about value appropriation (as would be a focus of rational economic perspectives) but also about the elusive areas of value creation. For example, how do the roles of the investor and investee complement, aid, or thwart one another? Are our current approaches to studying the phenomenon the appropriate ones, or should we approach the field in new ways? Are the lenses and attitudes we have adopted the most useful, or are we being blinded by our own perspectives? We take up in the next two sections recent critiques of the larger field of management scholarship itself to consider their implications for future research in venture capital. Implications of the ‘engaged scholar’ view for future venture capital work Rather than simply enumerate under-researched topics and gaps in the literature, we center our suggestions on adopting the ideas laid out by Van de Ven and Johnson (2006) in this section and by Ghoshal (2005) in the following section. Our view is that lack of prior study in a given area, by itself, is woefully inadequate justification for its future study. To warrant study, the understanding of the topic must also be important either to the phenomenon itself or to theory, or to both. In this section, we focus on how future research in venture capital should be conducted so as to ensure these aims. What is appealing for venture capital researchers about Van de Ven and Johnson’s (2006) exhortation for engaged scholarship is that it draws on existing strengths in venture capital research and promises ways to build where we most need work: enhancing our scholarly rigor and legitimacy. At the same time, this approach asks not that we become remote arm-chair theorists but that we become fuller scholars by growing closer to the phenomenon itself. In short, Van de Ven and Johnson oﬀer five guidelines for engaged scholarship: (1) design work to study big problems grounded in reality; (2) design research projects to draw on and create a collaborative learning community; (3) design studies to examine an extended duration of time; (4) employ multiple models and methods; and (5) re-examine assumptions about scholarship and the roles of researchers. The implications of these suggestions for future research in venture capital are the following:7 1.

Design the work to study big problems grounded in reality. Asking the big and relevant questions requires practitioner or stakeholder involvement. It is the interaction between scholars and practitioners, through what Van de Ven and Johnson refer to as a process of knowledge arbitrage, which produces the questions that are both grounded in reality and theoretically relevant. Such work is especially likely to fire the imaginations of scholars and practitioners alike. Big problems grounded in reality will have appeal to politicians, planners, community groups and many others beyond investors and entrepreneurs (for example how may high growth opportunities be nurtured in our town/city/region in such a way as to preserve culture, build community,

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Handbook of research on venture capital and foster innovation?). Of course, such issues are likely to be complex and thus are typically not amenable to being studied using a single lens or perspective. Thus, interdisciplinary research will be necessary to capture and/or disentangle the complexity. In short, this guideline suggests that compelling problems or issues of great importance should drive the research questions asked and the means taken to answer them. In the process of focusing deeply on such problems, many preconceived ideas about specific theoretical approaches or even disciplines will be set aside. Research should not be a hammer searching for a nail. Design the research project to be a collaborative learning community. Engaging venture capitalists and entrepreneurs (as well as community leaders and the like) in real world research settings requires time to develop trust and reciprocal knowledge. Such long-term cooperation is unlikely to occur unless all sides are truly participants in the research process. The process of arbitrage between other stakeholders and scholars, which ensures that the questions asked are both of theoretical importance and grounded in reality, requires collaboration. Collaboration between researchers of diﬀerent disciplinary backgrounds or ‘research circles’ (Landström, 2005) would also increase the plurality of perspectives from which important questions can be analyzed. Some obvious risks and concerns in such collaborative research eﬀorts include issues of academic objectivity, scientific methodological requirements, and issues surrounding the proprietary use of research findings. Van de Ven and Johnson argue that with clear rules of engagement between research partners, these problems can be managed and the benefits will outweigh the risks. In the venture capital setting, such rules might include ways to minimize eﬀort required on the part of entrepreneurs and investors, ways to ensure that proprietary knowledge is protected, and ways to provide broad access to researchers. Put simply, researchers must help their partners deal with their specific, idiosyncratic problems, and their partners must be willing to help researchers gain insights into broader issues that may not be of immediate concern to them. A practical issue worthy of explicit mention here is that access to the venture capital community is extremely limited. An engaged scholar would have to be aware that s/he may face extraordinary challenges both in ‘getting inside’ or getting access to investors and their limited partners, but also in convincing them of the value of participating in the research process and of the trustworthiness of the researcher to fully protect all proprietary information. Design the study for an extended duration of time. As mentioned above, time is a critical element to build relationships and trust, not only with research partners in collaborative research eﬀorts, but also with research subjects on whose information we depend to advance our research. Time is thus a necessary condition to achieve the previously stated objectives of arbitrage and cooperation. Fortunately, studies conducted over an extended period of time also oﬀer the extremely important advantage of allowing researchers the possibility to make a deeper and more valid assessment of causality than is possible with cross-sectional studies or snapshots taken at diﬀerent points in time. Day-to-day, immersed involvement over a long period of time and across many ventures is necessary to understand, for example, whether the problem is bad leadership leading to bad performance or bad performance leading to bad leadership.

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Calls for more longitudinal research are not new in entrepreneurship nor in other research settings. Virtually every one of the ‘Sexton series’ in entrepreneurship research from the early 1980s to the present has called both for more longitudinal research and for higher quality, in-depth qualitative research.8 These calls continue. For example, Freear et al. (2002) point out the desperate need to examine the process of business angel investing over time in order to understand the dynamics of angel–entrepreneur relationships and the role of business angel investing in the entire process from bootstrapping to angel investing to institutional venture capital and corporate venture capital. Having made the case for long-term research projects, we understand that structural characteristics inherent to our profession impede eﬀorts to carry out such research. Still, creative solutions can overcome some of these obstacles. For instance, senior researchers may be able to design and carry out longer-term research projects with shorter-term subcomponents that can be tackled by more junior faculty, whose time horizons are apt to be quite short. Employ multiple models and methods. The complexity of the questions that are likely to emerge from the engaged scholarship approach require multiple frames of reference. Van de Ven and Johnson point out that triangulation of methods and models not only increases reliability and validity but also promotes learning among interdisciplinary research partners and facilitates the arbitrage process. For example, some stakeholders may derive a great deal of benefit from participating in simulation exercises that test cognitive capabilities, whereas others may learn by articulating in conversation (using for example a verbal protocol approach) how and why they make decisions as they do. Of course, structural diﬃculties also exist for adopting a broad multi-method approach. Not only do some journals have strong preferences for certain types of methods over others, but conducting research via multiple methods is time consuming and inevitably presents dilemmas of interpretation and reconciliation. It must also be mentioned that in many circles the use of multiple theoretical perspectives in a single work is strongly discouraged. We propose that venture capital researchers, especially those in senior positions, should be vigilant in trying as many various methods of inquiry as can be usefully employed. We also advocate the use of multiple theoretical perspectives, but this latter suggestion must be accompanied with strong justification for its necessity, given the bias against such approaches. We firmly believe that such barriers to advancing our knowledge are counter-productive. We do believe that much of the most innovative and insightful research in entrepreneurship has indeed occurred in venture capital research that stretches the boundaries of common practice. For example, venture capital researchers have already been innovators in terms of methodology via event studies, experiments, policy capturing, direct observation and case studies, simulations, verbal protocol, conjoint analysis, and many other pertinent methods. And we have made good use of the more standard secondary database, interview, case, and survey methods. We have successfully experimented with theoretical perspectives such as justice theories and social exchange, among other things. Re-examine assumptions about scholarship and the roles of researchers. Engaged scholarship implies that the degree of researcher intervention is dictated by the nature of the research problem or question. Preconceived notions that researchers’ objectivity must be preserved at all costs should perhaps be questioned. Yet the fear of altered

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Handbook of research on venture capital or ‘artificial’ observations or outcomes renders this suggestion highly controversial. That is, the danger exists that by imposing themselves amidst the phenomenon of interest, researchers may alter the phenomenon itself. Nevertheless, engaged scholarship accepts this limitation on the grounds that what is to be gained in understanding, depth, and intimacy makes up for potential loss of objectivity and an ‘undisturbed’ reality. The principle of scientific objectivity remains a worthwhile ideal, but we should not be afraid to roll up our sleeves and dig into the subject when necessary. Moreover, many might argue that the ‘pretense’ of objectivity is just that, a pretense and an ideal.

In sum, we believe that researchers adopting the engaged scholarship approach will produce innovative insights unavailable through more detached approaches. For example, venture capital governance occurs largely through the mechanism of the board of directors, yet little work has explored how these boards actually make decisions because of the diﬃculty of gaining access to board meetings (Sapienza et al., 2000). A truly engaged scholar may be able to develop the level of trust with the entrepreneur and the investors that allows the kind of access and understanding not previously possible. In terms of the metaphorical kaleidoscope that we introduced in Figure 2.1, such an approach would place the scholar amidst the entrepreneur–investor–process triangle in the center of the figure. A social exchange theory approach would suggest focusing on variations in board behavior depending on the development of reciprocity (or lack thereof), whereas an agency perspective might suggest examining the role of the board as a supplement to or substitute for bonding costs. The vantage from within would result in more intimate views than would the ordinary position of the scholar on the outer rim of the lens looking in, and, theoretically, would lead to more valid interpretation of observed behavior. Besides the time, eﬀort and cost hurdles that ultimately must be dealt with as an ‘engaged scholar’ in any research setting, the venture capital context poses an additional barrier that must be noted. Venture capitalists have been literally besieged by researchers seeking their aid in conducting research. The presumption that they would want to ‘engage’ with us is a strong one. We can only note that succeeding in gaining their trust and attention is a significant challenge.9 Implications of the ‘positive organizational scholarship’ view for future venture capital work10 A posthumous publication of the views of Sumantra Ghoshal (2005) regarding trends in the theoretical content of management literature sheds another light upon the issues and challenges facing business scholars in the twenty-first century. Ghoshal expresses dismay over several trends in research which he claims are traceable to two common sources: (1) Attempts by many to treat the social science of business as an exact science; and (2) Acceptance by the majority of the assumption of rational economic self-interest as the sole explainer of behavior. Ghoshal’s article expresses a view similar to that stated at various times over the years by William Bygrave, that is, that business researchers suﬀer from ‘physics envy’, a condition in which scholars seek to emulate the physical sciences in their theorizing, testing and interpretation by assuming that variables interact with a sort of law-like consistency. Such assumptions have the attractiveness for those seeking ‘pure’ science of making investigations mathematically tractable and parsimonious. Further, the

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single motive explanation also simplifies analysis and interpretation. The problem is that we know that these assumptions are not accurate. As one of our colleagues is fond of saying, ‘Good theory cannot be generated from bad assumptions.’11 Ghoshal (2005) argues that treating the study of human behavior as an exact science which can be based on one underlying law leads researchers to (1) an exaggerated ‘pretense’ of knowledge; that is, a greater belief in the certainty of conclusions than is warranted; and (2) an ideology-based gloomy vision of organizational reality which assumes that the pursuit of self-interest (with guile!) is the sole driver of behavior and ignores the explanatory power of aﬀect and emotion. Ghoshal argues that the pretense of knowledge combined with an ideology-based gloomy vision has several very negative consequences for theory and practice, and his work holds several suggestions for combating these trends. We review five of them here: 1.

2.

Abandon the smug arrogance of certainty about the nature of organizational life. Ghoshal suggests that the exaggerated ‘pretense’ of knowledge leads to sloppiness in theorizing, research design and prescription. Consistent with the engaged scholar view, Ghoshal cautions us to develop deep, accurate understanding of the phenomenon as a prerequisite for interpretation and prescription. This suggestion runs counter to the growing emphasis on large samples built on secondary data, data which is assumed somehow to be more valid and generalizable than carefully collected primary data. In terms of Weick’s (1979) famous ‘dial’ of theory development (which emphasizes the tradeoﬀs among parsimony, generalizability and accuracy), the trend in entrepreneurship research has been to favor generalizability and parsimony over accuracy. This movement reflects attempts to overcome the weaknesses of anecdotal reflections based on inadequate sample size and selection that plagued early research in the area. Ironically, entrepreneurship scholars (including those focused on venture capital) may have become too remote from the phenomenon. Adopt a balanced view of human nature in shaping premises and assumptions. Ghoshal argues that an ideology-based, inaccurate ‘gloomy vision’ of organizations has come to infect our theorizing. This negative view dismisses alternative plausible motivations beyond self-interest and beyond rational calculation of self-serving ends. Using self-interest as an unquestioned premise has serious consequences for inferring causes of failings and for prescribing remedies. Ghoshal’s plea for toning down the ‘negativism’ is actually a plea for greater realism. Humans have both self-serving and other-serving tendencies (Lawrence and Nohria, 2002). Further, both ‘negative’ and ‘positive’ emotions (for example greed, fear, trust or liking) may be important elements to understand, elements whose ramifications we have hardly tapped. For example, despite the vast and impressive literature that we have produced on investment selection, monitoring, CEO replacement, and the like, we still fall short of understanding exactly how these incredibly important, novel and uncertain decisions are actually made. In their astute game theoretic analysis of investor–investee interactions, Cable and Shane (1997) portray all of the economic reasons that the exchange partners should find it in their best interest to ‘cooperate’. Yet, if we dig beneath the surface, this cold, calculating self-interest veils a deeper game more akin to coercion than to collaboration. In this world, exchange partners do not keep their end of the bargain because it is the right thing to do, but only because it is to their

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Handbook of research on venture capital advantage to do so. In this world, promises and integrity are only as meaningful as the conditions that mandate them – cooperation becomes synonymous with coercion. As Bhide and Stevenson (1990) astutely point out, in reality people act with integrity and goodwill a great deal more than can be explained by enlightened self-interest. Why is that so, and what should it mean for our theorizing and hypothesis testing? Keep human choice and ethics within the equation of organizational decisionmaking. According to Ghoshal, the upshot of accepting economic self-interest as the sole driving force for human endeavor is that we remove individual responsibility and ethical norms from theoretical consideration. The assumption of economic selfinterest as the sole motivation for action trivializes human choice as a subject for study. Many venture capital researchers have already explicitly noted that the applicability of assumptions varies with settings and/or with the subjects considered. For example, Van Osnabrugge (1998) has found that business angels explicitly consider a range of motives in ‘developing’ or ‘mentoring’ entrepreneurs. Arthurs and Busenitz (2003) discuss the limitations of explaining investor/investee decisions using either only agency theory (which assumes self-interest and opportunism on the part of managers) or only stewardship theory (which assumes good faith stewardship on the part of managers). In short, researchers must avoid succumbing to the temptation to adopt simple, mathematically tractable assumptions that make hypothesis testing neat but inaccurate. Expanding our conceptualization of the drivers of human behavior expands the power and accuracy of our theorizing. Remember that our theorizing aﬀects practice. Ghoshal points out that researchers’ negative presumptions become self-fulfilling prophecies, with undesirable consequences not only for the quality of theorizing but also for practice. When theorists teach students to expect opportunism and self-serving dishonesty, they give such behavior currency and unintended legitimacy as industry norms. We argue here that although malfeasance and dishonesty do indeed occur, they are not necessarily the normal or expected behavior in practice. This suggestion to keep in mind that students may come to practice what we preach has overtones that go beyond the ordinary scope of being a researcher. Like entrepreneurs, we as researchers do play a small part in creating the world we inhabit. Take up the ‘positive challenges of management’. The antecedents of integrity, forbearance, and justice might be as productively explored as are the mechanisms to deal with their absence or betrayal. Although it is perhaps human nature to experience fear of the negative more strongly than joy in the positive, as researchers of venture capital we should, like our subjects, seek paths to create or realize the upside potential of our work. Critical elements of the venture capital process include such positive concepts as inspiration and innovation, for example. Where do these come from? How may they be stimulated and enhanced? The rational economic perspective is silent on such issues, providing little guidance for understanding the sources of inspiration, let alone such responses as magnanimity. Even in commonly investigated phenomena, such as the post-investment activities of venture capitalists, too little has been done to understand the creative rather than the fiduciary actions of investors. Most works in the literature treat investors as concerned solely with avoiding risk or protecting value when in fact realizing the upside of investments is paramount in many cases. Creating gains is not the same as avoiding losses.

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We can relate the above reflections to our ‘kaleidoscope’ of venture capital research by employing yet another metaphor. Ghoshal’s portrayal of the modern, cynical researcher can be understood by comparing this researcher with the title character in Nathaniel Hawthorne’s short story ‘The minister’s black veil’. In this story, the minister in a small New England town emerged one morning to face his parishioners wearing for the first time a black veil through which he now viewed the congregation, and through which they now viewed him. He now saw everything a bit more darkly, and they too imagined that he harbored dark secrets and dark thoughts too unpleasant to reveal. Not only were those on both sides of the veil aﬀected by its darkness, but the dark veil seemed to invest the minister with a certain power over others. By analogy, this story illustrates two problems in contemporary management research in general and venture capital research in particular. First, the assumption of self-interest with guile as the true nature of the human actor aﬀects both those adopting the view and those glimpsed through it. Further, the assumption of the negative view of human nature (the dark veil) invests its adopters with power. This power stems from the fear people have of being seen as too naïve, of being portrayed as seeing the world through ‘rose-colored glasses’. Ghoshal challenges us to do more than view venture capital activity solely through the dark veil of unbridled opportunism and self-interest – to see other views of actual and possible realities. Consider, for example, the meaning of the ‘game’ in Cable and Shane’s (1997) analysis: if reputation and reciprocity are seen not just as self-serving mechanisms to be calculated about and gambled upon, but rather as desirable human status to aspire to and uphold, then, collaboration is indeed collaboration, and coercion is recognized for what it is. If we indeed let go of our arrogant air of certainty, adopt a balanced view of human nature, keep ethics and responsibility in the picture, remember that what we teach has eﬀects, and take up the challenge of unearthing antecedents of positive outcomes we will complete the circle of theorizing. We believe that the spirit of these two works is not to repudiate and abandon all that has come before but rather to dig in deeply, questioningly, and with renewed vigor. Like Ghoshal, our call is not for naïve denial of ill-will but for balanced recognition of the multiplexity of human choice and action. Conclusion This chapter was devoted to giving a taste of how venture capital research in management sciences has progressed over its brief history and how it might evolve in the future. It was not our intent (nor would it have been possible) to thoroughly review the works comprising the managerial view of the venture capital phenomenon, much less the entire literature which also includes the contributions of finance and economics. We instead broadly remarked on how the descriptive roots of the literature have provided a sound basis for further study, and we oﬀered a means of classifying work by focus on venture capital type, stage in the venture capital process, and whose perspective was being studied. Our metaphor of the kaleidoscope revealed a few areas of neglect, most of which certainly merit additional study. However, we have suggested here that perhaps more important than merely noting what has not been studied is to consider how we ought to approach future research to ensure that it is meaningful, revealing, and valid.12 Echoing the exhortations of Van de Ven and Johnson (2006) and Ghoshal (2005) we have encouraged management researchers to immerse themselves in their phenomena, broaden and deepen their theorizing and methods, and address questions that enrich theory and practice in meaningful ways.

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Based on what venture capital researchers have already accomplished, we are optimistic about the future. Venture capital research (like entrepreneurship research in general) has benefited from its multidisciplinary roots and its connection to practice. Our exhortation to take the ‘engaged scholarship’ approach seriously, implies that these roots and this connection should be preserved and enhanced. If we go a step farther and foster the kind of increased stakeholder cooperation, immersion in the field, and long-term research designs suggested by the engaged scholar view, we will face significant obstacles in terms of time, money, access and eﬀort. However, as a relatively unified subfield within the area of entrepreneurship we have the potential to jointly accomplish some ends that would not be possible individually. Our review has surfaced a series of suggestions that represent an ideal of scholarship. For the most part, these recommendations do not represent single, specific areas of inquiry but rather approaches to the study of venture capital that might yield significant insight. These general suggestions may be summarized as follows: ● ● ● ● ● ●

Stay close to the phenomenon and study ‘big’ issues. Develop learning communities among academics and the venture ecosystem. Study phenomena over time via multiple theories and methods. Seek a balanced, humble view that reaches beyond rational self-interest. Explore the ethical and aﬀective aspects of decision-making. Explore the bright side of entrepreneurship and its value creating correlates.

Our practical side recognizes the diﬃculty and burdens of adopting such approaches. We have suggested, therefore, that eﬀorts to achieve what we have laid out may need to be accomplished in teams and that these teams might best be led by senior scholars whose career ‘clocks’ are not ticking quite so loudly. We heartily recommend that junior scholars participate and engage, but we also are cognizant of the fact that they may also need to nurture parallel conventional studies that have shorter time frames to completion. In terms of the current dominant rational thinking paradigm, we are suggesting that future research should neither abandon these roots altogether nor ignore the rational actor approach in future studies. We do suggest, however, that eﬀorts to look beyond the narrow confines of rational economic thinking will allow us to discover and conjure some important, new questions that may have been obscured by the current view. Furthermore, the broader set of stakeholders (such as local communities, individual entrepreneurs, institutional representatives and the like) have legitimate interests that have little to do with profit taking. To provide insights for these interests, we will have to delve deeply into issues of the processes and mechanisms of value creation unconstrained by assumptions regarding rent appropriation. In short, we will have to consider societal outcomes beyond profit generation. Returning briefly to our kaleidoscope, we can identify several specific suggestions for future research. Research in the business angel domain would be especially suited to exploration of the processes of venture and value creation. Furthermore, the role of emotion and aﬀect is especially amenable to study in the business angel context because business angels, more so than institutional venture capitalists or corporate venture capitalists, have ‘skin in the game’ but are unconstrained by having to justify their decisions to outside third parties. The corporate venture capital context, on the other hand,

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provides an interesting setting in which to contrast entrepreneurial processes and leadership in new versus established organizations. Any of these settings (or perhaps a comparison of the three) could be used to examine the path-dependent nature of investment decisions, including both the impact of early investment decisions on the development of the venture as well as on the nature of later decision making. Our positive organizational scholarship and engaged scholar views suggests that such studies might be viewed from alternative lenses, over time, via a multiplicity of instruments. We are reminded, too, that these issues can and should be viewed from the perspectives not only of the venture capitalist but of the entrepreneur and upon occasion by that of outside stakeholders. Finally, we cannot help but conclude that venture capital research is but beginning to reveal all that it might, not only about its own complex workings, but also about entrepreneurship itself. Acknowledgements The authors are indebted to Hans Landström, Gordon Murray and Andy Van de Ven for comments on early versions of this chapter. Notes 1.

2. 3.

4. 5.

6. 7. 8.

9.

10. 11. 12.

Broadly construed, ‘venture capital’ refers to provision of outside equity for a claim against increases in value of an independent entity. We, however, use the term in this chapter not to refer to the broader set of all private equity, but primarily to refer more closely to what Bygrave and Timmons (1992) call ‘classic venture capital’, the provision of equity into earlier stage, high potential ventures (see Chapter 1). Gordon Murray pointed out to us that perhaps an astrolabe is a more apt metaphor, given the randomness of the outcomes that result when using a kaleidoscope. Nevertheless, we choose the kaleidoscope, despite its imperfection, because we think it has the advantage of audience familiarity. It should be noted that an additional limitation of this kaleidoscope metaphor is that it implies that the researcher is on the outside looking in at the phenomenon. As we discuss later, the ‘engaged scholar’ view places the researcher within the phenomenon as an observer/participant. We are indebted to Andy Van de Ven for this observation. In this chapter when we use the term ‘investor’ we are referring to the venture capitalist, even though in the institutional venture capital context the limited partner may be the actual source of the funds invested. In our focus on managerial venture capital literature we almost entirely ignore the vast and significant contributions of Josh Lerner and Paul Gompers to the study of venture capital. From the early 1990s to the present, these two have produced (singly and/or in combination with one another) the most significant stream of work on the financial processes and structures in the institutional venture capital industry. This latter reflection on the possibility that agency theory is less appropriate in some contexts outside the US is not necessarily shared by all venture capital researchers. We thank Gordon Murray for this comment. Please take note that we draw heavily on the work of Van de Ven and Johnson (2006) for these suggestions; we oﬀer this reminder to avoid filling these pages with repeated references to their work. Donald Sexton (along with several colleagues over time) was a pioneer in publishing early serious scholarly work in entrepreneurship beginning in 1982 with The Encyclopedia of Entrepreneurship and continuing with The Art and Science of Entrepreneurship, The State of the Art of Entrepreneurship, Entrepreneurship 2000 and Handbook of Entrepreneurship Research. This observation was suggested by Gordon Murray. Indeed, Professor Murray sees access to venture capitalists and their limited partners as perhaps the most daunting and important for the success of future research on the industry. Gordon sees the presence of industry databases as a two-edged sword, one that provides significant quantitative information that may help researchers overcome the common method issues that plague primary research but that also may tempt researchers to conduct studies without adequate depth of knowledge. This section is largely based on Ghoshal (2005); for brevity’s sake, we forgo repeated references. For additional examples on this topic, see Cameron et al. (2003). Phil Bromiley, former Curtis L. Carlson Professor of Strategic Management, University of Minnesota; statement made often in conversation. Although we have highlighted new approaches to conducting future research, an explicit mention of areas requiring greater study is not unwarranted. Gordon Murray suggested the following to us in providing

84

Handbook of research on venture capital feedback to this chapter: performance of institutional venture capitalists and their industry; the eﬀects of venture capital funding on their recipients; the process of raising funds; the internationalization of the venture capital industry; the role of government as investor and industry supporter.

References Aggarwal, V. (1973), The Selection Criteria and Evaluation Techniques used by Venture Capitalists, MBA thesis, University of California at Berkeley. Aldrich, H.E. (1999), Organizations Evolving, London: Sage Publications. Arthurs, J.D. and L.W. Busenitz (2003), ‘The boundaries and limitations of agency theory and stewardship theory in the venture capitalist/entrepreneur relationship’, Entrepreneurship: Theory & Practice, Winter, pp. 145–62. Bhide, A. and H.H. Stevenson (1990), ‘Why be honest if honesty doesn’t pay’, Harvard Business Review, 68, Sept.–Oct., 121–29. Block, Z. and I.C. MacMillan (1993), Corporate Venturing: Creating New Businesses within the Firm, Boston, MA: Harvard Business School Press. Briskman, F. (1966), Venture Capital: The Decision to Finance Technically-based Enterprises, MS thesis, Massachusetts Institute of Technology. Bruton, G.D., V.H. Fried and S. Manigart (2005), ‘Institutional influences on the worldwide expansion of venture capital’, Entrepreneurship: Theory & Practice, 29(6), 737–60. Busenitz, L.W., D.D. Moesel, J.O. Fiet and J.B. Barney (1997), ‘The framing of perceptions of fairness in the relationship between venture capitalists and new venture teams’, Entrepreneurship: Theory & Practice, 21(3), 5–22. Bygrave, W.D. (1988), ‘The structure of the investment networks of venture capital firms’, Journal of Business Venturing, 3(2), 137–58. Bygrave, W.D. and J.A. Timmons (1992), Venture Capital at the Crossroads, Cambridge, MA: Harvard Business School Press. Cable, D. and S. Shane (1997), ‘A prisoner’s dilemma approach to entrepreneur–venture capitalist relationships’, Academy of Management Review, 22(1), 142–77. Cameron, K.S., J.E. Dutton and R.E. Quinn (eds) (2003), Positive Organizational Scholarship, San Francisco, CA: Berrett-Koehler Publishers, Inc. De Clercq, D. and H.J. Sapienza (2001), ‘The creation of relational rents in venture capitalist–entrepreneur dyads’, Venture Capital, 3(2), 107–27. De Clercq, D. and H.J. Sapienza (2005), ‘When do venture capital firms learn from their portfolio companies?’, Entrepreneurship: Theory & Practice, 29(4), 517–35. Elango, B., V.H. Fried, R.D. Hisrich and A. Polonchek (1995), ‘How venture capital firms diﬀer’, Journal of Business Venturing, 10(2), 157–80. Fiet, J.O. (1995), ‘Risk avoidance strategies in venture capital markets’, Journal of Management Studies, 32(4), 551–75. Freear, J., J.E. Sohl and W.E. Wetzel (2002), ‘Angles on angels: financing technology-based ventures – a historical perspective’, Venture Capital, 4(4), 275–88. Fried, V.H. and R.D. Hisrich (1995), ‘The venture capitalist: A relationship investor’, California Management Review, 37(2), 101–14. Ghoshal, S. (2005), ‘Bad management theories are destroying good management practices’, Academy of Management Learning & Education, 4(1), 75–91. Giﬀord, S. (1997), ‘Limited attention and the role of the venture capitalist’, Journal of Business Venturing, 12(6), 459–83. Gorman, M. and W.A. Sahlman (1989), ‘What do venture capitalists do?’, Journal of Business Venturing, 4(4), 231–49. Harvey, M.G. and R.F. Lusch (1995), ‘Expanding the nature and scope of due diligence’, Journal of Business Venturing, 10(1), 5–22. Jensen, M.C. and W.H. Meckling (1976), ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, 3(4), 305–60. Landström, H. (1993), ‘Informal risk capital in Sweden and some international comparisons’, Journal of Business Venturing, 8(6), 525–61. Landström, H. (1998), ‘Informal investors as entrepreneurs’, Technovation, 18(5), 321–54. Landström, H. (2005), Pioneers in Entrepreneurship and Small Business Research, New York: Springer. Landström, H., S. Manigart, C. Mason and H. Sapienza (1998), ‘Contracts between entrepreneurs and investors: terms and negotiation processes’, paper presented at the Babson Conference, Ghent. Lawrence, P. and N. Nohria (2002), Driven. How Human Nature Shapes our Choices, San Francisco, CA: Jossey-Bass. Lerner, J. (1994), ‘The syndication of venture capital investments’, Financial Management, 23(3), 16–28.

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Lockett, A. and M. Wright (1999), ‘The syndication of private equity: Evidence from the UK’, Venture Capital, 1(4), 303–24. MacMillan, I.C., D.M. Kulow and R. Khoylian (1989), ‘Venture capitalists’ involvement in their investments: extent and performance’, Journal of Business Venturing, 4(1), 27–48. MacMillan, I.C., R. Siegel and P.N.S. Narasimha (1985), ‘Criteria used by venture capitalists to evaluate new venture proposals’, Journal of Business Venturing, 1(1), 119–29. Manigart, S. (1994), ‘The founding rate of venture capital firms in three European countries (1970–1990)’, Journal of Business Venturing, 9(6), 525–42. Mason, C. and R.T. Harrison (1996), ‘Informal venture capital: a study of the investment process, the postinvestment experience and investment performance’, Entrepreneurship and Regional Development, 8, 105–25. Maula, M. (2001), Corporate Venture Capital and the Value-Added for Technology-based New Firms, PhD thesis, Helsinki University of Technology. Maula, M., E. Autio and G. Murray (2003), ‘Prerequisites for the creation of social capital and subsequent knowledge acquisition in corporate venture capital’, Venture Capital, 5(2), 117–35. Mitchell, F., G.C. Reid and N.G. Terry (1997), ‘Venture capital supply and accounting information system’, Entrepreneurship: Theory & Practice, 21(4), 45–63. Muzyka, D. and S. Birley (1996), ‘Trade-oﬀs in the investment decisions of European venture capitalists’, Journal of Business Venturing, 11(4), 273–88. Parhankangas, A. and H. Landström (2004), ‘Responses to psychological contract violations in the venture capitalist–entrepreneur relationship: an exploratory study’, Venture Capital, 6(4), 217–42. Poindexter, J.B. (1976), The Eﬃciency of Financial Markets: The Venture Capital Case, PhD thesis, New York University. Robbie, K., M. Wright and B. Chiplin (1997), ‘The monitoring of venture capital firms’, Entrepreneurship: Theory & Practice, 21(4), 9–29. Sahlman, W.A. (1990), ‘The structure and governance of venture-capital organizations’, Journal of Financial Economics, 27(2), 473–522. Sapienza, H.J. (1989), Variations in Venture Capitalist–entrepreneur Relations: Antecedents and Consequences, PhD thesis, University of Maryland, College Park. Sapienza, H.J. and A.K. Gupta (1994), ‘Impact of agency risks and task uncertainty on venture capitalist–CEO interaction’, Academy of Management Journal, 37(6), 1618–33. Sapienza, H.J. and M.A. Korsgaard (1996), ‘Procedural justice in entrepreneur–investor relations’, Academy of Management Journal, 39(3), 544–74. Sapienza, H.J. and S. Manigart (1996), ‘Venture capitalist governance and value added in four countries’, Journal of Business Venturing, 11(6), 439–70. Sapienza, H.J., M. Korsgaard and D. Forbes (2003), ‘The self-determination motive and entrepreneurs’ choice of financing’, in J.A. Katz and D. Shepherd (eds), Advances in Entrepreneurship, Firm Emergence, and Growth: Cognitive Approaches to Entrepreneurship Research, Oxford UK: Elsevier JAI, pp. 105–38. Sapienza, H.J., M.A. Korsgaard, P.K. Goulet and J.P. Hoogendam (2000), ‘Eﬀects of agency risks and procedural justice on board processes in venture capital-backed firms’, Entrepreneurship and Regional Development, 12(4), 331–52. Shepherd, D.A. (1999), ‘Venture capitalists’ assessment of new venture survival’, Management Science, 45(5), 621–33. Shepherd, D.A. and R. Ettenson (2000), ‘New venture strategy and profitability: A venture capitalist’s assessment’, Journal of Business Venturing, 15(5/6), 449–69. Shepherd, D.A. and A.L. Zacharakis (1999), ‘Conjoint analysis: a new methodological approach for researching the decision policies of venture capitalists’, Venture Capital, 1(3), 197–218. Smart, G.H. (1999), ‘Management assessment methods in venture capital: an empirical analysis of human capital valuation’, Venture Capital, 1(1), 59–73. Sohl, J. (2003), ‘The private equity market in the USA: Lessons from volatility’, Venture Capital, 5(1), 29–46. Tyebjee, T.T. and A.V. Bruno (1984), ‘A model of venture capitalist investment activity’, Management Science, 30(9), 1051–166. Van de Ven, A.H. and P.E. Johnson (2006), ‘Knowledge for theory and practice’, Academy of Management Review, 31(4), 802–21. Van de Ven, A.H., D.E. Polley, R. Garud and S. Venkataraman (1999), The Innovation Journey, New York: Oxford University Press. Van Osnabrugge, M.S. (1998), The Financing of Entrepreneurial Firms in the UK: A Comparison of Business Angel and Venture Capitalist Investment Procedures, PhD thesis, Hertford College, Oxford University, England. Weick, K.E. (1979), The Social Psychology of Organizing (2nd edn), New York: Random House. Wells, W.A. (1974), Venture Capital Decision-making, PhD thesis, Carnegie-Mellon University.

3

Venture capital: A geographical perspective Colin Mason

Introduction A major focus of applied research on venture capital concerns the ‘equity gap’ – in other words, the lack of availability of small amounts of finance. In the case of formal (or institutional) venture capital funds, because of the fixed nature of most of the costs that investors incur in making investments it is uneconomic for them to make small investments. Informal venture capital investors – or business angels – are able to make small investments because they do not have the overheads of fund managers and do not cost their time in the same way. However, most business angels, even when investing in syndicates alongside other business angels, lack suﬃciently ‘deep pockets’ to fully substitute for the lack of venture capital fund investment. Hence, whereas the market for investments of under £250 000/$500 000 is served fairly eﬀectively by business angels, and the over £5m/$10m market is satisfied by venture capital funds, there is a gap in the provision of amounts in the £250 000/$500 000 to £5m/$10m range which are too large for business angels but too small for professional investors. This gap is mostly experienced by new and recently started growing businesses. Governments have responded in a variety of ways in an attempt to increase the supply of small scale, early stage venture capital (see Murray in Chapter 4 and Sohl in Chapter 14). However, much less attention has been given to ‘regional gaps’ in the supply of venture capital – that is, the under-representation of venture capital investments in particular parts of a country relative to their share of national economic activity (for example their share of the national stock of business activity). If it is accepted that venture capital – both institutional and informal – makes a significant contribution to the creation of new businesses and new industries then regions which lack venture capital will be at a disadvantage in generating new economic activity and technology clusters. This chapter reviews the literature on the geography of venture capital. It looks separately at informal venture capital and formal, or institutional, venture capital. The literature on the geography of informal venture capital is very limited and fairly superficial. There are enormous diﬃculties in identifying business angels and developing a database of investments, hence most studies have been based on small samples with limited geographical coverage or depth. Moreover, issues of geography, place and space have rarely been given attention in studies of the operation of the informal venture capital market. The literature on the geography of institutional venture capital is also limited. It has mainly been contributed by economic geographers. Because of the tendency for scholars to work in disciplinary ‘silos’ it means that this literature is largely unknown amongst ‘mainstream’ scholars of venture capital who are typically in the management and economics disciplines. A further consequence is that when scholars from such disciplines do write about the geographical aspects of venture capital they generally ignore these geographical contributions and treat such geographical concepts as place, space and distance in simplistic terms. Finally, in order to put boundaries on the scope of this chapter it is 86

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concerned exclusively with the geography of venture capital investing within individual countries. There is a separate literature on the internationalization of venture capital (see Wright et al. (2005) for a review). The next section reviews what can be gleaned from the literature on the role of geography of the informal venture capital market (section 2). The chapter then moves on to consider the formal, or institutional, venture capital market, initially by considering outcomes, describing the uneven nature of venture capital investing, illustrated by the examples of the USA, Canada, the UK and Germany (section 3) and then works backwards to explanations, attributing this uneven geography of investing to the combination of the localized distribution of the venture capital industry and the localized nature of investing. The role of long distance flows of venture capital in reinforcing the clustering of venture capital investments is also discussed. Section 4 brings some of these earlier themes together in the form of a short case study of Ottawa, Canada, a thriving technology cluster. The intention is to show how economic activity is initially funded in emerging high-tech clusters by a combination of ‘old economy’ business angels and the importing of institutional venture capital from elsewhere, but over time, as it develops successful technology companies so a technology angel community emerges and it also develops its own indigenous supply of institutional venture capital funds. Section 5 draws the chapter to a conclusion with some thoughts on future research directions and a brief consideration of the implications for policy. A fuller discussion of policy issues can be found by Murray in Chapter 4 of this volume. Geographical aspects of the informal venture capital market Business angels are very diﬃcult to identify. They are not listed in any directories and their investments are not recorded. Consequently, research has generally been based on samples which are too small to be spatially disaggregated. Moreover, the identification of business angels is often based either on ‘snowballing’ or samples of convenience which have an in-built geographical bias. This has severely restricted the ability of researchers to explore either the geographical distribution of business angels and their investment activity or to compare the characteristics of business angels and their investment activity in diﬀerent regions and localities. Some studies do make comparisons with findings from independent studies conducted in other regions and countries but the lack of consistency in methodologies, sampling frames and definitions renders such comparisons highly suspect. However, since the majority of business angels are cashed-out entrepreneurs (up to 80 per cent according to some studies) and other high net worth individuals, the size of the market in diﬀerent regions is likely to reflect the geography of entrepreneurial activity and the geography of income and wealth, both of which have been shown to be unevenly distributed within countries (for example Davidsson et al., 1994; Keeble and Walker, 1994; Reynolds et al., 1995; Acs and Armington, 2004). The location of business angels The only study which has looked at the geographical distribution of business angels is by Avdeitchikova and Landström (2005). Based on a ‘large’ (n = 277) sample of informal investors in Sweden (defined as anyone who has made a non-collateral investment in private companies in which they did not have any family connections) they suggest that both investments (52 per cent) and the amounts invested (77 per cent) are disproportionately

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concentrated in metropolitan regions (which comprise 51 per cent of the total population). However, this is a less geographically concentrated distribution than is the case for institutional venture capital fund investments. Regional comparative studies suggest that business angels also diﬀer by region. For example, a study that was based on a large sample of Canadian business angels (n = 299) (Riding et al., 1993) noted that business angels in Canada’s Maritime Provinces (Nova Scotia, Prince Edward Island and New Brunswick) are distinctive in terms of the typical size of their investments, sectoral preferences, rate of return expectations and expected time to achieve an exit (Feeney et al., 1998). Investors in Atlantic Canada and Quebec are also the most parochial (63 per cent and 58 per cent of investments within 50 miles of home compared with a national average of 53 per cent) (Riding et al., 1993). Johnstone (2001) makes an important contribution, suggesting that remote and declining industrial regions are likely to suﬀer from a mismatch between the supply of angel finance and the demand for this form of funding. He demonstrates that in the case of Cape Breton, in the province of Nova Scotia in Canada, the main source of demand for early stage venture capital is from knowledge-based businesses started by well-educated entrepreneurs (mostly graduates) with formal technical education and training who are seeking valueadded investors with industry- and technology-relevant marketing and management skills and industrial contacts. However, the business angels in the region have typically made their money in the service economy (retail, transport, and so on), have little formal education or training, are reluctant to invest in early stage businesses and are not comfortable with the IT sector. Moreover, their value-added contributions are confined to finance, planning and operations. This suggests that the informal venture capital market in ‘depleted communities’ is characterized by stage, sector and knowledge mismatches. There is rather more evidence on the role of geography – specifically the distance between the investor’s location and that of the investee company – in the business angel’s investment decision. This literature has looked at three issues: (1) the locational preferences of business angels; (2) how location is handled in the investment decision; and (3) the locations of actual investments. Locational preferences Various survey-based studies in several countries have asked business angels if they have any geographical preferences concerning where they invest. These studies reveal that some angels have a strong preference to make their investments close to home while others impose no geographical limitations on where they will invest. In the USA Gaston (1989) reported that 72 per cent of business angels wished to invest within 50 miles of home and only 7 per cent had no geographical preferences. However, other US studies – based on smaller sample sizes and confined to specific regions – report that well under half of all business angels will limit their investing to within 50 miles of home (Table 3.1). Studies in other countries are equally inconsistent in their findings. For example, in Canada, a study of Ottawa angels reported that 36 per cent imposed no geographical limits on their investments (Short and Riding, 1989). In the UK, Coveney and Moore (1997) reported that 44 per cent of angels would consider investing more than 200 miles or three hours’ travelling time from home, compared with only 15 per cent whose maximum investment threshold was 50 miles or one hour. Scottish business angels are rather more parochial, but even here 22 per cent would consider investing more than 200 miles or three hours

Venture capital: A geographical perspective Table 3.1

89

Locational preferences by business angels: selected studies Connecticut and Massachusetts (Freear et al., 1992; 1994)

New California England (Tymes and USA Active (Wetzel, 1981) Krasner, 1983) (Gaston, 1989) angels (all figures in percentages) Less than 50 miles 50–300 miles Over 300 miles Outside USA Other geographical restriction No geographical preference

Virgin angels

36 17 – – 7

41 – – – 13

72 10* – – 11

32 20 19 5 –

25 25 12 0 –

40

33

7

24

38

100

87

100

100

100

Note: * 50–150 miles

from home, compared with 62 per cent wanting to invest within 100 miles of home (Paul et al., 2003). The role of location in the investment decision Studies of how business angels make their investment decisions suggest that the location of potential investee companies is a relatively unimportant consideration, and much less significant than the type of product or stage of business development (Haar et al., 1988; Freear et al., 1992; Coveney and Moore, 1997; van Osnabrugge and Robinson, 2000). A more nuanced perspective is oﬀered by Mason and Rogers (1996). Their evidence suggests that most angels do have a limit beyond which they prefer not to invest, but – to quote several respondents to their survey who used virtually the same phrase – ‘it doesn’t always work that way’. In other words, the location of an investment in relation to the investor’s home base appears to be a compensatory criterion (Riding et al., 1993), with angels prepared to invest in ‘good’ opportunities that are located beyond their preferred distance threshold. Locations of actual investments Studies which have focused on the actual location of investments made by business angels reveals a much more parochial pattern of investing (Table 3.2). The proportion of investments located within 50 miles of the investor’s home or oﬃce ranges from 85 per cent amongst business angels in Ottawa to 37 per cent amongst business angels in Connecticut and Massachusetts. In the UK, Mason and Harrison (1994) found that two-thirds of investments by UK business angels were made within 100 miles of home. In other words, the actual proportion of long distance investments that are made is much smaller than might be anticipated in the light of the proportion of investors who report a preference for or willingness to consider long distance investments.

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Table 3.2

Location of actual investments made by business angels: selected studies

New England (Wetzel, 1981) Less than 50 miles 50–300 miles Over 300 miles/ diﬀerent country Total

Connecticut and Massachusetts Ottawa (Short Canada (Riding (Freear et al., 1992) and Riding, 1989) et al., 1993) (all figures in percentages)

58 20 22

37 28 36 (28+8)

85 4 11

53 17 29

100

100

100

100

Reasons for the dominance of short distance investments This dominance of local investing reflects several factors. First, it arises because of the eﬀect of distance on an investor’s awareness of potential investment opportunities. Information flows are subject to ‘distance decay’, hence, as Wetzel (1983, p. 27) observed, ‘the likelihood of an investment opportunity coming to an individual’s attention increases, probably exponentially, the shorter the distance between the two parties.’ Indeed, in the absence of an extensive proactive search for investment opportunities, combined with the lack of systematic channels of communication between investors and entrepreneurs, most business angels derive their information on investment opportunities from informal networks of trusted friends and business associates (Wetzel, 1981; Haar et al., 1988; Aram, 1989; Postma and Sullivan, 1990; Mason and Harrison, 1994), who tend to be local (Sørheim, 2003). Second, business angels place high emphasis on the entrepreneur in their investment appraisal – to a much greater extent than venture capital funds do (Fiet, 1995; Mason and Stark, 2004). Their knowledge of the local business community means that by investing locally they can limit their investments to entrepreneurs that they either know themselves or who are known to their associates and so can be trusted. This point is illustrated by one Philadelphia-based angel quoted by Shane (2005, p. 22): ‘we have more contacts in the Philadelphia area. More of the people we trust are here in the Philadelphia area. So therefore we are more likely to come to some level of comfort or trust with investments that are closer.’ A third reason is the tendency for business angels to be hands-on investors in order to minimize agency risk (Landström, 1992). Maintaining close working relationships with their investee businesses is facilitated by geographical proximity (Wetzel, 1983). Landström’s (1992) research demonstrates that distance is the most influential factor in determining contacts between investors and is more influential than the required level of contact. This, in turn, suggests that the level of involvement is driven by the feasibility of contact rather than need. Furthermore, active investors give greater emphasis to proximity than passive investors (Sørheim and Landström, 2001). Proximity is particularly important in crisis situations where the investor needs to get involved in problem-solving. As one of the investors in the study by Paul et al. (2003, p. 323) commented ‘if there’s a problem I want to be able to get into my car and be there in the hour. I don’t want to be going to the airport to catch a plane.’

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Finally, angels need to monitor their investments. This is often done by serving on the board of directors. It is desirable that the angel can travel to, attend and return in a day in order to minimize their travel costs. Some angels prefer to monitor their investments by making frequent visits to the businesses in which they invest, described by one angel in Shane’s study as ‘seeing them sweat’ (Shane, 2005, p. 22). This is much easier to do if the investment is local. Avdeitchikova and Landström (2005) provide statistical support for these explanations. In their study of Swedish informal investors, they found that investors who rely on personal social and business networks as their primary method for sourcing deals, and active investors who provide hands-on support to their investee businesses, are the most likely to invest close to their home/oﬃce. Some studies have further observed that experienced angels have the greatest awareness of the benefits of investing close to home. Freear et al. (1992; 1994) noted that whereas 38 per cent of virgin angels had no geographical restrictions on where they would be prepared to invest, this fell to 24 per cent amongst active angels (see Table 3.1). In a study of UK investors, Lengyel and Gulliford (1997, p. 10) noted that whereas the majority (67 per cent) of investors gave preference to investee companies which were located within an hour’s drive, actual investors placed an even bigger emphasis on distance in their future investments, with 83 per cent indicating that they would prefer their future investments to be within 100 miles of where they lived. The characteristics of long distance investments Nevertheless, long distance investments do occur. In studies of New England (Wetzel, 1981; Freear et al., 1992) and Canada (Riding et al., 1993) between 22 per cent and 36 per cent of investments were over 300 miles from the investor’s home or oﬃce (see Table 3.2). In the UK, Mason and Harrison (1994) found that one-third of investments were in businesses located more than 100 miles from the investor’s home. Even in studies that have reported very high levels of local investing, at least 1 in 10 investments were over a long distance. For example, 11 per cent of investments made by Ottawa-based business angels were over 300 miles away (Short and Riding, 1989), while in Finland, 14 per cent of investments were over 300 miles away from the investor’s home (Lumme et al., 1998). Long distance investing is distinctive in several respects. First, in terms of investors, those who have industry-specific investment preferences (including technology preferences) are more willing to make long distance investments, and the pattern of their actual investments supports this preference (Lengyel and Gulliford, 1997). Paul et al. (2003) suggest that the willingness of angels to make non-local investments is related to the funds that they have available to invest and the number of investments that they have made. They note, for example, that distance is not an issue for ‘super-angels’ with more than £500 000 available to invest. Such investors are also more likely to be well-known and so more likely to be approached by entrepreneurs in distant locations. The ‘personal activity space’ of angels is also relevant. Investors with other interests elsewhere in the country will look for additional investments in these locations in order to reduce the opportunity costs of travelling. Second, certain deal characteristics are associated with long distance investing. Size of investment is important, with angels willing to invest further afield when making a £100 000 investment than a £10 000 investment (Innovation Partnership, 1993). The amount of involvement required is also relevant, with one angel observing that an investment requiring ‘a one day a week involvement is going to be closer than [one which

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requires] a one day a month involvement’ (Innovation Partnership, 1993). Third, angels will make long distance investments if someone from the location in which the business is based that they know and trust is co-investing with them. From this fragmentary literature it can be concluded that there is not a national informal venture capital market. Rather, in view of the dominance of short distance investing it is best described as comprising a series of overlapping local/regional markets. Localities and regions diﬀer in terms of both the numbers of business angels and their investment capabilities. There are also more subtle, but equally significant, diﬀerences in terms of the characteristics of investors, their investment preferences and the nature of the hands-on support which they can provide to investee companies. It follows from this that informal venture capital is not equally available in all locations. Nevertheless, some long distance investing does occur. However, there is little support from the available evidence to suggest that regions with a deficiency of informal venture capital can import their capital needs from elsewhere. Indeed, in their exploratory study of long distance investing by business angels in the UK Harrison et al. (2003) suggest that investors in the South East of England – the most economically dynamic and most entrepreneurial region in the UK – are the least likely to make long distance investments, and long distance investments in technology businesses are most likely to flow from economically less dynamic regions and into the South East region (which contains the major technology clusters). Institutional venture capital: a geographical analysis Definitions Whereas the informal venture capital market comprises high net worth individuals investing their own money in unquoted companies, the formal, or institutional, venture capital market consists of venture capital firms – in other words, professional fund managers who are investing other people’s money. Most venture capital firms are ‘independents’ who raise their finance from financial institutions (for example banks, insurance companies, pension funds) and other investors (for example wealthy families, endowment funds, universities, companies). The investors in the funds managed by venture capital firms (termed ‘limited partners’) are attracted by the potential for superior returns from this asset class but lack the resources and expertise to invest directly in companies themselves. Moreover, as they are only allocating a small proportion of their investments to this asset class (typically a maximum of 1–2 per cent) it is more convenient to invest in funds managed by venture capital firms (who are termed the ‘general partners’) who have specialist abilities in deal selection, deal structuring and monitoring. This enables venture capital firms to deal more eﬃciently with asymmetric information than other types of investor. Venture capital firms also have skills in providing value-adding services to their investee businesses and securing an exit for the investment which maximizes returns. The other, much smaller category of venture capital firm is ‘captives’. These are venture capital firms that are subsidiaries of financial institutions (especially banks) or non-financial corporations and who raise their investment funds from their parent organization. (See Cumming, Fleming and Schwienbacher in Chapter 5 for a more detailed discussion). Three smaller types of institutional investors are also of note. First, some non-financial corporations make venture capital investments for strategic reasons associated with R&D or market considerations, an activity which is termed corporate venturing. Second, some

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countries have venture capital funds that are funded entirely by investments by private individuals and who qualify for tax incentives. Examples include the UK’s Venture Capital Trusts and Canada’s Labor-Sponsored Venture Capital Funds (Ayayi, 2004). Third, in many countries there are government-funded venture capital funds which have been established for economic development reasons usually in regions which lack private sector venture capital funds (Hood, 2000). Location of investments The availability of information on the geographical distribution of venture capital investing is rather poor. The main source of information is in the form of highly aggregated statistics produced annually by national venture capital associations or by organizations acting on their behalf. However, this simply records the location of investments by region, oﬀers limited disaggregation by type of investment and provides no information on investment source. A further concern relates to the comprehensiveness of the coverage (Karaomerlioglu and Jacobsson, 2000). Members of national venture capital associations tend to be skewed towards larger investors, including those which might not be regarded as belonging to the venture capital industry,1 whereas many small-scale local investors are not members and so are excluded. Investments by most corporate investors (that is nonfinancial companies making strategic minority investments in small firms) and business angels, including business angel syndicates, are also not covered. There are some commercial sources of data which do provide deal-specific information (including locations of investor and investee business). However, these suﬀer from a lack of comprehensive coverage, being biased towards larger deals. In the USA venture capital investments are highly concentrated at all spatial scales: regional, state and metropolitan area. The pattern at the regional scale is bi-coastal, with venture capital investing concentrated in California, New England and New York (Table 3.3). Within individual states venture capital is concentrated in cities. At the metropolitan area scale just 10 such areas attracted 68 per cent of all investments in 1997–98, with just two – San Francisco and Boston – accounting for 39 per cent (Zook, 2002). Equally, there are large swathes of the USA, including much of the south and mid-west, which have attracted relatively little venture capital investing. The geography of venture capital investing closely relates to the locations of high-tech clusters (Florida and Kenney, 1988a; 1988b; Florida and Smith, 1991; 1992). In Canada venture capital investments are concentrated in Ontario and Quebec at the provincial scale, with the Atlantic and Prairie provinces having the smallest amounts of activity (Table 3.4). At the metropolitan area scale venture capital is concentrated in The Greater Toronto Area (24 per cent), Montreal (20 per cent) and Ottawa (16 per cent) (2004 figures) which together account for just 28 per cent of total population. Indeed, underlying the metropolitan focus of venture capital investing, just nine cities2 accounted for 82 per cent of all venture capital investments in Canada by value. Turning to Europe, it should first be noted that the definition of venture capital is rather broader than is the case in North America, and includes private equity firms which invest in corporate restructuring situations such as management buy-outs, institution-led buyouts and public-to-private deals. These deals are typically very large, usually well in excess of £10m. The geographical distribution of venture capital investing in the UK favours London and the South East (Table 3.5) (Mason and Harrison, 2002). These regions have

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Table 3.3

The location of venture capital investments in the USA, 2005

Alaska/Hawaii/Puerto Rico Colorado Washington DC/Metroplex Los Angeles/Orange County Mid West New England North Central North West NY Metro Philadelphia Metro Sacramento/N. California San Diego Silicon Valley South Central South East South West Texas Upstate NY Other US Grand Total

$

%

17 044 900 618 597 900 966 841 500 1 501 132 000 773 419 400 2 672 148 900 319 268 200 964 114 500 1 865 528 600 580 389 900 80 262 200 1 035 312 000 7 901 433 500 54 604 000 1 219 747 600 590 206 100 1 103 720 900 59 391 300 57 099 000

0.1 2.8 4.3 6.7 3.5 12.0 1.4 4.3 8.3 2.6 0.4 4.6 35.4 0.2 5.5 2.6 4.9 0.3 0.3

22 380 262 400

100

number 5 80 194 176 147 398 60 156 168 90 15 125 939 4 204 79 167 30 2 3039

% 0.2 2.6 6.4 5.8 4.8 13.1 2.0 5.1 5.5 3.0 0.5 4.1 30.9 0.1 6.7 2.6 5.5 1.0 0.1 100

Source: PriceWaterhouseCoopers/National Venture Capital Association Money Tree™ Report (www.pwcmoneytree.com/moneytree/index.jsp)

the largest location quotients – a simple statistical measure to show whether a region has more, or less, than its ‘expected’ share of venture capital investments by dividing this figure with some measure of the region’s share of national economic activity (in this case the business stock). The only other regions with more than their expected shares of venture capital investments by amount invested (indicated by a location quotient greater than unity) are the East Midlands and West Midlands. Regions with the lowest location quotients are in the ‘north’, notably Wales, Northern Ireland, Yorkshire and The Humber, the North West and North East. Because of the dominance of MBO investments in the UK there is a much weaker relationship between venture capital investing and high-tech clusters (Martin et al., 2002). However, early stage investments continue to be disproportionately concentrated in London, the South East and Eastern regions and are more closely linked to high-tech clusters (such as Cambridge) and more generally to the locational distribution of high-tech firms (Mason and Harrison, 2002). A number of other West European countries, notably France, also exhibit high levels of geographical concentration of venture capital investments in just one or two regions (Martin et al., 2002). In Germany, 65 per cent of total investment in 2003 and 2004 was concentrated in just three of the 15 federal states – Bavaria, Baden-Wurttemberg and North Rhine-Westphalia (Fritsch and Schilder, 2006). Nevertheless, venture capital investments are less geographically concentrated in Germany than in other countries, with five states having location quotients greater than unity (Martin et al., 2005).

Venture capital: A geographical perspective Table 3.4

Location of venture capital investments in Canada, by province, 2005

Amount invested Province

$m

British Columbia Alberta Saskatchewan Manitoba Ontario Quebec New Brunswick Nova Scotia Prince Edward Island Newfoundland Territories Total

95

Companies financed

%

No.

%

225.7 64.3 30.9 10.9 751.0 709.8 15.6 17.2 2.8

12.3 3.5 1.7 0.6 41.1 38.8 0.9 1.0 0.1

58 22 17 18 156 297 13 6 2

9.8 3.7 2.9 3.0 2.6 49.7 2.2 1.0 0.3

0.2 0.3

0.0 0.0

1 1

0.2 0.2

1828.9

591

Financings* No.

Total investments

%

No.

%

69 23 18 18 170 313 16 8 2

10.8 3.6 2.3 2.3 26.6 49.0 2.5 1.3 0.3

198 41 32 39 510 675 30 16 6

12.9 2.7 2.1 2.5 33.3 42.9 2.0 1.0 0.4

1 1

0.2 0.2

1 1

0.1 0.1

639

1531

Note: * companies may receive more than one investment in a year, hence the number of financings exceeds the number of companies raising finance Source: Thomson Macdonald (www.canadavc.com)

Little attention has been given to the extent to which these patterns of investing exhibit stability over time. In the UK the regional distribution of venture capital investments became less unevenly distributed during the 1990s compared with a decade earlier. The dominance of London and the South East was reduced (declining location quotients), while the older industrial regions, such as the East and West Midlands and Yorkshire and The Humber, increased their shares of venture capital investments. However, this gain was mainly in the form of management buy-outs; early stage investments continue to be concentrated in London and the South East (Mason and Harrison, 2002). In the USA the investment ‘bubble’ of the late 1990s – caused by a large inflow of capital into the venture capital sector, resulting in more, and larger, investments – did lead to a short-lived spatial diﬀusion in investment activity as venture capital firms had to look further afield for investment opportunities. However, in the subsequent investment downturn post-2000 venture capital firms quickly reversed this geographical expansion in investment activity to re-focus on investments closer to home (Green, 2004). Indeed, the share of investing by value in the top three states of California, Massachusetts and Texas has increased from 54 per cent in the pre-‘bubble’ period (1995–98) to 55 per cent in the ‘bubble’ years (1999–2000) and to 61 per cent in the immediate ‘post-bubble’ period (2001–2002). Explaining the geographical concentration of venture capital investments This uneven geographical distribution of venture capital investments arises from the combination of the clustering of the venture capital industry in a relatively small number of cities, and the localized nature of venture capital investing.

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Table 3.5 Location of venture capital investments in the United Kingdom, by region, 2001–2003 inclusive

All investments – companies Region South East London South West Eastern West Midlands East Midlands Yorkshire and The Humber North West North East Scotland Wales N. Ireland Total

All investments – amount invested

Early stage investments – amount invested

Number

%

LQ*

£m

%

LQ

£m

%

LQ

758 830 210 413 262 147 191 304 117 301 116 128

20.1 22.0 5.6 10.9 6.9 3.9 5.1 8.0 3.1 8.0 3.1 3.4

1.27 1.38 0.60 1.08 0.84 0.47 0.72 0.84 1.24 1.14 0.71 1.06

3.063 4031 664 827 1374 1147 319 641 194 820 126 100

23.0 30.3 5.0 6.2 10.3 8.6 2.4 4.8 1.5 6.2 0.9 0.8

1.46 1.91 0.54 0.62 1.24 1.27 0.34 0.50 0.58 0.88 0.22 0.25

238 229 26 216 17 22 10 54 6 64 31 25

25.8 24.9 3.9 23.5 1.8 2.4 1.1 5.9 0.7 6.9 3.4 2.7

1.64 1.56 0.42 2.32 0.22 0.35 0.16 0.61 0.26 0.99 0.78 0.85

3777

13306

921

Note: * Location quotient (LQ) divides a region’s share of total venture capital investment by its share of the total population of businesses registered for VAT. A value of greater than one indicates that venture capital investments are over-represented in that region. A value of less than one indicates that venture capital is under-represented in that region Source: British Venture Capital Association, Report on Investment Activity

The spatial clustering of venture capital firms Venture capital firms are clustered in just a small number of cities, typically major financial centres and cities in high-tech regions. Since most venture capital firms have only a single oﬃce, including branch oﬃces has only a minor eﬀect in reducing this high level of spatial clustering. In the USA venture capital oﬃces are concentrated in San Francisco, Boston and New York. In Canada the main centre for venture capital firms is Toronto (59 per cent), with smaller concentrations in Calgary, Montreal (both 9 per cent) and Vancouver (8 per cent). In the UK 71 per cent of venture capital firms have their head oﬃces in Greater London. There is greater dispersal in Germany. Munich is the biggest single host to venture capital firms but accounts for less than 20 per cent of the total (Fritsch and Schilder, 2006). In total, six cities account for 65 per cent of venture capital firms: nevertheless, all of them are major banking and financial centres (Martin et al., 2005). The concentration of venture capital firms in financial centres reflects the origins of many of them as oﬀshoots of other financial institutions (notably banks). It also oﬀers access to the pools of knowledge and expertise that venture capital firms require to find deals, organize investments and support their portfolio companies. Hence a location in a financial centre enables appropriately qualified staﬀ to be recruited and provides proximity to other financiers, entrepreneurs, legal, accounting and consultancy firms and headhunters during the investment process. The USA is unusual in having such a large

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proportion of venture capital firms located in Silicon Valley, a high-tech region. In contrast to the venture capital firms in financial centres, these firms have typically been started by successful technology entrepreneurs and raised a lot of their funding from local high net worth individuals (particularly wealthy cashed-out entrepreneurs). Technology regions in other countries – such as Cambridge in the UK and Ottawa in Canada – typically have only a handful of local venture capital firms, and ‘import’ much of their funding from venture capital firms based in the major financial centres (London, Toronto, and so on). However, these local venture capital firms have often been established by successful local technology entrepreneurs (for example Amadeus in Cambridge, started by Hermann Hauser, and Celtic House in Ottawa, started and initially funded by Terry Matthews), and illustrates how technology clusters benefit from the institution-building activities of such individuals. The localized nature of venture capital investing The clustering of venture capital oﬃces need not necessarily lead to the uneven geographical distribution of venture capital investments – the money could be invested in distant regions. But in practice venture capital investing is characterized by spatial biases which favour businesses located close to where the venture capitalists themselves are located. Florida and Smith (1991; 1992) have observed that venture capital firms located in high-tech clusters tend to restrict their investing to the cluster. Powell et al. (2002) report that just over half of all biotech firms in the USA attracted venture capital investment from local sources. This proportion was even higher amongst smaller, younger, more science-focused firms and amongst firms in the main biotech clusters (Boston, San Francisco and San Diego). Moreover, the tendency for venture capital firms to invest locally increased during the 1990s. In the case of Internet investing, Zook (2005) points to a strong statistically-significant correlation between the oﬃces of venture capital firms and the number of investments at all spatial scales from five-digit zip code to metropolitan statistical area, with the strongest correlation for early stage investments. Martin et al. (2005) similarly report a strong tendency for German venture capital firms to invest locally, with most Länder dependent on local venture capital firms for investment. On average nearly half of all firms raising venture capital have been funded by local investors, with this proportion rising to 68 per cent in the case of the Bayern region which is centred on Munich. This strong spatial proximity eﬀect arises because of the absence of publicly available information on new and young businesses. Their unproven business models, untested management teams, new technologies and inchoate markets all represent key sources of risk and uncertainty for investors (Sorenson and Stuart, 2001). Venture capitalists seek to overcome this uncertainty about the future prospects of potential investee businesses by information sharing with other investors, consultants, accountants and a wide range of other actors. Information sharing of this type is built on mutual trust that has been earned through repeated interaction, while the nature of this information flow tends to be personal and informal and therefore hard to conduct over distance. As a consequence, less information is available about businesses in distant locations. Making local investments is therefore one of the ways in which venture capital firms can reduce uncertainty, compensate for ambiguous information and thereby minimize risk (Florida and Kenney, 1988a; Florida and Smith, 1991). This reliance on personal and professional contacts – what one venture capitalist terms ‘Rolodex power’ (Jurvetson, 2000, p. 124) – can be seen

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at every stage in the venture capital investment process: deal flow generation, deal evaluation and post-investment relationships. Deal flow. At the deal flow stage, venture capitalists rely on their connections and relationships to find the best deals (Zook, 2005). Most venture capital firms are inundated with business plans and have to develop systems which allow them to quickly identify and focus on those which have the best prospects for success. There are two sources of deal flow: deals which come in cold and those which are referred by the venture capitalist firm’s network – for example, law firms, accountancy firms, other venture capitalists and entrepreneurs. Venture capitalists are unable to rely on the information provided by the entrepreneur in deals which come in without an introduction. Instead, they rely on their networks – which tend to be local – as a means of receiving deal flow which has already been screened for relevance and quality. As one venture capitalist quoted by Zook (2005, p. 83) explained, ‘I depend on someone I know to alert me to good deals. If I don’t know this person at all and if they’re coming in totally cold, they have to say something really compelling to get me to look at it.’ Moreover, venture capitalists can place a high level of trust in the quality of these referrals because these organizations and individuals concerned are putting their reputation on the line when they refer deals to venture capitalists. Deal evaluation. The outcome of the initial screening is a much smaller number of opportunities which the investor thinks have potential. These undergo a detailed evaluation. As Banatao and Fong (2000, p. 302) observe, ‘at this stage the venture capitalist’s contacts in his Palm Pilot are his best friend.’ Venture capitalists use their extensive contacts to research the background of the entrepreneurs, the viability of the market, likely competition already in place or on the horizon and protection of the intellectual property. At the start-up and early stages of investing, considerable emphasis is placed on the people. What have they done? Are they credible? Do they have the right integrity and ethics? This is particularly the case in situations where the investor believes in the technology but there is no industry and market (von Burg and Kenney, 2000). In such situations – before a dominant design or standard has emerged – venture capitalists ‘have to bet on the entrepreneurs presenting the business plan’ (von Burg and Kenney, 2000, p. 1152). It is easier and quicker for a venture capitalist to check an entrepreneur’s résumé if he or she is local, by using their own knowledge and local connections. The quality of information is also likely to be better (Zook, 2004). Several Ottawa-based venture capitalists commented on how easily due diligence could be done on a local entrepreneur (Harrison et al., 2004, p. 1064): This is a community where most of the people are spin-outs of spin-outs. Two phone calls and I can find out everything . . . For the most part, you are dealing with teams and at least some of the team members come from the Ottawa community . . . Because I have six or seven investments in semiconductors, there are not many people in the Ottawa area in the semiconductor industry that I don’t already know or know someone who knows them, or who has worked with them in the past and so on. Ottawa is a small town, so typically the individual worked at Nortel at some stage in his career and you can find someone who worked alongside him at one point. I look at where they worked . . . If they’ve worked at half a dozen places there’s got to be one of those places where I know somebody.

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99

So, as Zook (2005, p. 81) notes, ‘limiting investments to nearby firms produces easier and faster access to an entrepreneur’s references, which can often be double-checked by a venture capitalist’s own personal connections and knowledge.’ Post-investment relationships. The local focus becomes even more important once an investment is made. Venture capitalists not only provide finance; they also monitor the performance of their investee companies to safeguard their investment, usually by taking a seat on the board of directors, setting goals and metrics for the companies to meet and supporting their portfolio companies with advice and mentoring in an eﬀort to enhance their performance. They may even play a role in managing the company in the case of scientist-led young technology businesses. Supporting and monitoring their investments – which is an important part of managing the risk and accounts for a significant proportion of a venture capitalist’s time – also emphasizes the importance of proximity. Even though some forms of support do not require close contact there will nevertheless be many occasions when face-to-face contact is required and the venture capital firm will incur high costs each time a non-local firm is visited. It is undoubtedly the case that geographical proximity plays an important role in both the level and quality of support that businesses are able to obtain from their venture capital investors (Zook, 2004; 2005). First, venture capitalists can work more closely with their investee companies in their support and advisory roles when they are located nearby. Second, venture capitalists have abundant contacts and deep knowledge of particular industries: providing referrals to these sources of expertise is an important value-added contribution that venture capitalists make. This social network is more readily tapped when investee businesses are geographically proximate to the venture capitalist (Powell et al., 2002; Zook, 2005). Third, a further benefit which accrues when the venture capitalists and investee businesses are geographically proximate is that ‘unplanned encounters at restaurants or coﬀee shops, opportunities to confer in the grandstands during Little League baseball games or at soccer matches, or news about a seminar or presentation all happen routinely . . .’ (Powell et al., 2002, p. 294). In short, it is precisely because venture capital is more than just the provision of capital that geographical proximity is important (Hellman, 2000, p. 292). Summary. In their eﬀorts to minimize risk and uncertainty venture capitalists place a heavy reliance on their network of contacts to source quality deals, evaluate these deals, provide timely assistance to their portfolio companies and monitor their performance. This favours local investing because all of these activities become increasingly diﬃcult to undertake over long distances (Zook, 2005). Venture capital as a location factor This strong emphasis on local investing by venture capital firms can also attract businesses from other regions where venture capital is lacking and which are seeking to raise finance. This is well illustrated by Zook (2002; 2005) in his account of the geography of Internet businesses. He notes that the importance of obtaining venture capital, combined with its limited mobility, was a significant factor in encouraging Internet entrepreneurs in other parts of the USA to move to the San Francisco area during the emergent phase of the industry in the 1990s, either prior to starting their business or soon after founding a business elsewhere. A mix of both push and pull factors lay behind this trend. First, the venture capitalists in San Francisco were very receptive to approaches for funding by Internet entrepreneurs in this period: those ‘venture capitalists who had been scanning for

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the next promising breakthrough jumped on the opportunity of the internet and began to fund and be approached by a wide variety of internet entrepreneurs’ (Zook, 2002, p. 162). However, venture capitalists in other locations often ‘didn’t get it’ – they did not know, understand or believe in the Internet industry – and so were more likely to reject funding proposals from Internet entrepreneurs. Second, the lesson from the successes of Netscape and Yahoo! was the importance of speed to market in order to secure firstmover advantages. Thus, the strategy of Internet entrepreneurs during the Internet frenzy of the late 1990s was to ‘get big fast’. This required raising venture capital so that they could quickly scale-up, hiring the resources, developing routes to market and so on in order to gain competitive advantage. Internet entrepreneurs also recognized the value that venture capital investors could add through their networks and knowledge. However, ‘smart money’ in particular invests close to home (Zook, 2005). Thus, location became a strategic choice for Internet entrepreneurs: ‘entrepreneurs had to go to Silicon Valley because that was where the money was’ (Zook, 2005, p. 61). Demand-side factors Until now the discussion has been considering supply-side factors as a reason for the geographical concentration of venture capital investing. However, the presence or absence of venture capital also influences the demand side. A further consequence of the localization of venture capital firms and their investment activity is that knowledge of venture capital investing varies from place to place (Thompson, 1989). This, in turn, has implications for the demand for venture capital (Martin et al., 2005). Knowledge and learning about venture capital will spread through the local business community in areas where venture capitalists are concentrated. Thus, both entrepreneurs and intermediaries, including accountants, bankers, lawyers and advisers, will have a greater understanding of the role and benefits of venture capital, what types of deals venture capitalists will consider investing in and the mechanics of negotiating and structuring investments. And, as noted earlier, the connections that lawyers, accountants and others have with venture capital firms means that the businesses that they refer for funding will be given serious consideration. The overall eﬀect is to raise the demand for venture capital in locations where venture capital is already established. As Martin et al. (2002, p. 136) observe: A strong mutually reinforcing process seems to be at work: venture capitalists emerge and develop where there is a high level of SME – and especially innovative SME – activity and this in turn stimulates further expansion of the local venture capital market which in turn contributes yet further to the formation and development of local SMEs, and so on.

In areas which have few or no venture capital firms, in contrast, knowledge amongst entrepreneurs and the business support network will be weak and incomplete, intermediaries will lack connections with venture capital firms and, perhaps most significantly of all, will be less competent in advising their clients on what it takes to be ‘investable’. The eﬀect is to depress demand for venture capital. Long distance investing The discussion thus far has emphasized the localized nature of venture capital investing. However, it is important to recognize that long distance investing also occurs.

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The eﬀect of long distance investing is actually to reinforce the geographical clustering of venture capital investments, rather than producing a more dispersed distribution of investments, because it ‘flow[s] mainly to areas with established concentrations of high tech businesses’ (Florida and Smith, 1992, p. 192). The best evidence on venture capital flows is by Florida and Smith (1991; 1992) for the USA. They note that venture capital firms that are based in financial centres such as New York and Chicago make most of their investments in distant places, typically high-tech regions. This contrasts with the venture capital firms in these high technology regions which make a high proportion of their investments locally, although some long distance investing occurs. Powell et al. (2002) similarly note for the biotechnology industry that New York money invests in Boston, San Diego and the rest of the country whereas both Boston and San Francisco investors tend to invest within-state. Likewise, in Germany venture capital firms in the major clusters of venture capital make a significant minority of their investments in the Bayern region, centred on Munich which is a major technology cluster. Indeed, Bayern is the second most important region, after their own local region, for investments by venture capital firms, accounting for 29 per cent of investments by Hamburg-based venture capitalists and by 25 per cent of those based in Dusseldorf (Martin et al., 2005). The key point is that long distance venture capital investments typically occur in the context of the syndication of investments between non-local and local investors (see Wright and Lockett, 2003 and Manigart et al., 2006 for discussions of syndication in venture capital). Sorenson and Stuart (2001, pp. 1582–3) have observed that ‘venture capitalists expand . . . their active investment spaces over time . . . primarily through joining syndicates with lead venture capitalists in distant communities.’ Syndication arises because young, growing businesses – particularly technology businesses – typically require several rounds of investment before they are successful, with each round involving larger amounts. However, venture capital firms seek to mitigate risk through diversification, investing in a portfolio of businesses, some of which they hope will be successful, oﬀsetting the losses from unsuccessful investments. Clearly, the initial investor would cease to have a diversified portfolio if it continued to provide all of the funding that a business needed. Investee businesses also benefit from having additional investors co-funding later rounds because they are able to access a wider range of valueadded skills. Indeed, their initial investor’s value-added skills may be more appropriate to businesses at their start-up or early growth, whereas businesses which have successfully negotiated this stage will require a diﬀerent set of value-added contributions which their initial investor may not possess. Because of the presence of a local lead investor distance is not important to these later stage co-investors, who themselves can either be local or non-local. They are willing to trust the local venture capital fund to undertake the deal evaluation, monitoring and support functions, including taking a seat on the board, leaving them to take a purely passive role. If the long distance investors do contribute value-added functions then they are of a type that does not require close contacts with the investee business. There is a strong reciprocal eﬀect in syndication, with the local investor likely to be invited by the other venture capitalists into deals that they lead, which serves to reinforce the trust factor. Thus, syndication is a particular feature of longer established venture capital firms. Florida and Kenney (1988a, p. 47) suggest that ‘investment syndication is perhaps the crucial ingredient in the geography of the venture capital industry.’

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Venture capital clusters and technology clusters: the case of Ottawa It is widely thought that the local availability venture capital is critical in incubating and sustaining entrepreneurially-based high-tech clusters. As DeVol (2000, p. 25, emphasis added) comments: ‘by financing new ideas venture capitalists are catalysts instrumental in building a cluster as they provide a means for new firms to be formed.’ In other words, it is suggested that a well functioning venture capital infrastructure is required for a regional technology cluster to develop. But this contradicts evidence from Silicon Valley (Saxenian, 1994) as well as other clusters such as Ottawa (Mason et al., 2002), Washington DC (Feldman, 2001) and Cambridge (Garnsey and Heﬀernan, 2005) that venture capital lags rather than leads the emergence of entrepreneurial activity. However, venture capital is needed for the sustained growth and development of a cluster (Llobrera et al., 2000): without venture capital a cluster is likely to stagnate or decline (Feldman, 2001; Feldman et al., 2005). The Ottawa technology cluster: an overview This process is illustrated by Ottawa, Canada’s capital city, which is one of the main regions for venture capital investing in Canada. (See Shavinina, 2004 for an overview of Ottawa’s technology cluster.) It currently has around 1500 technology companies which employ around 70 000 workers (down from a peak of 85 000 at the peak of the technology boom in 2000). Over 75 per cent of Canada’s telecoms R&D is undertaken in Ottawa. It is the location for several of the federal government’s R&D facilities and is also the home of many leading private sector technology companies, including Nortel Networks, Newbridge Networks (acquired by Alcatel in 2000), Corel Corporation, JDS-Uniphase and Mitel Corporation – although many of these companies underwent substantial retrenchment during the post-2000 technology downturn. Nortel undertakes a large share of its worldwide research in Ottawa. Recognition of Ottawa as a centre for telecoms technology has led to global companies such as Cisco Systems, Nokia, Cadence Design Systems and Premisys Telecommunications seeking a presence in the region during the late 1990s either through greenfield site development or the acquisition of local companies. Ottawa’s emergence as a high technology cluster is largely attributable to the start-up and growth of entrepreneurial companies over the past 40–50 years. Its origins date back to the early post-war period with the founding of Computing Devices of Canada Ltd in 1948 as a spin-out from the government’s National Research Council (NRC) Laboratories to produce military computer hardware. Both NRC and other Government research labs have been the origin of many other spin-outs since then. A further significant building block was the decision of Northern Telecom (the forerunner of Bell Northern Research and later Nortel Networks) to move its R&D facilities from Montreal to Ottawa in the 1950s. This facility has gone on to become one of the largest and most innovative telecommunications research centres in the world, although it has contracted since 2000. It has also been a significant source of spin-outs over the years. A further boost to the cluster occurred in the mid-1970s with the closure of Microsystems International – a subsidiary of Northern Telecom – one of the earliest developers of semiconductor technology following a temporary downturn in the chip business. The company had attracted a large number of highly skilled IT engineers and scientists to Ottawa. Following the closure some of the redundant workers started their own companies. More than 20 start-ups can be attributed to former Microsystems employees.

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Venture capital in the early stages of cluster development The key point is that the initial emergence and early growth of Ottawa’s technology cluster occurred in the absence of local sources of venture capital. One observer noted in 1991 that compared to technology clusters in the USA, ‘Ottawa is conspicuous by its . . . low venture capital investment’ (Doyle, 1991). Indeed, prior to the 1990s the only sources of venture capital in Ottawa were provided by Quebec lumber companies which began to invest in local high-tech companies in the 1960s. One of these companies was acquired by Noranda which went on to create Noranda Enterprises, Ottawa’s first venture capital company, in the late 1970s. Noranda ‘participated in nearly every successful high technology company that was ever formed in the Ottawa-Carlton Region’ (Doyle, 1993, p. 12). However, Noranda and the other investors provided expansion capital. The only source of start-up finance was therefore from business angels.3 A survey of high-tech start-ups founded since 1965 (but primarily between 1978 and 1982) found that few had raised external finance, none had raised venture capital and the most important source of funding was the personal savings of their founders (Steed and Nichol, 1985). As recently as 1996 the Canadian Venture Capital Association (CVCA) directory listed just two venture capital companies in Ottawa: a branch oﬃce of the Business Development Bank, a Crown Corporation which provides both debt and equity finance to Canadian SMEs via a network of branch oﬃces, and Capital Alliances, a Labor Sponsored Venture Capital Fund, started by the former managing partner of Noranda Enterprises which had closed in the early 1990s.4 Moreover, venture capital firms in other parts of Canada and the USA showed no interest in investing in Ottawa. The 1997 Ottawa Venture Capital Fair was the first to attract non-local investors. For much of the 1990s the only significant supplier of venture capital in Ottawa was Newbridge Networks, founded in 1986 by the entrepreneur Terry Matthews (who had previously co-founded Mitel with Michael Cowpland who went on to found Corel). Newbridge was acquired by Alcatel in 2000. The Newbridge Aﬃliates Programme was essentially a form of corporate venture capital. The aﬃliates were companies developing products that were compatible with Newbridge equipment and so could leverage Newbridge’s sales force. The aﬃliates programme provided these companies with direct investment by Newbridge and also by Matthews himself, as well as mentoring and ongoing support, including back oﬃce functions. The aﬃliates programme was wound down in the late 1990s. However, Matthews continued his involvement in venture capital by establishing Celtic House, initially with oﬃces in Ottawa and London, but it subsequently opened a further oﬃce in Toronto. He was the only investor in the first fund but Celtic House’s second and third funds have raised funding from a variety of investors. The recent boom in venture capital investing The availability of venture capital in Ottawa has been transformed since the late 1990s. Indeed, $1.2 billion (Can) was invested in Ottawa-based businesses in 2000, equivalent to 25 per cent of the Canadian total, four times larger than the 1999 figure and seven times bigger than in 1997. The post-2000 tech-downturn has seen a drop in the scale of venture capital investment (in part linked to declining valuations). Nevertheless, even in the downturn Ottawa continued to attract a disproportionate share of Canadian venture capital activity.

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This growth in venture capital investing has two sources. First, there has been an increase in the number of Ottawa-based venture capital funds, including several local funds (in many cases started by ex-Newbridge staﬀ who had been involved in the aﬃliates programme) and branch oﬃces of Canadian venture capital funds. In addition, other Canadian and US venture capital firms put people on the ground to act as their ‘eyes and ears’. Second, a number of investors based elsewhere in Canada and the US – notably in Toronto and Boston – started investing in Ottawa-based businesses. In most cases – and especially in the case of US investors – these investors have been brought in by the original investors to provide second or third round funding. Accompanying this growth in venture capital investing has a significant expansion in the population of business angels. This has been a direct consequence of the many successful, cashed-out entrepreneurs since the mid-1990s and the large number of senior executives from the large company sector (for example Nortel, Newbridge, JDS-Uniphase) who have made significant money from stock options, Moreover, these angels – unlike those who funded earlier generations of technology start-ups such as Mitel and Lumonics – are technologically savvy and are investing in areas that they understand so that they are able to bring commercial know-how to support the entrepreneurs that they are funding. One of the value-added contributions that business angels can provide is to make introductions to venture capital funds. Indeed, Madill et al. (2005) noted that 57 per cent of technology-based firms which raised angel financing went on to raise finance from venture capital funds; in comparison, only 10 per cent of firms that had not secured angel funding obtained venture capital. This reflects the role of business angels in building up start-up companies to the point where they become ‘investor ready’. The reputation of a business angel can also be a positive signal to venture capital funds. Indeed, one local venture capitalist observed that he has invested in firms ‘largely because of the quality of their angels’ (quoted in Mason et al., 2002, p. 267). There are four interrelated factors which account for this recent interest amongst venture capitalists in investing in Ottawa (Mason et al., 2002). First, several contextual factors favoured Ottawa. The venture capital industry experienced a boom in fund raising in the second half of the 1990s, fuelled by a ‘hot’ IPO market and an active takeover market for young technology companies. Thus, there was plenty of money looking for profitable opportunities. In particular, US venture capitalists were finding that the money they had to invest was outstripping the investment opportunities available locally, so they began to look further afield (cf. Green, 2004). One of the key sectors in which venture capitalists were interested in was communications – voice, data, telephony and infrastructure businesses. These were precisely the sectors in which Ottawa was strong. Venture capital firms which specialized in communications technology recognized that Ottawa has an international reputation for world class technology in this area and knew that they could not overlook the region as a source of potential opportunities. Two of Ottawa’s own venture capital funds – Celtic House and Skypoint Capital – also specialize in communications technology. Second, the sale of three young venture capital-backed companies in 1997 and 1998 for what at the time were extremely high valuations demonstrated to the venture capital community that, in the words of one local investor, ‘Ottawa is a great place to make money.’ A further important consequence was that the monetary rewards of the entrepreneurs and staﬀ in these companies (through stock options) had a dramatic eﬀect on the attitude of engineers in the large companies, making them much more positive about starting, or

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working in, a young technology company. Hence, it became much easier for venture capitalists to attract people from major local companies to build strong start-up teams. Third, the success of global companies based in Ottawa, such as Nortel, JDS-Uniphase and Newbridge Networks, gave the region high visibility for the quality of its technology and engineers. This attracted the attention of US venture capitalists in particular, giving Ottawa-based entrepreneurs the credibility to get a hearing from venture capitalists. One former local economic development oﬃcial responsible for Ottawa’s Venture Capital Fair noted that ‘when [entrepreneurs] call and say, “we’re from Ottawa and we’re working in this area”, they get attention . . . because Ottawa is now really on their map.’ He went on to quote from a US venture capitalist who told him that ‘if you see a deal involving exNortel guys, I want to see it.’ Indeed, by the late 1990s US venture capitalists were visiting Ottawa ‘looking for ex-Nortel engineers or whatever engineers and funding their ideas.’ Interestingly, Boston-based venture capitalists have invested in Ottawa despite having no physical presence there. However, the flight time is only an hour and a half – and because of Ottawa’s small size could quickly get plugged into the local networks. Finally, Toronto-based venture capitalists also invested in Ottawa from a distance. Ottawa is an hour’s flying time from Toronto, close enough for Toronto-based venture capitalists to do a day’s business. However, by the late 1990s many Toronto-based venture capitalists were finding this model of investing to be problematic. They were unable to match the valuations paid by US venture capitalists for young technology companies. Moreover, the large size of many US funds meant that they did not need to syndicate the deal, thus excluding Canadian venture capital funds from the investment. This prompted the recognition amongst Toronto venture capitalists that they needed to invest at an earlier stage, ahead of the US investors, and therefore to already be an investor in companies when they raised a subsequent round of finance. To do this required a local presence in order to improve their deal referral sources. The Ottawa example therefore suggests that a technology cluster requires a previously established technology base comprising R&D activities, out of which emerge the first generations of technology companies which get funded by local, usually non-specialist, investors. However, it takes time to build a technology cluster capable of generating leading edge ideas, with an entrepreneurial culture and which can support the emergence and growth of world class companies that will generate high returns for investors. But once venture capitalists recognize this they will be attracted to invest. Conclusion Summary This chapter has drawn attention to the strong geographical eﬀects that characterize venture capital investing, contradicting the economist’s concept of perfectly mobile capital markets (Florida and Smith, 1991). Although venture capital firms can, and do, raise their investment funds from anywhere, there are strong geographical constraints on where they make their investments. First, investing locally is a way of minimizing uncertainty and reducing risk in identifying and evaluating investment opportunities and supporting their investee companies. In particular, the hands-on involvement of venture capitalists encourages local investing. These considerations may also encourage the relocation of new firms seeking finance from other regions which lack venture capital.

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Second, a significant proportion of venture capital is invested over long distances. However, because this investment is typically made alongside other venture capital firms, and requires a local investor to coordinate the syndicate and undertake the distance sensitive functions, it is highly constrained in where it can flow. Indeed, most long distance venture capital investments flow to major high-tech clusters which already contain significant clusters of venture capital firms and investment activity. The eﬀect is therefore to reinforce the geographical concentration of venture capital investing. It is for these same reasons that regions which lack local venture capitalists will encounter diﬃculties in accessing venture capital from afar. Third, the concentration of venture capital investing creates a virtuous circle in which knowledge and learning about venture capital spreads to local entrepreneurs and intermediaries, resulting in increased demand for venture capital. The exact opposite occurs in venture capital deficient regions where knowledge and understanding of this type of finance in the business community will be weak, so entrepreneurs will be less inclined to seek it and intermediaries will be less competent in getting their client’s investment ready. Given the positive eﬀect that venture capitalists have on new firm formation and growth, as both capitalist and catalyst, the eﬀect of the geographical clustering of their investments, in turn, contributes to uneven regional economic development. In the case of Silicon Valley, for example, proximity to abundant sources of venture capital enables firms to raise finance at a younger age, complete more funding rounds and raise more money at each round. This translates into better performance: faster growth, profitability, greater employment and a high likelihood of achieving an IPO.5 By having early access to venture capital this gives start-ups substantial first-mover advantages, enabling pioneer firms to transform ideas quickly into marketable products and become industry leaders (Zhang, 2006). Future research directions The geographies of venture capital have been largely ignored by those scholars who have approached the topic from entrepreneurial and finance perspectives. The subject has also attracted surprisingly limited attention from economic geographers despite the growing interest in the geography of money (Martin, 1999; Pollard, 2003). Hence, many significant research questions need to be addressed. It is inevitable that any research agenda is personal and idiosyncratic. Based on the material that has been reviewed in this chapter, five topics are identified as priorities for further research. First, considering business angels, there is a need for research which can ‘put boundaries on our ignorance’ (Wetzel, 1986, p. 132): for example, better quality statistical information on the locational distribution of business angels, the characteristics of business angels in diﬀerent locations, the circumstances in which long-distance investments occur (assessing the roles of investor characteristics, investment characteristics and local environment), and how angels who make long-distance investments mitigate the locational challenges. These are fairly straightforward questions but pose considerable challenges simply because of the diﬃculties in obtaining comprehensive statistical information on business angels and their investment activity. Second, most geographical analyses of venture capital investing have used highly aggregate data. Future studies need to make use of databases, such as Thomson Financial’s Venture Expert Database, which contains a range of information on companies which

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have received venture capital, and their investors, thereby permitting a much greater range of geographical questions to be explored. Third, moving from the macro scale, and quantitative data, to the micro-scale and qualitative data, there is a need for greater insights into the way in which both business angels and venture capital firms factor location and distance into their investment decisions. Even though most investors – particularly those who specialize in early stage investing – emphasize the importance of investing locally, ‘exceptions’ are not hard to find (Mason and Rogers, 1996). This might suggest that the location of the potential investee is a compensatory factor, waived if other aspects of the investment are particularly favourable. This is likely to require ‘real time’ research methodologies. More generally, there is a need to explore the spatial biases of investors which influence their attitudes to investment opportunities in diﬀerent locations. Fourth, there is a need to tease out the connections between venture capital and technology clusters. There are two particular issues. The first concerns the popular view that venture capital is a pre-condition for the emergence of technology clusters. This chapter has highlighted the case of Ottawa, and cited several other studies, which clearly demonstrate that venture capital lags cluster development, with the funding of the early generations of spin-oﬀ companies being undertaken by various actors, including business angels, established companies and government, and subsequently may attract venture capitalists located in other regions who make and monitor their investments on a fly-in, fly-out basis. Local sources of venture capital only emerge when a critical mass of entrepreneurial activity is reached, the cluster develops an identity of its own, entrepreneurial success stories begin to emerge and the quality of the region’s technology is recognized. More research is needed to explore these processes. The second concerns the process of knowledge spillovers in clusters. Firms that are located in clusters derive competitive advantages by gaining rapid access to knowledge on innovation, production techniques and competitive strategies of other firms. This knowledge, which is tacit and therefore diﬃcult to transfer, circulates mainly by inter-personal contact. Research has tended to focus on three main processes: the mobility of technicallyqualified workers within the local labour market, the spin-oﬀ process, involving individuals or teams leaving their existing employers to start new businesses, and various forms of cooperative behaviour between firms in the cluster (for example suppliers, sub-contractors, strategic alliances). It has not considered the role of venture capitalists as either a generator or diﬀuser of information. However, as this chapter has emphasized, venture capitalists sit at the centre of an extended network in which they share information with other investors, entrepreneurs, corporate financiers, head-hunters, consultants and experts. This provides them with deep knowledge about likely technological and market trends in particular industries which they draw upon to make decisions on what to invest in and what not to invest in, and supporting their portfolio of investee companies. How this shapes the trajectory of technology clusters is an important issue for research. Finally, the venture capital industry is dynamic and as it has matured it has become more heterogeneous. Research therefore needs to avoid extrapolating from what happens in Silicon Valley, or even the USA and to examine venture capital investing practices in diﬀerent regions. There is also a need to recognize that investment processes and practices change over the course of the investment cycle and that this produces diﬀerent geographies (as Green, 2004, demonstrated). Research must also distinguish between ‘venture

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capital’ – which can be defined as investing in new and growing entrepreneurial businesses – and ‘private equity’ – which involves investing in established companies which typically require restructuring and often takes the form of management buy-outs (MBOs) in which the incumbent management along with the investors purchase their division or subsidiary from the parent group to become co-owners. Venture capital and private equity have diﬀerent geographies (Mason and Harrison, 2002) and their local and regional impacts are also very diﬀerent. Fundamentally venture capital is providing finance which is used for investment in growth whereas private equity is providing finance to enable ownership change to occur. Moreover, private equity deals are typically highly leveraged – in other words, they have a high long-term debt component which is secured against the future cash flows of the business to pay shareholders. Such businesses have to generate cash in order to service this debt. This might involve asset sales. If they are unable to service the debt then they will have to cut back on investment which may lead to loss of market share and, in turn, to a decline in operating eﬃciencies and ultimately to financial distress. Wrigley (1999, p. 205) has shown in the case of the US retail sector that the transformation of the capital structures of firms can have vital implications for the economic landscape, both directly, through the spatial reorganisation of the activities of the high-leveraged firm, and indirectly, through the restructuring of markets by rival firms responding to the commitments implicit in those transformations. . . . Divestiture, market consolidation and avoidance . . . spatial predation, market entry, expansion and exit . . . and competitive price response by rival firms . . . are just some of the outcomes.

Researchers also need to be alert to the changing nature of the venture capital industry. Two trends are particularly significant. First, venture capital has been growing in popularity as an asset class amongst financial institutions. One of the consequences is that funds have substantially larger amounts of money under management. This, in turn, has driven up both the minimum and average size of investments and led to an increasing emphasis on later stage investments in established businesses which have larger capital needs than start-ups. Second, there has been a shift from generalist to specialist investors who focus on specific industry ‘spaces’ (either vertical or horizontal). Both trends can be expected to have geographical consequences, notably a weakening in the significance of local investing (Mason et al., 2002). Policy implications The evidence concerning the catalytic eﬀect which venture capital has on business startup and growth has prompted governments to see venture capital as an essential ingredient in their eﬀorts to promote technology-led economic development in lagging regions. However, as Florida and Kenney (1988b, pp. 316–17) observed, ‘simply making venture capital available will not magically generate the conditions under which high technology entrepreneurship will flourish.’ In similar vein, Zook (2005) comments that ‘simply pumping additional capital into a region will not necessarily produce the dynamism of established venture capital centres.’ First, as Venkataraman (2004) notes, venture capital needs to be combined with talented individuals – typically business executives who can generate and develop novel ideas, start companies, make the prototype, obtain the first customer, develop products and markets and compete in the rough and tumble of competitive markets. This, in turn, will generate some successes which provide the role models

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for others. Without such a flow of high risk–high return businesses, private sector venture capitalists will not invest, and wealthy local investors will shun becoming business angels and invest in other asset classes instead. Second, it has been repeatedly emphasized that providing money is only part of the role of venture capitalists. Hence, using public money to create ‘venture capital’ funds which are staﬀed by managers who lack the value-added skills of venture capitalists will be ineﬀective. According to Venkataraman (2004, p. 154) the money will flow ‘straight to low-quality ventures’. However, as the example of Ottawa highlighted, regions which do oﬀer good investment opportunities will attract venture capital. The implication for venture capital-deficient regions is therefore clear. Trying artificially to create a regional pool of venture capital is likely to be ineﬀective. Venture capital will only be attracted to places with novel ideas and talented individuals (Venkataraman, 2004). Instead, policy-makers should concentrate on developing the region’s technology base, encourage business start-up and growth, and enhance the business support infrastructure. Specifically this means investing in the region’s research institutions to develop knowledge in which they have some comparative advantage – to attract talented individuals from other regions and generate a steady flow of novel technical ideas – and initiatives which enhance the entrepreneurial culture of the region and raise the entrepreneurial competences of the population (Venkataraman, 2004). As one long-term participant and latterly an observer of Ottawa’s high-tech cluster observed, referring to venture capitalists: ‘if you build it they will come’ (quoted in Mason et al., 2002, p. 277). Acknowledgements I am grateful to Hans Landström for his insightful comments on earlier drafts of this chapter. It was completed while in receipt of a Visiting Erskine Fellowship at the University of Canterbury, New Zealand. I am most grateful to the University of Canterbury for the award of this Fellowship. Notes 1. Notably private equity firms which invest in large companies to facilitate their restructuring. 2. Vancouver, Victoria, Kitchener-Waterloo, Calgary, Edmonton, Ottawa, Greater Toronto Area, Montréal and Québec City. These cities accounted for 45 per cent of Canada’s population at the 2001 Census of Population. 3. For example, Mitel was started with seed money from local lawyers while Lumonics raised its money from local businessmen (‘retailers, lawyers and car lot owners’: Mittelstaedt, 1980). 4. Noranda Enterprises – the only Ottawa-based venture capital company listed in the 1992 CVCA directory – was closed down in the early 1990s following acquisition of the parent company in the late 1980s. Its new owners saw it as a resources company and so in 1992 closed its investment activities (despite having achieved a 38 per cent compound rate of return to shareholders: Doyle, 1991; 1993). 5. However, venture capital-backed firms in Silicon Valley also have lower survival rates. Zhang (2006) suggests this may reflect the lack of prudent screening. A more plausible explanation may be the competition between venture capital firms for investment opportunities leading to over-investment in specific markets.

References Acs, Z.J. and C. Armington (2004), ‘Employment growth and entrepreneurial activity in cities’, Regional Studies, 38, 911–27. Aram, J.D. (1989), ‘Attitudes and behaviours of informal investors toward early stage investments, technology based ventures and coinvestors’, Journal of Business Venturing, 4, 333–47. Avdeitchikova, S. and H. Landström (2005), ‘Informal venture capital: scope and geographical distribution in Sweden’, paper to the Babson Kauﬀman Entrepreneurship Research Conference, Babson College, 9–11 June. Ayayi, A. (2004), ‘Public policy and venture capital: the Canadian labor sponsored venture capital funds’, Journal of Small Business Management, 43, 335–45.

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Banatao, D.P. and K.A. Fong (2000), ‘The valley of deals: how venture capital helped shape the region’, in C.-M. Lee, W.F. Miller, K.G. Hancock and H.S. Rowen (eds), The Silicon Valley Edge, Stanford, CA: Stanford University Press, pp. 295–313. Coveney, P. and K. Moore (1997), Business Angels: Securing Start-Up Finance, Chichester: Wiley. Davidsson, P., L. Lindmark and C. Olofsson (1994), ‘New firm formation and regional development in Sweden’, Regional Studies, 28, 395–410. DeVol, R.C. (2000), Blueprint for a High-Tech Cluster: the Case of the Microsystems Industry in the South West, Santa Monica, California: Milken Institute Policy Brief No. 17. Doyle, D. (1991), From White Pines to Red Tape to Blue Chips, Ottawa: Doyletech Corporation for the Ottawa–Carleton Economic Development Task Force. Doyle, D. (1993), The Availability of Risk Capital for High-Tech Based Firms in Canada: A Review of the Issues, Ottawa: Doyletech Corporation for Industry, Science and Technology Canada. Feeney, L., H. Johnstone and A.L. Riding (1998), ‘A profile of informal investors in Canada: a comparison of Canadian and Maritime investors’, paper to the CCSBE 15th Annual Conference, Halifax. Feldman, M.P. (2001), ‘The entrepreneurial event revisited: firm formation in a regional context’, Industrial and Corporate Change, 10, 861–91. Feldman, M.P., J. Francis and J. Bercovitz (2005), ‘Creating a cluster while building a firm: entrepreneurs and the formation of industrial clusters’, Regional Studies, 39, 129–41. Fiet, J.O. (1995), ‘Risk avoidance strategies in venture capital markets’, Journal of Management Studies, 32, 551–74. Florida, R. and M. Kenney (1988a), ‘Venture capital, high technology and regional development’, Regional Studies, 22(1), 33–48. Florida, R. and M. Kenney (1988b), ‘Venture capital and high technology entrepreneurship’, Journal of Business Venturing, 3, 301–19. Florida, R. and D.F. Smith Jr. (1991), ‘Venture capital formation, investment, and regional industrialisation’, Annals of the Association of American Geographers, 83, 434–51. Florida, R. and D.F. Smith Jr. (1992), ‘Venture capital’s role in economic development: an empirical analysis’, in E.S. Mills and J.F. McDonald (eds), Sources of Metropolitan Growth, New Brunswick, NJ: Center for Urban Policy Research, pp. 183–209. Freear, J., J.E. Sohl and W.E. Wetzel Jr. (1992), ‘The investment attitudes, behavior and characteristics of high net worth individuals’, in N.C. Churchill, S. Birley, W.D. Bygrave, D.F. Muzyka, C. Wahlbin and W.E. Wetzel, Jr. (eds), Frontiers of Entrepreneurship Research 1992, Babson Park, MA: Babson College, pp. 374–87. Freear, J., J.E. Sohl and W.E. Wetzel Jr. (1994), ‘Angels and non-angels: are there diﬀerences?’, Journal of Business Venturing, 9, 109–23. Fritsch, M. and D. Schilder (2006), ‘Does venture capital really require spatial proximity? An empirical investigation’, unpublished working paper, Technical University of Freiberg, Faculty of Economics and Business Administration. Garnsey, E. and P. Heﬀernan (2005), ‘High-technology clustering through spin-out and attraction: the Cambridge case’, Regional Studies, 39, 1127–44. Gaston, R.J. (1989), Finding Venture Capital for your Firm: a Complete Guide, New York: John Wiley & Sons. Green, M.B. (2004), ‘Venture capital in the United States 1995–2002’, The Industrial Geographer, 2(1), 2–30. Haar, N.E., J. Starr and I.C. MacMillan (1988), ‘Informal risk capital investors: investment patterns on the east coast of the USA’, Journal of Business Venturing, 3, 11–29. Harrison, R.T., C.M. Mason and S.Y. Cooper (2004), ‘Entrepreneurial activity and the dynamics of technologybased cluster development: the case of Ottawa’, Urban Studies, 41(5/6), 1045–70. Harrison, R.T., C.M. Mason and P.J.A. Robson (2003), ‘The determinants of long distance investing by business angels’, in W.D. Bygrave, C.G. Brush, P. Davidsson, J. Fiet, P.G. Greene, R.T. Harrison, M. Lerner, G.D. Meyer, J. Sohl and A. Zacharakis (eds), Frontiers of Entrepreneurship 2003, Babson Park, MA: Babson College, pp. 116–29. Hellman, T.F. (2000), ‘Venture capitalists: coaches of Silicon Valley’, in C.-M. Lee, W.F. Miller, K.G. Hancock and H.S. Rowen (eds), The Silicon Valley Edge, Stanford, CA: Stanford University Press, pp. 276–94. Hood, N. (2000), ‘Public venture capital and economic development: the case of Scotland’, Venture Capital, 2, 313–41. Innovation Partnership (1993), Private Investor Networks, a study commissioned by the National Westminster Bank plc, Manchester: The Innovation Partnership. Johnstone, H. (2001), ‘Equity gaps in depleted communities: an entrepreneurial response’, in W. During, R. Oakey and S. Kauser (eds), New Technology-Based Firms in the New Millennium, Oxford: Pergamon, pp. 84–94. Jurvetson, S. (2000), ‘Changing everything: the internet revolution and Silicon Valley’, in C.-M. Lee, W.F. Miller, K.G. Hancock and H.S. Rowen (eds), The Silicon Valley Edge, Stanford, CA: Stanford University Press, pp. 124–49.

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Karaomerlioglu, D.C. and S. Jacobsson (2000), ‘The Swedish venture capital industry: an infant, adolescent or grown-up?’, Venture Capital, 2, 61–80. Keeble, D. and S. Walker (1994), ‘New firms, small firms and dead firms: spatial patterns and determinants in the United Kingdom’, Regional Studies, 28, 411–27. Landström, H. (1992), ‘The relationship between private investors and small firms: an agency theory approach’, Entrepreneurship and Regional Development, 4, 199–223. Lengyel, Z. and J. Gulliford (1997), The Informal Venture Capital Experience, London: Local Investment Networking Company. Llobrera, J.T., D.R. Meyer and G. Nammacher (2000), ‘Trajectories of industrial districts: impact of strategic intervention in medical districts’, Economic Geography, 76, 68–98. Lumme, A., C. Mason and M. Suomi (1998), Informal Venture Capital: Investors, Investments and Policy Issues in Finland, Dordrecht, Netherlands: Kluwer Academic Publishers. Madill, J.J., G.H. Haines Jr. and A.L. Riding (2005), ‘The role of angels in technology SMEs: a link to venture capital’, Venture Capital, 7, 107–29. Manigart, S., A. Lockett, M. Meuleman, M. Wright, H. Landström, H. Bruining, P. Desbrières and U. Hommel (2006), ‘Venture capitalists’ decision to syndicate’, Entrepreneurship: Theory & Practice, 30, 131–53. Martin, R. (ed.) (1999), Money and the Space Economy, Chichester: Wiley. Martin, R., C. Berndt, B. Klagge and P. Sunley (2005), ‘Spatial proximity eﬀects and regional equity gaps in the venture capital market: evidence from Germany and the UK’, Environment and Planning A, 37, 1207–31. Martin, R., P. Sunley and D. Turner (2002), ‘Taking risks in regions: the geographical anatomy of Europe’s emerging venture capital market’, Journal of Economic Geography, 2(2), 121–50. Mason, C. and A. Rogers (1996), ‘Understanding the business angel’s investment decision’, Venture Finance Working Paper No. 14, Southampton: University of Southampton and University of Ulster. Mason, C. and M. Stark (2004), ‘What do investors look for in a business plan? A comparison of the investment criteria of bankers, venture capitalists and business angels’, International Small Business Journal, 22, 227–48. Mason, C., S. Cooper and R. Harrison (2002), ‘Venture capital and high technology clusters: the case of Ottawa’, in R. Oakey, W. During and S. Kauser (eds), New Technology-Based Firms in the New Millennium, Volume II, Oxford: Pergamon, pp. 261–78. Mason, C.M. and R.T. Harrison (1994), ‘The informal venture capital market in the UK’, in A. Hughes and D.J. Storey (eds), Financing Small Firms, London: Routledge, pp. 64–111. Mason, C.M. and R.T. Harrison (2002), ‘The geography of venture capital investments in the UK’, Transactions of the Institute of British Geographers, 27, 427–51. Mittelstaedt, M. (1980), ‘Ottawa: the new high tech haven’, Canadian Business, June, pp. 43–6, 82–5, 87, 105. Paul, S., G. Whittam and J.B. Johnston (2003), ‘The operation of the informal venture capital market in Scotland’, Venture Capital, 5, 313–35. Pollard, J.S. (2003), ‘Small firm finance and economic geography’, Journal of Economic Geography, 3, 429–52. Postma, P. and M.-K. Sullivan (1990), Informal Risk Capital in the Knoxville Region, Knoxville, TN: University of Tennessee. Powell, W.W., K.W. Koput, J.I. Bowie and L. Smith-Doerr (2002), ‘The spatial clustering of science and capital: accounting for biotech firm–venture capital relationships’, Regional Studies, 36(2), 291–305. Reynolds, P.D., B. Miller and W.R. Maki (1995), ‘Explaining regional variations in business births and deaths: US 1976–88’, Small Business Economics, 7, 389–407. Riding, A.L., P. DalCin, L. Duxbury, G. Haines and R. Safrata (1993), Informal Investors in Canada: The Identification of Salient Characteristics, Ottawa: Carleton University. Saxenian, A. (1994), Regional Competitive Advantage: Culture and Competition in Silicon Valley and Route 128, Cambridge, MA: Harvard University Press. Shane, S. (2005), Angel Investing, report for the Federal Reserve Banks of Atlanta, Cleveland, Philadelphia, Kansas City and Richmond, Cleveland: Weatherhead School of Management, Case Western Reserve University. Shavinina, L.V. (ed.) (2004), Silicon Valley North: A High-tech Cluster of Innovation and Entrepreneurship, Amsterdam: Elsevier. Short, D.M. and A.L. Riding (1989), ‘Informal investors in the Ottawa–Carleton region: experiences and expectations’, Entrepreneurship and Regional Development, 1, 99–112. Sorenson, O. and T.E. Stuart (2001), ‘Syndication networks and the spatial distribution of venture capital investments’, American Journal of Sociology, 106(6), 1546–88. Steed, G.P.F. and L.J. Nichol (1985), ‘Entrepreneurs, incubators and indigenous regional development: Ottawa’s experience’, unpublished manuscript, Ottawa: Department of Geography, University of Ottawa. Sørheim, R. (2003), ‘The pre-investment behaviour of business angels: a social capital approach’, Venture Capital, 5, 337–64. Sørheim, R. and H. Landström (2001), ‘Informal investors – a categorisation with policy implications’, Entrepreneurship and Regional Development, 13, 351–70.

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Thompson, C. (1989), ‘The geography of venture capital’, Progress in Human Geography, 31(1), 62–99. Tymes, E.R. and O.J. Krasner (1983), ‘Informal risk capital in California’, in J.A. Hornaday, J.A. Timmons and K.H. Vesper (eds), Frontiers of Entrepreneurship Research 1983, Babson Park, MA: Babson College, pp. 347–68. Van Osnabrugge, M. (2000), ‘A comparison of business angel and venture capitalist investment procedures: an agency theory-based analysis’, Venture Capital, 2, 91–109. Van Osnabrugge, M. and R.J. Robinson (2000), Angel Investing: Matching Start-Up Funds with Start-Up Companies, San Francisco: Jossey Bass. Venkataraman, S. (2004), ‘Regional transformation through technological entrepreneurship’, Journal of Business Venturing, 19, 153–67. Von Burg, U. and M. Kenney (2000), ‘Venture capital and the birth of the local area networking industry’, Regional Policy, 29, 1135–55. Wetzel, W.E. (1981), ‘Informal risk capital in New England’, in K.H. Vesper (ed.), Frontiers of Entrepreneurship Research 1981, Wellesley, MA: Babson College, pp. 217–45. Wetzel, W.E. Jr. (1983), ‘Angels and informal risk capital’, Sloan Management Review, 24(4), 23–34. Wetzel, W.E. (1986), ‘Entrepreneurs, angels and economic renaissance’, in R.D. Hisrich (ed.), Entrepreneurship, Intrapreneurship and Venture Capital, Lexington, MA: Lexington Books, pp. 119–39. Wright, M. and A. Lockett (2003), ‘The structure and management of alliances: syndication in the venture capital industry’, Journal of Management Studies, 40, 2073–102. Wright, M., S. Prutti and A. Lockett (2005), ‘International venture research: from cross-country comparisons to crossing borders’, International Journal of Management Reviews, 7, 135–65. Wrigley, N. (1999), ‘Corporate finance, leveraged restructuring and the economic landscape: the LBO wave in US food retailing’, in R. Martin (ed.), Money and the Space Economy, Chichester: Wiley, pp. 185–205. Zhang, J. (2006), ‘Access to venture capital and the performance of venture-backed start-ups in Silicon Valley’, unpublished Working Paper, San Francisco: Public Policy Institute of California. Zook, M.A. (2002), ‘Grounded capital: venture financing and the geography of the Internet industry, 1994–2000’, Journal of Economic Geography, 2(2), 151–77. Zook, M.A. (2004), ‘The knowledge brokers: venture capitalists, tacit knowledge and regional development’, International Journal of Urban and Regional Research, 28(3), 621–41. Zook, M.A. (2005), The Geography of the Internet Industry, Oxford: Blackwell Publishing.

4

Venture capital and government policy Gordon C. Murray

Introduction It is instructive to observe that all venture capital markets of which we are aware were initiated with government support. These markets do not appear to emerge without some form of assistance. This leads to the question as to what it is that requires the need for government support in these markets, at least in their formative stages. (Lerner et al., 2005)

The above quote is taken from a contemporary evaluation of public venture capital activity in New Zealand. It is one of a number of formal reviews of early-stage venture capital activity that have recently been concluded by government policy makers with the assistance of academic researchers.1 The authors of the New Zealand evaluation suggest that, despite venture capital being a financing instrument most widely associated with the ‘animal spirits’ of the free market and of entrepreneurial agents unrestricted by public interference, the state may well have an important role in both initiating risk capital programs as well as providing a conducive environment for the seeding and commercial growth of such activity. This view of the importance of government commitment to entrepreneurial action, particularly in nascent (usually new knowledge or new technology-derived2) industries, has support from several academic researchers (Bottazzi and Da Rin, 2002; Lerner, 2002; Gilbert et al., 2004; Page West III and Bamford, 2005) who see evidence of a significant increase of public initiated and financed venture activity on an international scale. Venture capital and the role of public actors may be seen as one part of such a wider movement to support new enterprise. These authors suggest that the logic behind this growth of activity is a widening appreciation of entrepreneurship policies ‘as one of the most essential instruments from economic growth . . . for a global and knowledge-based economy’ (Gilbert et al., 2004, p. 321). More tangible roles for public intervention are given by, among others, Lerner, 1999; Jeng and Wells, 2000; Keuschnigg and Nielsen, 2001; 2002; Keuschnigg, 2003. They emphasize the importance of government in setting the supportive legal and economic framework conditions necessary for risk capital activity to flourish. Similarly, Audretsch and Keilbach (2004) see the entrepreneurial catalyst as the ‘missing link’ in endogenous economic growth theory. Entrepreneurs become the critical conduit for knowledge spillovers and the subsequent creation of valuable new products and services. However, academic support for a public role(s) in developing early-stage venture capital markets is, at best, conditional and cautionary (Lerner, 1998). Successful policy makers will have to act with a deft hand. There is plentiful evidence that governments are at least as likely to produce overall negative eﬀects by their involvement in markets as they are to engineer a lasting improvement in market conditions (Gilson, 2003; Armour and Cummings, 2006). Economists are particularly circumspect regarding micro-policy interventions at the ‘black box’ level of the firm or venture capital fund. Their preferred 113

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prescriptions are more anonymously concerned with removing market barriers that impede individual agents (for example business angels, venture capital firms or entrepreneurs) from pursuing their own commercial interests. But the involvement of government in risk capital markets presumes some form of serious and persistent market failure. Determining the importance or even existence of market failures will, in turn, require a view of both demand and supply-side eﬃciencies. The diﬃculty of determining market failure, despite its widespread presumption in entrepreneurship finance policy initiatives, is noted below. Academic and policy interests closely reflect the rapidly growing importance of venture capital activity at both national and international levels over the last 25 years. Governments’ recent endorsement of venture capital’s status as an important instrument of entrepreneurial and innovation policy has been particularly noteworthy in Europe (EC, 1998; 2001; 2003a; 2003b; 2005b; 2006a; 2006b; Murray, 1998; Martin et al., 2003).3 A profusion of contemporary public schemes is also indicative of governments’ contingent response to the rapid reduction in supply of early-stage risk capital after the year 2000 collapse in technology markets (Sohl, 2003). High potential young firms were among the first casualties of the changing market conditions at the start of the present century. In several European markets, publicly supported funds were quickly to become one of the most important and continuing sources of risk capital for new enterprises in the hiatus of privately-funded, institutional and informal venture finance following the dot.com collapse (Auerswald and Branscomb, 2003; EC, 2004; NEFI, 2005; Small Business Service/Almeida Capital, 2005). It would be incorrect to assume that venture capital is exclusively Anglo-Saxon in its nature or distribution although a strong association exists between countries in the former British Empire and the international centers of venture capital activity. Nascent or growing venture capital industries now exist in virtually all developed economies in the world. They are frequently encouraged by government action. Similarly, policy makers in the emerging economies of China, Russia, and Brazil are also now exploring the development potential of risk capital.4 India already has an established venture capital community.5 Despite the assumption that venture capital is a suitable subject for policy action, surveys of SME finance repeatedly show that entrepreneurs’ receipt of risk capital from professional investors is an extremely rare event. Reynolds et al. (2003) ‘guesstimate’ that less than half a per cent of all nascent entrepreneurs receive either venture capital or business angel finance at start-up. A 2004 survey of UK SMEs showed that less than 2 per cent of respondents had ever raised institutional venture capital (Small Business Service, 2005). A similar percentage has been recorded in Europe (see European Commission, 2005a). Given that the UK has the largest and most advanced venture capital/private equity industry in Europe, it is probable that other countries are unlikely to register significantly greater risk capital activity among their young firms. European studies confirm this reality of the scarcity of venture capital receipt (European Venture Capital Association, 2005). Early-stage (‘classic’) venture capitalists primarily target technology-based young firms because of their potential for very rapid growth in attractive and immature markets. Yet, in a 1997 survey of 600 high-tech start-ups in Germany and the UK (that is conducted at the start of the technology bull market), Bürgel et al. (2004) found that only around 1 in

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10 of UK firms had received venture capital. In Germany, this ratio went down to 1 in 14. Even in the US, Auerswald and Branscomb (2003) note that the supply of institutional venture capital finance for technology development trails significantly behind business angels, corporations and the Federal Government. It is salutary to note that in 2005, the US and UK venture capital industries invested collectively in only 412 seed and start-up deals (BVCA, 2006;6 PricewaterhouseCoopers/National Venture Capital Association, 2006). This is from two major world economies where, collectively, over one million new businesses are started every year. Thus, institutional venture capital still remains a specialist financing instrument of relevance only to a tiny percentage of the population of new and growing enterprises in any economy. This continues to be the case even during a bullish, new technology market. This chapter will seek to summarize what consensus may be found in seeking an appropriate role and mode of action for government in the light of the evidence of both academic enquiry and policy experience. The question of why governments appear to be so interested in venture capital will be addressed while also noting the considerable influence of US experience. The circumstances under which government itself becomes involved in either influencing or participating directly in risk capital investment will be explained. The nature of policy instruments at governments’ disposal are subsequently catalogued including the growing interest in ‘equity-enhancement’ programs that incentivize private venture capital agents. The chapter will also seek to address why governments have also become involved in the ‘alternative’ policy direction of supporting informal investors or business angels. The chapter will conclude by suggesting future research questions of both academic and policy import. Why are governments so interested in venture capital? The attraction of an established venture capital industry lies in its putative ability both to help finance the creation of new industries and, in so doing, to transform and reinvigorate mature and established economies (Apax Partners, 2006; European Commission, 2006a; 2006b). The joint application of risk capital and high levels of managerial and entrepreneurial experience is seen as a particularly attractive resource combination (Sapienza, 1992) which possibly explains venture capitalists’ popularly perceived ability to both identify and nurture exceptional new and innovative enterprises. It is evident that the venture capital experience of the United States in the second half of the twentieth century has exerted a huge influence on the entrepreneurship policy ambitions of the majority of developed and emerging economies alike. Above all, it was America’s unique ability to generate a stream of new companies of enormous vigor and global span from the nation’s advanced science and technology research centers. American venture capital clusters, pre-eminently Silicon Valley and Route 128, are perceived as the ‘gold standard’ of early-stage innovation finance systems (Bygrave and Timmons, 1992). Venture capital – both in its institutional and informal variants – is seen as part of the very fabric of the USA’s ability to remain at the forefront of knowledge production and commercialization (Edwards, 1999) through risk capital’s contribution to the entrepreneurship/economic growth link (Audretsch and Keilbach, 2004). Multi-country findings from the Global Entrepreneurship Monitor (GEM) further validate venture capital ‘as playing a central role in facilitating high growth entrepreneurship’ (Reynolds et al., 2000).

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Accordingly, policy goals are often crudely framed as ‘How does country X or region Y create the necessary conditions to replicate a Silicon Valley’ (Armour and Cumming, 2006). As the emerging BIC economies7 grow their global share of the production of manufactured goods of increasing sophistication, high value, knowledge-based goods and services are seen to be of growing importance for the continued prosperity of developed economies. Thus, the question of how to emulate world-class examples of innovative and entrepreneurial excellence remains an urgent policy goal for mature Western economies as traditional markets erode (Archibugi and Iammarino, 1999). In Europe, these concerns about regional competitiveness are exemplified by the Lisbon Agenda which sought by 2010 to make Europe the most competitive world region in which to establish and grow a new business (EC, 2004; Kok, 2004). Despite the absence of a resolution of the question of how to create a new Palo Alto in Bavaria or a Route 128 around Helsinki, governments’ concerns for the continued support of the domestic science base (including the commercialization of intellectual property from laboratory to successful enterprise) remain intertwined with a strong faith in the value of venture capital finance. Venture capital is as much an instrument of innovation policy as enterprise policy. That many governments recognize the importance of venture capital finance is, of course, no argument that they should directly engage in such commercial actions. Most free-market oriented, public administrations have considerable reservations about direct state involvement in specialist financing activities. They would prefer to remove themselves completely from this commercial role. None the less, governments reserve the right to intervene if there is clear evidence that: 1) the supply of appropriate finance is insuﬃcient; 2) as a consequence, material economic and other benefits from entrepreneurial actions are being lost to the domestic economy; and 3) no private investors will independently increase the supply of risk capital. Thus, public intervention is predicated on an ‘insuﬃcient’ response from private capital markets. Market failure We have argued that, given the evolution of the venture capital industry, the competencies and dynamism of its professional managers and the weight of institutional money now at their disposal, there appears little direct role for the state. Yet, there exists a conundrum. As the size and scale of venture capital activity has grown internationally, governments have perversely become increasingly drawn into the investment process. The state has become both a provider of public funds to private venture capital firms and, on occasions, an active investor directly selecting new enterprises. Governments have by default been obliged to assume responsibilities for early-stage enterprise financing activities that many academic and industry observers believe should better be left to eﬃcient capital markets. Their involvement in the investment process is recognition that the institutional venture capital industry increasingly believes that early stage investments are not suﬃciently attractive. A market failure can be said to have occurred when the price mechanism fails to produce a socially optimal outcome. In eﬀect, rent-seeking investors8 being unable to capture the full economic and social value of their investments provide less finance (venture capital) than could eﬀectively and profitably be employed in existing opportunities. In these circumstances, public intervention is one possible contingent response to private market shortcomings (European Commission, 2001). At best, the public involvement is seen as

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temporary and should be designed to be phased out as the venture capital market corrects (OECD, 2004). Yet, the term ‘market failure’ is ambiguous at best. It is frequently used, and mis-used, to argue the case for public intervention and state subsidy in areas where the market appears to deliver less of a product or service than may be deemed desirable by interested parties. Within the context of SME finance, there are repeated calls from entrepreneurs, small enterprise owners and their lobbyists for the state to intervene in order to encourage the providers of finance (typically banks or venture capital firms) to lend more debt or invest more equity capital. These arguments frequently resort to some vague definition of ‘public good’ and are often linked, in the case of venture capital, with arguments promoting internationally competitive, innovation and technology policies. Rarely do such submissions acknowledge that a reduction in supply of finance may be an eﬃcient market’s reaction to an insuﬃcient supply of attractive companies. Thus, the term market failure is often used as a label rather than a serious argument. The specific market(s) in which the problem occurs needs to be carefully defined. Repeated surveys of finance for SMEs are ambiguous in their findings. For example, a large proportion of small business owners do not require external finance (Small Business Service, 2005). A Eurobarometer survey found that over three-quarters of SMEs have suﬃcient financing and only 14 per cent of respondents put easier access to finance as their primary concern (EC, 2005a). However, it is the much smaller population of high potential and rapidly growing young firms that are most likely to seek external finance. These immature firms with, as yet, limited assets are also one group that is most likely to find finance is problematic both in its supply and in the cost of access. This is particularly the case for knowledge-based young firms with intellectual and experiential assets that are largely intangible and tacit. (See, for example Bank of England, 1996; Storey and Tether, 1996; OECD, 1997; Westhead and Storey, 1997; European Commission, 2003a; 2003b; Maula and Murray, 2003; 2007.) For policy makers, the quandary exists in determining when a constraint in the supply of finance to a potential user is either: 1) an adverse outcome of an ineﬃcient and/or illinformed market; or 2) a rational and well informed judgment by an eﬃcient market on an unattractively priced proposal. In the former case, often called ‘the equity gap’, there may be an argument for publicly incentivizing either economic principles or agents to provide a greater supply of debt or equity (Keuschnigg, 2003). In the latter case, the failure resides in the entrepreneur’s inability to demonstrate the attractiveness of the business proposal. In contemporary policy vocabulary, this venture is not yet ‘investment ready’ (Mason and Harrison, 2001). Here, the prescription is much more likely to be public interventions to improve human capital. A ‘supply-side’ response that seeks to manipulate investors’ returns would not address the core ‘demand-side’ problem of poor quality enterprises. The longevity of the ‘equity gap’ The term ‘equity gap’ has entered the policy vocabulary. It was first used in an oﬃcial British governmental report in 1931 that looked at the availability and access of small and medium sized businesses to sources of external finance. The Macmillan Report concluded that firms were facing impediments in the search for capital that were not a function of their attractiveness as individual investment opportunities. Rather, because of their size and designation as small businesses, owners were facing discriminatory actions by the institutional

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providers of business finance. Thus, the equity gap was conceived as a supply-side market failure. Successive oﬃcial reports in the UK (Bolton, 1971; Wilson, 1980; National Economic Development Oﬃce, 1986; Williams, 1998; Pickering, 2002; HM Treasury and Small Business Service, 2003) over the three-quarters of a century since the Macmillan Report have broadly echoed its findings that the capital markets are frequently discriminatory against smaller firms.9 However, the phenomenon is not unique to one nation but universal to market-based economies obliged to make judgments on partial information. It is perhaps not the longevity of the gap that is surprising but, rather, its continuing notoriety. That the gap remains an issue of substantive debate (HM Treasury and Small Business Service, 2003) is in large part because of the changing nature of the enterprises aﬀected by capital constraints. The financing problems experienced by firms which could be classified as ‘high-tech’ or ‘R&D intensive’ (Butchart, 1987; OECD, 1997) only gained visibility in the latter quarter of the twentieth century. The use of the term ‘knowledge economy’ with its implication of intangible (and thus un-bankable) intellectual assets is similarly recent (Sweeney, 1977). Murray (1995) and latterly Sohl (1999) have both argued that the use of the term ‘equity gap’ in the singular is a misrepresentation of the harsher realities faced by the young and growing firm in its vulnerable years prior to the accumulation of suﬃcient collateralbased assets or reputation. They both suggest that there exists a second equity gap represented at the stage where seed or start-up capital had been exhausted and no additional providers were prepared to ‘follow-on’ from the original external investor. For small earlystage venture capital funds or business angels with limited resources to fund follow-on rounds without the participation of new syndicate partners, the absence of external cofunding also severely prejudices investment performance. This discussion implies the delineation of a range of funding which is considered to be within the equity gap problem. The UK government believes that the gap exists for small firms seeking investments broadly between £500 000 to £2 million (HM Treasury and Small Business Service, 2003). Yet, its exact quantification remains vague and inconclusive. The term, and its estimation, is frequently anecdotal. More than one gap has been identified for more than one reason (Lawton, 2002; Sohl, 2003). The institutional venture capital industry largely denies the import of the gap arguing that there are few supply-side constraints. Rather, they counter that the (demand-side) failure is in the quality of the entrepreneurs seeking risk capital (Queen, 2002). Causes of market failure when investing in knowledge-based industries The term equity gap nicely describes a financing constraint aﬀecting high potential but as yet immature and vulnerable businesses. The actual reasons causing investors to provide insuﬃcient finance are embedded in the investment process and the risks and reward that such investment decisions will incur. Further, there is an operational question of materiality. The investment process has high sunk costs and often little advantages of scale. Thus, small investments may incur transactions costs out of all kilter with the probable benefits of the investment. In these circumstances, a rational and informed decision not to invest in an early stage venture cannot be seen as a market failure. On the contrary, it is the market working eﬀectively. None the less, there are genuine sources of market failure aﬀecting new knowledge-based firms. Two are particularly pernicious: information asymmetries and R&D spillovers.

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Information asymmetries In extremis, a highly innovative but immature technology employed to produce novel products and services provided to new customers by a technically knowledgeable but commercially inexperienced entrepreneur (possibly coming from a university environment) and who is starting a new enterprise provides a full spectrum of the sources of potential risk that the venture capital investor has to manage (NEFI, 2005). At its earliest stages, the technology is not proven in its applications. Even if the technology works as it is envisaged, it will be used to create products and services which are not yet widely available nor in some cases even fully comprehended by either future suppliers or users. In such circumstances, how does the firm or its investor(s) determine the attractiveness of products or services that as yet do not exist? These information challenges will remain while the company grows (see Box 4.1) up until that extremely unlikely event that the technology attains a dominant position and becomes comprehensively understood as an industry standard. Thus, we can have simultaneously technology risk, market risk, managerial risk and financial risk, each impacting on a new high-tech enterprise (Amit et al., 1990; Storey and Tether, 1998). Multiple decisions have to be made, often very quickly, on highly imperfect knowledge. As Amit et al. (1990) contend, less able entrepreneurs will choose to involve venture capitalists, whereas the more profitable ventures will be developed without external participation because of the adverse selection problem associated with asymmetric information. Amit’s argument implausibly assumes that unknown entrepreneurs, regardless of skills, have alternative and suﬃcient sources of finance available.

BOX 4.1 ● ● ●

● ● ●

●

INVESTMENT RISKS IN NEW TECHNOLOGYBASED FIRMS

Exceptional technical entrepreneurs are rarely competent or experienced business managers. Project assessment and due diligence are highly problematic in areas concerning ‘leading edge’ technologies. Uncertainty is compounded by the need to analyze both technological feasibility and the existence of a sufficiently large and attractive market (often for a product which does not yet exist). The speed of the change and the threat of technological redundancy often require an extremely rapid rate of commercial exploitation. Competitive response and the availability of alternative products/services are likely to be rapid in dynamic and attractive new technology markets. Successful NTBFs need to grow, internationalize and develop second generation products in a very short time horizon.These imperatives place exceptional managerial, financial and technical demands on a new business. The scarcity of large, liquid and technologically informed capital markets increases the uncertainty of the future financing of the investee firm and the profitable ‘exit’ of the venture capital investor.

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Risk is a computable state based on estimated probabilities. Thus, seed, start-up and other early-stage investments in unique enterprises where no prior history exists are particularly problematic. Without reference benchmarks, investors also face incomputable uncertainty of a Knightian nature (Knight, 1921). Audretsch and Keilbach (2004), in referring to new technology environments, uses the term ‘hyper uncertainty’. The use of quantitative approaches is eﬀectively nullified in such a speculative and volatile environment. The main implication of this situation is that the presence of nonquantifiable uncertainty aﬀects commercial decisions by amplifying their perceived risk components (Einhorn and Hogarth, 1985; Kahn and Sarin, 1988; Ghosh and Ray, 1997). As a result, early-stage venture capital investments may oﬀer investors the prospect of little confidence of higher returns but with a considerable likelihood of project failure. In such circumstances, the abandonment of seed investments in favor of later stage deals by commercial investors can be viewed as highly rational (Dimov and Murray, 2006). R&D spillovers Audretsch (2004) also observes that it cannot be assumed that desirable spillover eﬀects, that is whereby society at large gains access to and benefits from the availability of a valuable new innovation, are automatic. The entrepreneur is a critical agent in the dissemination of innovative ideas. In early-stage classic venture capital activity, a majority of investments in a portfolio will either fail or return (at best) a negligible net present value when the time cost of money and an appropriate risk premium are computed (Fenn et al., 1995; Murray and Marriott, 1998; Rosa and Raade, 2006). Where attractive net returns are made by the fund, it is likely to result from the realization of a small minority of exceptional investments within the portfolio (Huntsman and Hoban, 1980; Bürgel, 2000). Given these uncertainties, the venture capital investors will seek to ensure contractually that when abnormal rents are generated they are owned by the investors (van Osnabrugge, 1999). Hence, the attention given by technology investors to ensure that they have strong patent protection (Salhman, 1990; Kortum and Lerner, 2000). Indeed, the investors’ ability to appropriate the commercial benefits of their actions is likely to aﬀect their original investment decision. None the less, the full value of a novel technology and the consequent stream of new products and services are rarely harvested in their entirety by the investors. Competitors may emulate and copy key attributes, both legally and illegally. The bargaining power of suppliers or customers may also erode the innovator’s surplus rents (Griliches, 1992). In a study of 600 high-tech start-ups in Germany and the UK, Bürgel et al. (2004) found that the high-tech young firms experienced their first serious competitive threat after a median period of 16 months of sales. In these circumstances, both entrepreneurs and investors may well feel that the enterprise risks and uncertainties are too high and their ability to secure both full and attractive returns from successful technology enterprises are too doubtful. This is likely to result in an undersupply of investment regardless of the fact that the existence of the innovation has benefits to a wide range of parties. Griliches estimates that the gap between the private and the social rate of return spans 50–100 per cent of the private rate of return. Small firms because of their lesser market power and inability to finance the aggressive defense of intellectual ownership infringements are particularly likely to see an erosion of their returns (Mansfield et al., 1977).

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Policy challenges in the venture capital arena Based on a near universal admiration as to the vigor of the US innovation financing system, several governments have sought to emulate elements of the American venture capital system. The assumption is made, often implicitly, that elements of a system may be isolated and applied within other diﬀerent contexts. This raises a set of issues of both theoretical and operational complexity that policy makers ignore at their peril. The influence of a US exemplar Given the noted hegemony of the USA innovation finance system, it is legitimate to question what can be learned from the American experience of venture capital activity and readily applied to other national economies both in the developed and developing world. Yet the simplicity of the question betrays an ignorance of both ‘path dependency’ (Kenney and von Burg, 1998) or what it is that can actually be made transferable even assuming that the environmental and institutional conditions (for example tax regimes, legal and corporate governance structures, and so on) exist for such a transfer to be possible.10 Gilson (2003) is explicit in his assertion that others cannot follow USA experience in order to reach ‘the holy grail’ of a flourishing venture capital market modeled on Silicon Valley. He notes that because of the US industry’s highly idiosyncratic history, ‘the manner in which the US venture capital market developed is not duplicable elsewhere’ (p. 3). He goes on to argue that other countries might be obliged to use public policy measures given the inability to copy another country’s history.11 State interest in entrepreneurial action has moved from exhortation to involvement as many commercial investors have abandoned early-stage equity finance (Sohl, 2003; Cumming et al., 2005; Coller Capital, 2006). General and limited partners’ actions are an articulate judgment of the economic attractiveness of the early-stage market. Their desertion has left a financing (equity) gap that governments have felt obliged to try and fill. This move from early to later stage deals (‘style drift’) is most evident in European venture capital markets. However, it is not an exclusively European phenomenon. Gompers (1998) shows that US investors also moved to later stage deals as the size of the finance under management by venture capital general partnerships increased rapidly in the late 1990s. This same phenomenon was earlier described by Bygrave and Timmons (1992) and more recently by Branscomb and Auerswald (2003). The specific problem of minimum fund scale ‘Ask an LP what he thinks of investing in European venture tech and he is likely to respond “what is European venture tech”?’ (European Venture Capital Journal, November 2004). The single biggest problem – facing both governments keen to encourage early-stage investment in new technology-based firms as well as for general and limited partnerships prepared to consider early-stage risk capital investment activity – is simply put. With very few exceptions, the investment record of early-stage funds worldwide has been very poor (European Venture Capital Association, 2005). The general exceptions to this rule over the long term have been from the upper quartile of US technology investors. The consistency of poor venture capital returns in Europe has been so uniform as to make a number of institutions question whether Europe actually has a viable, early-stage technology investment activity (Ernst and Young, 2004).

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Table 4.1

Long-run investment returns to venture capital and private equity in Europe

European private equity funds formed 1980–2005. Net returns to investors from inception to 31 December 2005 Stage Early stage Development Balanced All venture Buyouts Generalist All private equity

Pooled IRR

Upper Quartile

Top Quarter IRR*

0.1 9.2 8.3 6.3 13.7 8.6 10.3

2.3 9.0 8.5 6.2 17.8 8.8 10.6

13.6 18.8 23.7 17.1 31.8 10.3 22.9

Note: * The top quarter IRR is the pooled return of funds above the upper quartile Source: Thomson Financial (venturexpert database)

The pooled IRR statistic of all ventures for Europe of 6.3 per cent p.a. in Table 4.1 can be compared to the US equivalent of 16.5 per cent p.a. for the period 1986–2006 (both sets of statistics are from Thomson). Söderblom and Wiklund (2005), in seeking to determine robust reasons for the apparent consistent diﬀerence in performance between US and European early-stage venture capital funds, reviewed over 120 academic papers. They concluded that the following venture capital firm-related variables appeared to be repeatedly associated with successful professional equity investments: ● ● ● ● ●

Industry specialization (knowledge eﬀects); Large fund size (scale eﬀects); Strong syndicated deal flow (network eﬀects); Management and technical competence (human capital eﬀects); and Large and rapid investments per successful enterprise (implementation eﬀects).

Collectively, these firm-level influences can be interpreted as the positive application of ‘scale and scope economies’ to the risk capital investment process. Murray and Marriott (1998), in a simulation of early-stage venture capital fund activity, showed that fixed costs have a severe eﬀect on the net performance of small funds. Excess costs particularly fell on the venture capital firm or general partner (Figure 4.1). This view is also corroborated by Dimov and Murray’s (2006) analysis of the supply determinants of seed capital in their investigation of seed capital fund activities from 1962 to 2002. They showed that the most active seed investors over time were almost exclusively large and well established US funds. The top five venture capital investors active in seed capital which were all US based12 had, on average, made 92 seed investments from total funds under management of nearly $4 billion per venture capital firm.

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50 40 30 I R 20 R

Limited Partners’ IRR Management IRR

% 10 0 7.5

10

15

20

25

30

35

40

45

50

–10 –20

Fund size £ million

Figure 4.1 Simulation model of the eﬀect of fund size on management’s and private partners’ returns (Murray and Marriott, 1998) Small is not beautiful The most conspicuous outcome of these studies is to challenge the apparent willingness of policy makers to create and to support programs which encourage the formation of sub-optimal, and ultimately non-viable, seed capital funds. Here, the state can be seen as both part of the problem as well as a possible solution to financing constraints. In the state’s absence, few private investors would have participated in such funds. Small, earlystage funds have a series of structural weaknesses that serve to undermine the probabilities that these funds will earn an acceptable risk adjusted return on the finance under their management (Box 4.2). One eﬀect of this sub-optimal fund size is a particularly damaging inability to recruit experienced professional investment executives in a highly competitive market for talent (European Investment Fund, 2005). Insuﬃcient fund size similarly reduces its attraction to institutional investors. These investors including pension funds, insurance companies and other money managers become limited partners in venture capital funds in order to add some controlled exposure to high risk/high reward opportunities (Bürgel, 2000; BVCA, 2000). Because of the multi-billion dollar global reach of these institutional investors, asset allocation has to be material in order to have any eﬀect on the performance of their investment portfolio. In these circumstances, a minority position for a limited partner demands involvement in a fund of suﬃcient scale in order to influence the institution’s overall performance. For all but the smallest institutional investors, a minority position in a closed venture capital fund of under US$100 million is likely to be irrelevant. Thus, a small seed fund’s circumstances often describe the worst of all worlds. It has modest funds to invest and little income with which to execute a strategy of finding and evaluating potential investee firms. It is unlikely to be fully diversified. Investee firms, particularly at start-up, are costly in their urgent need for advice, and the fund has little money to provide follow-on finance for the most attractive prospects in its portfolio. The lack of finance results in either impeding the portfolio firm’s growth plans and/or in the rapid dilution of the fund’s ownership share as syndication finance is arranged. These conditions are very likely to lead to a sustained poor investment record which will severely

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BOX 4.2

NEGATIVE CONSEQUENCES OF SMALL VENTURE CAPITAL FUND SIZE

Small, early-stage venture capital funds bear disproportionately the following dis-economies: ● ● ● ● ● ● ● ●

The high costs of reducing information asymmetries in immature, complex and dynamic markets The high levels of management support & guidance required by earlystage investees The limited ability to attenuate project risks by fully diversifying the venture capital fund The limited ability to invest large sums early in the life cycle of the investee firm The skewed risk/return profile resulting in the need for an exceptional success by the venture capital fund The long NTBF cycle and its implications on fixed term, fund structure/conduct/performance The limited ability to provide follow-on financing in a successful NTBF The danger of excessive dilution of ownership for the original investors in deal syndication

reduce the fund’s ability to survive by attracting subsequent follow-on funds from private sector investors. In these circumstances, policy makers outside the elite technology clusters of the USA are likely to see the earliest and most uncertain stages of equity investment virtually abandoned by commercial venture capital firms. Governments are obliged to come to a view as to their own response to such a withdrawal of private, early-stage funding sources to priority (new technology) young enterprises. Almost universally, they have considered the reduction (or absence) of support for such firms to be strategically and politically unacceptable. Government instruments to promote institutional venture capital finance Government’s influences on the entrepreneurial vigor of a national economy are manifold. For example, the institutional legal and fiscal frameworks (Fenn et al., 1995; La Porta et al., 1997; 1998), the incentive structure of personal and corporate tax systems, the regulatory regime’s impact on business, and the eﬃciency of the market for corporate control will each have profound (albeit not easily predicted) eﬀects on the incentives for entrepreneurial risk taking. As such, these influences also aﬀect the demand for venture capital as an important source of entrepreneurial finance. The eclectic nature of popular policy recommendations (see Box 4.3) reflects the wide spectrum of important influences on venture capital activity. Further, such conditions in order to be eﬀective will in turn have to be embedded in, and legitimized by, a culture of opportunity recognition and entrepreneurial endeavor (Shane, 2003). However, given the dynamic and linked nature of investment activities to both micro- and macro-economic variables, it is not

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BOX 4.3

125

VENTURE CAPITAL POLICY RECOMMENDATIONS

Investment regulations: ● ● ● ● ●

Ease quantitative restrictions on institutional investors to diversify sources of venture funds Support the development of a private equity culture among institutional investment managers Facilitate creation of alternative investment pooling vehicles, such as funds-of-funds Improve accounting standards and performance benchmarks to reduce opacity of venture capital funds and protect investors Remove barriers to inflows of foreign venture capital finance

Taxation ● ● ●

Reduce complexity in tax treatment of capital from different sources and types of investments Decrease high capital gains tax rates and wealth taxes which can deter venture capital investments and entrepreneurs Evaluate targeted tax incentives for venture capital investment and consider phasing out those failing to meet a cost–benefit test

Equity programs ● ● ● ● ● ●

Use public equity funds to leverage private financing Target public schemes to financing gaps, e.g. for start-up and early stage firms Employ private managers for public and hybrid equity funds Consolidate regional and local equity funds or use alternative support schemes Focus venture funding on knowledge-based clusters of enterprises, universities, support services, etc. Evaluate public equity funds and phase-out when private venture market matures

Business angel networks ● ● ●

Link local and regional business angel networks to each other and to national initiatives Ensure linkages between business angel networks and technology incubators, public research spin-offs, etc. Provide complementary support services to enhance investmentreadiness of small firms and increase demand

Second-tier stock markets ● ●

Encourage less fragmentation in secondary-stock markets through mergers, e.g. at pan-European level Enhance alternative exit routes such as mergers and acquisitions (M&As)

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necessarily easy to determine what factors are most important at any one time. Factors that constrain entrepreneurial activity (for example legal and regulatory compliance) may not by their removal necessarily act as an accelerator for greater entrepreneurial endeavor. A full treatment of environmental conditions conducive to venture capital finance is inappropriate in this chapter. Accordingly, we will focus specifically on what measures the state may employ directly to support the actions and eﬀectiveness of both the institutional and informal venture capital industries. The growing status of entrepreneurial activity The late twentieth century saw a coming together of two related trends of 1) an increasing awareness of the importance of small and young firms to the wider economy after Birch’s seminal MIT study (1979), and 2) an appreciation of the changing nature of economic value as represented by the growing importance of innovation via knowledgebased goods and services in mature and developed economies (Nonaka, 1994; Grant, 1996; Spender, 1996). Young high-tech firms were increasingly seen as an important conduit for continuing innovation particularly in fostering disruptive and nonincremental, technology developments (Drucker, 1985; Storey and Tether, 1998; Audretsch and Acs, 1990; Audretsch, 2002; Branscomb and Auerswald, 2003). Incumbent large firms were all too often seen as reactionary and thus vulnerable to adept new competitors (Christensen, 1997). The confluence of these new understandings meant that it was highly unlikely that governments could envisage not supporting entrepreneurial young firms. The ‘political stock’ of small firms increased throughout the 1980s and 1990s. The technology and Internet-related bull markets of the latter part of the 1990s, with their focus on young knowledge-based firms, further fueled public and government interest in entrepreneurial activity. Accordingly, the specific financial constraints faced by young firms in their attempts to grow, and particularly the appropriateness of risk capital finance to high potential, new enterprises, became an increasing focus of policy interest. Despite setbacks, there is also evidence that governments can and do learn over time. The environmental preconditions to eﬀective entrepreneurial action including its financing are increasingly being recognized in policy circles (OECD, 2004; Small Business Service, 2005; US Department of Commerce and European Commission Directorate General for Enterprise and Industry, 2005). Thurik (2003) summarizes Europe’s eclectic policy needs in order to stimulate greater entrepreneurial activity (Box 4.4). Thurik’s span of policy prescriptions reflects closely both the EC’s 2003 document Green Paper: Entrepreneurship in Europe and similarly the UK government’s own 2004 policy roadmap for a more entrepreneurial Britain (Figure 4.2). These enabling environmental conditions set a context in which venture capital programs can operate. The UK model is interesting for its belief in entrepreneurial activity and its comprehensive linking to government departments with both a commercial (for example DTI, Treasury and Inland Revenue) as well as a social mandate (Home Oﬃce). The encouragement of new enterprises in economically disadvantaged communities borrows from earlier experiences of immigration into both the British and US economies. The two above illustrations raise an important issue of policy priorities and focus. Venture capital is an important instrument for promoting enterprise.13 But as the US experience has also shown us, risk capital has played a critical role in the emergence of technology hubs on the East and West coasts. Thus, venture capital is additionally seen

Venture capital and government policy

BOX 4.4 1. 2. 3. 4. 5.

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FIVE AVENUES TO STIMULATE ENTREPRENEURSHIP

Demand side intervention R&D expenditure, stimulating competition Supply side intervention Labor mobility, regional development Influencing input factors Higher education, venture capital market Influencing preferences Attitude/mindset, image of entrepreneurship Individual decision making process Taxes, social security, level of benefits

Drivers of Policy

Productivity

Enterprise for all

Government Vision Many more people have the desire skills and opportunity to start a business Everyone with the ambition to grow their business is helped and supported A supportive business environment makes it easy for all small businesses to respond to government and access to its services

7 National Strategies

Building an Enterprise Culture Encouraging a more dynamic start-up market Building the capability for small business growth Improving access to finance for small businesses Encouraging more enterprise in disadvantaged communities Improving small businesses’ experience of government services Developing better regulation and policy

Source: Small Business Service (2004a)

Figure 4.2

UK government’s model of building an enterprise economy

as a major instrument of innovation policy. The conflation of the two policy goals is likely to result in some contradictions. Entrepreneurship is largely about mass activity including a wider interest in new enterprise at all levels of the citizenry. In contrast, innovation policy is frequently much more meritocratic in nature and seeks the promotion of technologies and enterprises of world-class competitive status. However, as the ‘TrendChart Innovation Policy in Europe’ (European Commission, 2004) report notes, priorities on innovation among EU states include ‘fostering an innovation culture’ and ‘building innovative capacity in smaller enterprises’. These instruments and goals of both innovation and entrepreneurship policies often appear remarkably similar.

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Venture capital intervention typologies As noted earlier in this chapter, governments have restricted their direct financial involvement in venture capital to the more problematic investment stages of seed, start-up and early firm growth (OECD, 2004). Their interventions are premised on a belief of the key role that professional risk capital can make to the innovative capacity of an economy. Hence their near exclusive focus on supporting seed, start-up and early growth stages. In these earliest and most speculative stages, it is still not fully evident that specialist earlystage venture capital investment is an activity than can be eﬀectively mediated through a market mechanism as apposed to directed grants or subsidy alternatives. As noted, this uncertainty is exacerbated by the historically poor returns to early-stage venture capital activities. Outside the special case of the United States ‘high-tech’ industries prior to the year 2000, risk-return characteristics have consistently been unfavorable for investors wishing to engage in early-stage ventures (Murray and Lott, 1995; Murray and Marriott, 1998; Lockett et al., 2002; Rosa and Raade, 2006).14 In direct contrast, the later stages of venture capital and private equity have been consistently profitable with management buy-outs becoming the European industries’ dominant product (Wright et al., 1994; EVCA, 2005). Private equity does not exhibit comparable problems of insuﬃcient scale or information asymmetries. Thus, government involvement in such later-stage actions is rare other than in the setting of the appropriate enabling legislation (Wright and Robbie, 1998). Having made the decision to intervene in the market for early-stage venture capital, the state has to decide what form of intervention will be most eﬀective for what purpose. While there are a number of national studies of venture capital programs (Lerner, 1999; Dossani and Kenney, 2002; Maula and Murray, 2003; 2007; Ayayi, 2004; Lerner et al., 2005), the value of such precedents is in part obscured by the specificity of the programs to their national context (Jääskeläinen et al., 2006). None the less, the risk capital decisions of government can be pared down to two generic choices: 1.

2.

Direct intervention – government as venture capitalist. Government may elect to become its own venture capitalist and undertakes all the roles that would otherwise be the responsibility of a rent-seeking, market intermediary. Here, the government run, venture capital firm has to undertake all the selection and due diligence, governance and nurturing duties incumbent on an early-stage risk capital investor. Given that the government is investing public finance in order to fulfill its role, the state assumes simultaneously both the roles of general and limited partner in the public fund. Indirect intervention – private venture capital firms as agent of government. Alternatively, government can delegate executive responsibility to a private venture capitalist fund manager. This is often done on the assumption that the state has neither the professional skills nor the experience to be a ‘direct’ risk capital investor. Once operational responsibility has been assumed by a private general partner agent, the position of the state becomes analogous to that of a limited partner in a traditional limited liability partnership (LLP) fund. Limited partners are not able to intervene in the operations of the fund manager at the risk of losing tax status privileges. Similarly, the government’s operational involvement ceases once the focus and mode of operation of the fund has been agreed and public monies committed. Indirect intervention via equity enhancement schemes is becoming the dominant contemporary mode of

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public involvement as the importance of highly skilled, and properly incentivized, investment managers is recognized (Gilson, 2003; OECD, 2004). Government uses multiple incentives with which to encourage the involvement of private venture capital agents. It will exploit the power of the state to provide additional and cheaper finance to the fund thereby allowing a leverage aﬀect to increase ‘up-side returns’. Government may further reduce the costs of the venture capital fund by contributing to a proportion of the operating costs of the fund. However, such operating subsidies are less common than alternative measures with a direct incentivizing eﬀect on the fund’s performance. Finally, the state may change the risk/reward profile of the fund by underwriting part or all of the risk of financial loss to the limited and general partners. Direct public involvement The state as a direct investor creates some challenging issues. First, there is the question as to whether government has appropriate personnel capable of carrying out such commercially sophisticated activities as equity investment in early-stage firms. It is unlikely that such persons are widely available as civil servants. Secondly, the state by its size and influence inevitably will create an impact – for good or ill. Thirdly, that the state has to assume the role of a direct investor may be seen as a consequence of its failure to incentivize a private market to take on this largely commercial role. A number of countries do have direct investment via public bodies. The Finnish Investment Industry program with civil servants investing public money directly into young enterprises primarily to fulfill government policy goals would meet this definition (Maula and Murray, 2003). Similarly, the Danish government financed VaekstFonden (Business Development Finance) also has a direct venture capital investment activity.15 Yet these programs raise some very considerable issues regarding the conflict between policy and commercial goals. As noted, direct involvement in new venture investment by government agencies carries a material risk of market disruption through the potential misallocation of capital and the possible ‘crowding out’ of private investors (Leleux and Surlemont, 2003). These undesired eﬀects can be due to both the commercial involvement of inexperienced public service personnel, who may often control substantial levels of finance relative to the total supply of early-stage venture finance in a market. In addition, there may be diﬀering return requirements of public investors (OECD, 1997; Manigart et al., 2002; Armour and Cumming, 2006). Government funding can further distort private markets by oﬀering finance which does not fully reflect the appropriate risk premium (Maula and Murray, 2003; 2007). Venture capital is a ‘learned’ activity (Bergemann and Hege, 1998; Shepherd et al., 2000; De Clercq and Sapienza, 2005). General partnerships often need the experience of managing and investing multiple funds before they have accumulated suﬃcient technical and market knowledge to provide their investors with acceptable returns (Gompers and Lerner, 1998). Many public programs have recognized the possible adverse eﬀects of government inexperience on market outcomes. None the less, government’s direct intervention in the supply of venture capital has frequently been defended on market failure arguments without reference to the eﬃcacy of such actions. It is perhaps inevitable that criticisms of market distortion have been leveled at such public programs. For example,

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the Canadian Labor-Sponsored Venture Capital Corporations – a program with both commercial and social goals and made attractive to individual investors via substantial federal tax breaks – have been accused of crowding out private venture capital activities (Cumming and MacIntosh, 2003). Indirect or ‘hybrid’ public/private venture capital models The OECD has used the term ‘hybrid’ to describe the structures where government and private interests work in concert as co-investors, that is limited partners, in a fund. Such structures are seen as an element of ‘best practice’ (OECD, 1997; 2004; US Department of Commerce and the European Commission, 2005). In eﬀect, the venture capital firm or general partner is acting as an ‘agent’16 for a group of principals (limited partners), one of which is the state using public monies. Governments’ history as active investors selecting commercially attractive projects is problematic at the very least with many illustrations of adverse selection. ‘Spotting winners’ among young and growing companies is fraught with danger (Hakim, 1989) and denies the stochastic nature of the firm formation process. A general conclusion from the last half a century is that government would do well to avoid placing itself in a position where it has to make nominally economic decisions that are bounded by other, usually political, conditions (OECD, 1997; Modena, 2002; Gilson, 2003). There appears to be a growing consensus on the limited role of government as a direct investor. Contemporary venture capital programs in, for example, the USA, the UK, Australia, New Zealand and Germany have each used private venture capital firms to invest on behalf of government in areas of new enterprise deemed important for policy reasons. The parallel involvement of both public and private investors can be seen in Figure 4.3. That the state would wish the participation of private investors to support its policy goals is self-evident. But why commercial investors would be prepared to be involved as limited partners in such a hybrid activity needs further explanation. Such an arrangement may do little to alter expected outcomes that led to the supply side, market failure in the first place. Thus, the involvement of the GP and any private sector LPs17 in the fund will frequently require the engineering of more attractive profit expectations in order for them to participate (Gilson, 2003; Maula and Murray, 2003; Hirsch, 2005; Jääskeläinen et al., 2006).

Private investors

Private Investment

‘Uncapped’ Profit share

Loan or Equity

Early-stage fund

Start-up & growing SMEs Source: Small Business Service (2004b)

Figure 4.3

Generic ‘hybrid’ venture capital model

Government

‘Capped’ Profit share

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In discussing the evolution of diﬀerent incentive structures in government’s support of venture capital, it is important to acknowledge the contribution of the Small Business Investment Company program created by the US Government’s Small Business Administration.18 The basic model of an ‘equity enhancement’ program by which the state’s involvement (either by direct investment or acting as a guarantor to other fund providers) enables additional and cheaper funds to be raised – thereby creating a leverage advantage to private investors – has been reflected in venture capital programs worldwide. It should be stressed that the full value of the Small Business Investment Company program in its various forms (that is bank owned, debenture and participating securities funds) was not restricted to the net returns generated by the funds. Indeed, the investment performance of these funds has been highly variable over time (Small Business Administration, 2002; 2004). Rather, the value of the program has been in the espousing of novel public–private experiments used to address the problem of the inadequate supplies of risk capital for young firms across a range of communities. Of critical importance, the Small Business Investment Company program also enabled a generation of US investment managers to obtain their first commercial experience of venture capital activity via government supported funds. There is an ‘infant industry’ argument for interceding in immature markets (Baldwin, 1969; Irwin and Klenow, 1994). In the UK, the governmentconceived venture capital firm, 3i plc and its predecessor ICFC, performed a similar industry development role from 1946 until the late 1980s (Coopey and Clarke, 1995). Public-funded incentives in hybrid funds Hybrid funds illustrate the imperative of government action in strategically important investment categories where consistently poor returns have precipitated a major reduction in private finance for young enterprises. Such structures also acknowledge that good investment managers will rarely tolerate the state having an executive role in their funds. This impasse is resolved by the use of government finance to incentivize private managers to engage in more risky, early-stage funds. It is the ‘hands-oﬀ’ provision of government leverage finance that has appealed to professional investment managers mindful of the need to increase fund scale in the challenging early-stage markets and frequently faced with private investor indiﬀerence. The term ‘equity enhancement’ is accurate. The state needs to incentivize the general and limited partners to be prepared to engage in a fund that includes public welfare goals as part of its raison d’être. In the absence of explicit economic incentives, there is little logic for profit maximizing, private agents to become involved. Pari passu funding, whereby the state and private investors provide investment finance on equal terms, only works where the returns to private investors are attractive enough without needing to skew the return distributions to private limited partners’ advantage. The state is obliged to enhance the returns to the general partner and to the other commercially motivated limited partners in order to attract private investors’ commitment to the co-investment model. Essentially, the public investor forgoes some of its rights to a pro rata share in the economic returns of the fund. Given that the state is often the largest single investor in the fund, a reduction of its share of any net capital gain can leverage a material increase to the other parties’ returns in the event of a moderately successful fund. In all cases, the state as a ‘special’ limited partner does not influence the commercial and executive decisions of the fund managers once the investment criteria of the fund are determined.

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Relative distributions of surplus are agreed ex ante. Hybrid funds commonly employ one or more of a range of incentive structures: 1.

2.

3.

4.

Capped returns to the state: the public limited partner invests at a rate which is commonly fixed at approximately the government’s cost of capital.19 Once this return threshold has been met from the proceeds of the sale of any portfolio companies, any further positive cash flows are exclusively shared between the other commercial LPs and the GP via its ‘carried interest’. Diﬀerential timing of limited partners’ cash flows (‘first in and last out’): for the general partners of the venture capital firm, their performance will be largely measured and communicated by one universal metric – the Internal Rate of Return of the fund.20 When the state is the first investor to have its committed finance fully drawn down and the last investor to have its monies returned with any associated surplus, the shorter investment period of the other private LPs directly benefits their returns. Again, the performance enhancement of the private or commercial partners is at the direct cost of the public partner. Guaranteed underwriting of investment losses incurred by the limited partners: government may seek to influence the investment decision by removing all or a large part of the costs of portfolio failure. Usually, a percentage of committed investments is guaranteed which may often vary from 50–75 per cent of investors’ costs. The guarantee may be on a fund or on individual portfolio investments. However, the guarantee schemes do not, in themselves, improve the returns to investors but rather cap losses. Thus, it is common for a guarantee to be put in place in addition to some other incentive which leverages the upside of a successful investment. Buy-back options: buy-back options give the private investors the opportunity to purchase the entirety of government’s interest in a program at a pre-determined time during the public/private program. The terms of the exchange are arranged ex ante and thus present the private investors with a clear incentive and opportunity for an early exit of the state as co-investor. Essentially, the facility is a purchase ‘option’ which may be exercised at some stipulated future date when economic future of the investment is possibly indicated but not fully known. One of the most admired of such programs was the Israeli Yozma program (1993–98). Seven countries have subsequently modeled programs on this Israeli experience.21

A list of a number of existing government-supported venture capital structures that have adopted one or more of the four described incentives programs is given in Table 4.2. Despite the increasing popularity of government involvement in hybrid, venture capital funds, rigorous evaluation of their eﬀects is limited. Evaluations have been undertaken on such schemes in the UK, New Zealand and Australia.22 However, unabridged evaluations are rarely available in the public domain.23 Thus, while we may assume that subsequent program rounds have learned from policy experience, our overall knowledge of contemporary venture capital policy actions and outcomes is limited. Agreed evaluation methodologies and the ability to compare and contrast across program and country are each urgently required in an area of government interest and action of increasing scale (Lundström and Stevenson, 2005).

Venture capital and government policy Table 4.2

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Publicly financed venture capital ‘equity enhancement’ schemes Examples (present & past)

Feature

Description

Incentive eﬀects

Public investor co-investing with private investors

Government matching the investments by private investors

Helps in setting up a fund. Also helps to build a suﬃciently big fund to benefit from economies of scale However, investing in pari passu with private investors does not have direct incentive eﬀects i.e. it does not improve the expected returns for private investors in market failure segments such as early stage

50% of the fund: Europe/EIF Finland/FII Israel/Yozma 50% of the fund: Australia/IIF and Pre-seed Fund USA/SBIC and SSBIC UK/regional venture capital funds

Capped return for public investors

After all the investors (including the public investor) have received certain IRR (e.g. interest rate perhaps some risk premium) the rest of the cash flows are distributed to private investors only

Capped return for the government increases the expected IRR for private investors. The incentive eﬀect is such that it increases the compensation for good performance. This in turn creates a strong incentive for the private investors to incentivize the general partners to make successful investments and add value to portfolio companies

UK/regional venture capital funds Australia/IIF and Pre-seed fund

Buy–out option for private investors

Private investors are given the option to buy the share of the government at (or until) a specific point of time at predetermined price (typically nominal price interest rate)

The eﬀect of buy-out option on the IRR of private investors is quite similar as the eﬀect of ‘capped return’ of public investor. However, there are two additional benefits: 1) The buy-out option gives both the public investor and the private investors an opportunity to demonstrate success earlier and more visibly than in the capped return alternative 2) In the case of success, government gets a quick exit from the fund and can put the money to work again instead of waiting for the returns on fund termination

Israel/Yozma New Zealand/New Zealand Venture Investment Fund

Downside protection

Downside protection means the government

Downside protection has a negative eﬀect from the incentive perspective. While downside

Germany/WFG Germany/tbg & KfW France/

Chile/CORFU

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Table 4.2

Feature

(continued) Examples (present & past)

Description

Incentive eﬀects

underwriting losses from the portfolio

protection helps support the IRR, it decreases the diﬀerence in returns for private investors and the management company between successful and unsuccessful investments. The eﬀects of good selection and value-added eﬀorts have a lower impact on the performance of the fund

SOFARIS Denmark/ Vaekstfonden (Loan Guarantee Scheme)

Fund operating costs

Government gives a subsidy for the management company to cover some of the costs from running the fund

The fund operating costs are neutral from the perspective of incentives to fund management or LPs while increasing the IRR of the fund

Europe/European Seed Capital Scheme

Timing of cash flows

Ordering of the cash flows so that public investor puts the money in first and gets the money out last

The IRR of the private investor can be enhanced through timing of cash flows improving the attractiveness of the fund

UK/Regional Venture capital Funds

Government’s role in venture capital ‘funds of funds’ The hybrid venture capital fund structure assumes that government is the co-partner and limited partner to an individual fund. In the ‘fund of funds’ option, the government does not signal preference for any one fund but supports investments in a range of funds that are sanctioned by the general partner management. The fund of funds manager, acting as an allocator of limited partners’ commitments, allocates finance to specific venture capital funds, not to individual investments. While several such fund of funds exist, governments tend to invest only in such groupings that specifically target young and high potential firms of policy interest. In France, the Fund for the Promotion of Venture capital (Fonds de Promotion pour le Capital Risque – FPCR) was set up in 2001. With €150 million, including European Investment Bank support, at its disposal, the FPCR has invested in 10 French venture capital funds. Investments are geared towards innovating companies less than 7 years old in sectors where it is diﬃcult to mobilize private funding, that is life sciences, ICT, electronics, new materials and environment and sustainable development. The UK equivalent is the UK High Technology Fund. This fund of funds, set up by government in 2000 and managed by a commercial investment company, has raised £126 million, of which £20 million only came from government. It invests exclusively in specialist technology venture capital funds located in the UK. This fund of funds also

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attracted EC assistance via the co-investment of the European Investment Fund. It is as yet too early to appraise the performance of either of these programs. Government policy and informal investors (business angels) So far in this chapter, discussions have focused on policy actions in the institutional market for risk capital. Thus, the unit of analysis has been the established, and often very visible, venture capital firms or general partnerships. Yet, advocates of the importance of business angels have repeatedly noted that the scale of the informal supply is likely to dwarf that of the institutional venture capital in all developed risk capital markets. There is clear evidence of this disparity in the US and the UK where both types of investor co-exist. This argument regarding the scale, and thus potential for economic transformation via business angels, is strongly made and mutually re-enforced by authors Mason, Kelly, Riding, Madill, Haines and Sohl writing in this book. Accordingly, governments concerned at the eﬀective supply of financial and business-related support to young and growing companies have increasingly become interested in informal investors or business angels.24 As Kelly rightly notes, government interest in these ‘publicly hidden’ investors was materially influenced by the work of pioneering academic researchers both in the USA and Europe. Given that three chapters in this book are devoted to diﬀerent aspects of business angel research and practice, this author will not repeat the analysis of acknowledged experts in the field. Rather this section will remain exclusively within the policy focus of the chapter and will look at how governments have sought to promote a vigorous and successful business angel sector. Investors of first resort Van Osnabrugge (1999) ‘guesstimates’ that business angels provide between 2–5 times the amount of finance to entrepreneurial firms in the US and possibly invest in up to 40 times the number of portfolio companies compared to institutional venture capital firms. Bygrave et al. (2003), using GEM data on 15 nations, subsequently oﬀer more modest diﬀerences in business angels’ favor of 1:1.6 in respect of funds allocated. Sohl (1999) argues that the ratio of understanding of business angels compared to their impact on the economy is lower than just about any other major contributor. Bygrave et al. (2003) support this view noting that entrepreneurs – and policy makers – should pay far less attention to institutional venture capital activities. They observe that new enterprises, including those involved in the commercialization of revolutionary research, are much more likely to be self-financed or gain support from business angels rather than from classic venture capital firms. In an international venture capital and private equity industry which is becoming increasingly dominated by scale, those parochial investors that are prepared to undertake local investments within the equity gap spectrum are an increasingly valued asset. The overall trend is for an increase in size, and thus concentration of venture capital funds, that continues to militate strongly against small investments.25 A complement to institutional investors In an ideal policy maker’s world, one might envisage informed and highly experienced business angels being the predominant seed capital providers to nascent businesses. Through their own commercial experience in allied sectors or activity, they would be able to oﬀer the new enterprise valuable practical experience of running a young company. Of

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equal value, they can provide a ‘certification eﬀect’ allowing fledgling entrepreneurs access to valuable commercial networks (Birley, 1985; Stuart et al., 1999; Steier and Greenwood, 2000), as well as oﬀering timely and pertinent advice on markets, production and so on. As the investee firm starts to grow and to demonstrate a major economic opportunity, the business angel could be the conduit to institutional venture capital. With firm growth accelerating, the influence of the business angel would give way to the more structured and ‘enterprise nurturing’ skills of the venture capital firm (Harrison and Mason, 2000). However, as with formal investing, practice is likely to fall short of idealized expectations. The business angel invests his/her own money and thus does not need to meet external regulatory standards. The venture capital firms are handling investors’ monies and must therefore be registered with the appropriate financial regulators. The former can act as idiosyncratically as they wish. Hunch, gut feel and subjective stimuli are all found to be important investment decision criteria. The institutional venture capital manager is much more likely to undertake industry-specific training and to have clear guidelines from both the general partners of the fund as well as industry guidance from the national venture capital industry association on due diligence, deal pricing, use of share structures, legal contracts and so on. Accordingly, unless well known and trusted by the venture capital investor, the idiosyncratic and untrained business angel is likely to be viewed with mistrust as an investment syndicate partner. As Kelly wisely notes: ‘complementarity’ does not presume ‘compatibility’. Business angels as a policy focus The three writers on business angels in this volume each make some brief observation on the policy implications of business angel activity. Mason, looking at the spatial dimensions of investment, argues that a supply of attractive investments will generate the supply-side response of adequate investments funds. His argument strongly reflects the venture capital communities’ argument that eﬀective demand (that is quality of proposals) is the greatest constraint to early-stage financing. Perhaps more interestingly Mason and Harrison (2003) have argued that the UK government, by promoting the Regional Venture Capital Funds program to address both spatial and early-stage inequities, have misunderstood both the nature of the problem and its prescription. They make a telling argument that business angel finance could be a much more appropriate response to such problems. Kelly mentions the three related problems of an excess demand for business angels’ equity finance from would-be entrepreneurs; the information asymmetry or search problem of investors and firms not knowing that each other exists; and the incentives problem of getting ‘virgin’ business angels to turn intention into tangible investment activity. Finally, Sohl addresses four areas of policy including promoting better linkages, sponsoring research in the field, more education of business angels, and unambiguous incentives for business angels to take the risks of equity finance. How government has actually sought to tackle the issue of stimulating informal investment will be addressed in the following sections. Targeting business angels as individuals Government has generally adopted a two-pronged strategy to facilitate the supply of informal investors in the national and local market. Firstly, they have had to address the ‘indirect measures’ (OECD, 2004) of taxation in order to ensure that the incentives available to private investors are commensurate with the level of (undiversified) risk that they

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have to assume. The major suppliers of venture capital at the institutional level are frequently tax exempt in the most developed venture capital economies, that is pension funds, insurance companies and university or family trusts.26 But for informal investors, the means by which successful investments are made and recouped are profoundly influenced by the detail of the prevailing personal taxation regimes. The OECD’s view is that it is counter-productive for a private investor to incur such high taxation and other costs that they reduce the underlying logic for making the original investment. It is diﬃcult to argue with this orthodoxy. A number of countries have ‘front end’ incentives that give significant income tax shelters for bearing the cost of entrepreneurial activity. In the event of a successful investment realization, Capital Gains Tax may be delayed or removed from investments held for specific lengths of time. Such fiscal incentives exist in, for example, the US, the UK, France, Ireland, Belgium and Canada. Because business angels are usually relying on their own personal income and wealth for investment activity, the system seeks to incentivize them to remain active investors by improving (and protecting) their returns compared to those parties not involved in the incentive schemes. However, as the OECD also acknowledges, while sophisticated changes to the tax system for high net worth individuals may prompt them to make more investments and/or retain their investments in growing companies for a longer period, it may also confuse other less sophisticated, informal investors. The UK has been one of the developed economies most interested in using fiscal incentives to encourage ‘virgin’ angels. In 1981, the Business Start-Up Scheme was announced. This program, which was the first to oﬀer entrepreneurial investor incentives, evolved over time to become the Business Enterprise Scheme. This was established to enable investors to obtain tax relief when purchasing ordinary shares in unquoted firms seeking seed-corn funds for development.27 It ran ten years from 1983 to 1993. In turn, the Business Enterprise Scheme metamorphosed into the Enterprise Investment Scheme in 199428 in order to provide a revised program that would incentivize individual investors to provide more risk capital funds for the UK’s SME sector.29 In a review of the eﬃcacy of this latter and extant program (Boyns et al., 2003), its authors concluded that the schemes had created significant ‘additionality’, thereby improving the resources available to young firms while increasing investors’ returns. The simplicity of the Enterprise Investment Scheme is particularly attractive to business angels as it makes no attempt to determine investment eligibility other than stipulating the qualifying and non-qualifying categories of investment (see Box 4.5).

BOX 4.5 ● ● ● ● ●

ENTERPRISE INVESTMENT SCHEME (UK): INVESTOR TAX BENEFITS

income tax relief – 20% of amount invested in terms of tax – period to hold shares of 3 years exemption from capital gains tax on shares held for the 3-year period capital losses on shares treated as income losses deferral of chargeable gain on any asset maximum invested per tax year for income tax relief is now £400 000 (€589 000)

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The UK scheme is not unique but rather is more established than many similar programs. It may be seen as an archetype or model given that it replicates the key criteria evident in most programs, namely: ● ● ● ● ●

Higher risk, young companies clearly targeted and specified by age, economic size and type of activity; total tax forgone is capped for both the recipient company and the individual investor; ex ante tax relief given on investors’ income when equity investment made in target business; investment losses can be used in further personal tax computations; and ex post Capital Gains Taxes either avoided or reduced after a minimum holding period.

Based on several countries’ experiences, a European-wide program, the Young Innovative Company Scheme is currently evolving (EuropaBio, 2006). It is proposed that, for eligible investments, no tax is levied on capital gains realized or stocks that have been held for a minimum of three years. The French equivalent of the Young Innovative Company program (that is Jeune Entreprise Innovante) was adopted by the French Parliament in the 2004 Budget Bill. A similar bill, HR 5198, the Access to Capital for Entrepreneurs Act of 2006, was presented to the US Congress in April of this year. Targeting business angels as co-investors These above schemes are directed at incentivizing the individual to invest directly or via a tax eﬃcient, trust fund structure. Government has also increasingly seen the business angel community as an entity that may be incentivized collectively at the fund level in a potentially similar fashion to institutional venture capital businesses. To date, the tax transparency attractions of the Limited Liability Partnership structure have largely been irrelevant to the private investor. Yet, a syndicate of business angels investing cooperatively on projects where the due diligence and other investment costs has been shared, as well as any eventual capital gains, is broadly equivalent to the established practices of the established venture capital industry. In recognition of this reality, the UK government has tried to find means by which it can invest alongside informal investors. Such leverage initiatives have had to address and accommodate the legal issue that the business angel is a personal investor rather than an institutional investor. However, as business angel networks or bespoke syndicates start to manage external funds, these diﬀerences begin to blur. A number of recent developments are noteworthy. Governments may invest as a public limited partner in a fund specifically made up of business angels investors. The UK’s 2004 scheme, the Enterprise Capital Fund, is designed in such a manner as to accommodate both institutional and informal investor groups. The bringing of business angel investors into a legal identity as a group or fund is relatively novel. It addresses the common problem of business angel investors being severely curtailed in the size of personal investments. Historically more common, the state may be a co-investor at the level of individual projects. Such a scheme has been in operation for several years in a primarily institutional venture capital context in Germany via the BTU program. An informal

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investor equivalent is seen in New Zealand’s Seed Co-investment Fund. This latter program that has been designed in the light of UK experience via the publicly co-funded Scottish Co-Investment Fund and the London Business Angel program. These schemes each bear common criteria of informal investor/government interaction: ● ● ● ●

State acts as a co-investor increasing scale of investment available; once conditions of investment eligibility met, the state is passive; criteria of eligible investment defined by age, size and economic activity; and state’s position as an investor is usually subordinate to private investors.

Networks, portals, match-makers and information asymmetries The institutional venture capital industry, like many professional services, may be seen as a dense network of complementary actors associated in the common delivery of specialist financial products and sharing critical information. Overlapping venture capital networks may, for example, be classified by stage of investment, types of opportunity, or location. Issues of access and preference determine a pecking order of venture capital firms and partners eﬃciently calibrated by industry reputations. The intensity of the venture capital locations or clusters in a relatively small number of major cities across Europe, America or Asia further increases the ability to communicate eﬀectively and quickly between interested parties. To date, the venture capital industries have been broadly characterized as country-specific. However, as the venture capital industry matures and leading players grow and expand their locus of operations at the expense of less successful partnerships, the incidence of internationalization has increased markedly (Mäkelä and Maula, 2005; Deloitte and Touche, 2006). Communications between informal investors or business angels compares poorly to the small number of well organized venture capital firms located within the umbrella of an eﬃcient and highly representative industry association. Gilson’s (2003) ‘simultaneity problem’ exists but is much more acute in an informal venture capital environment. A business angel has to signal to would-be investee businesses that he or she is interested in receiving business proposals. At the same time, the informal investor may wish to inform other angels of his/her30 presence and willingness to participate in syndicated investments. This lack of preceding contact, the diverse personal histories of the investors and the absence of physical market places each serve to confound eﬃcient communication. In the absence of such communication, it is similarly diﬃcult to ensure that investment proposals are fairly appraised and sensibly priced. It is not uncommon for an inexperienced investor to face an equally inexperienced entrepreneur with neither party able to assess the quality or the credibility of the business proposal or the financing oﬀered. Such circumstances are very vulnerable to ineﬃcient (or disastrous) outcomes either by chance or design. It is for these reasons that many in the insitutional venture capital industry remain highly ambivalent as to the involvement of business angels in professional venture capital investment deals. The cost of sorting out badly constructed or poorly priced financial arrangements previously arranged between an inexperienced business angel and entrepreneur may be suﬃciently time consuming for the venture capitalist to walk away from providing follow-on finance. As Giﬀord (1997) has noted, the constraining resource for many general partners is management time rather than the flow of opportunities or finance.

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In these circumstances, the involvement of government in activities which increase the information available to investors and/or investees is likely to be productive at modest cost. Similarly, the powerful national venture capital associations also have an interest in ensuring that informal investors looking for early-stage deals that might lead on to institutional venture capital activity are also sensibly advised, financed and structured. The policy benefits of reducing information asymmetries and ensuring deals are properly communicated to an active and deep market appear universally accepted. Accordingly, business angels networks on a local, national and (on occasions) international basis have been supported by both government and institutional venture capital associations. Sohl uses the generic term ‘portal’ to describe this interface between investors and entrepreneurs. Public transfers have also allowed the networks to be suﬃciently well financed to ensure the recruitment of appropriate management and training resources. A dissenting voice Lerner (1998) turns a refreshingly skeptical eye on business angel activity. This is a useful antidote as the business angel literature is often highly evangelical in its arguments. Lerner asks two questions that he contends are too often assumed rather than posed: 1) do private capital markets provide insuﬃcient capital to new firms; and 2) can governments better identify future winning businesses in which to invest? In the absence of robust empirical examination31 of both the contribution of angels and the value-added role of government, Lerner remains a skeptic. Picking up a major theme of this chapter, he notes that the importance of scale is clear, but business angels, with very few exceptions, are commonly characterized by their modest investment resources. Even when bandied together in investment syndicates, they are seldom likely to create an aggregate fund size of >$50 million. In classic venture capital terms, such a small fund size would now widely be seen as uneconomic. Lerner’s concern is that new enterprises of insuﬃcient potential to be financed by institutional venture capital firms are then taken up by sub-optimally sized business angel networks where the range and level of investment skills and experience are highly variable. In eﬀect, the informal investor network is both ‘second best’ in its resources and in the potential assistance that it can oﬀer entrepreneurial firms. Business angels are also far less regulated for minimum quality practices than their institutional equivalents. In Lerner’s arguments, there is an implied ‘trickle down’ process with classic venture capitalists first reviewing prospects and the huge majority they reject becoming part of the raw material of informal investors. Accordingly, he argues that we have at present little proof that fiscal incentive programs funded by the state are necessary to increase business angel activity, nor do we have a clear understanding as to how such programs may best be structured in order to realize policy goals (Lerner, 2002). While Lerner’s argument remains cogent, the assumption that business angels are second best to institutional venture capitalists when appraised by early-stage investment performance remains hotly debated. Lerner is supporting those academics who argue that there exists a failure in quality demand (‘investment readiness’ argument) rather than a lack of available risk capital for nascent enterprises (the ‘equity gap’ argument). Yet, in practice, the minimum size thresholds for new investments imposed by the majority of professional venture capitalists are now so high that it is highly unlikely that they would consider investing in a seed or startup investment other than for the most interesting opportunity in a new technology. Such

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speculative and exploratory investment could be viewed as placing a ‘put’ option on potentially important future developments (McGrath and MacMillan, 2000; Miller and Arikan, 2004). Yet, as Dimov and Murray (2006) demonstrate, such an integrated, market intelligence strategy is rarely undertaken by professional venture capital investors outside the largest US firms. Business angels – future policy interest Business angels by their very scale and ubiquity remain a focus of considerable interest to governments. Ironically, it is their lack of activity that makes them so enticing. A modest increase in informal investment activity is likely to have a much larger impact than an equivalent increase in institutional venture capital given the business angels’ predominant focus on early-stage investment. Accordingly, it is likely that business angels will increasingly feature in the enterprise policy activities of developed economies. Countries that facilitate and incentivize personal investment activity via generous fiscal incentives are likely to have an important head start. A number of trends will reinforce the growing policy interest in business angels. As the maturing, venture capital industry gets larger in terms of funds managed (rather than the numbers of venture capital general partnerships), a number of traditional venture capital funds will continue to withdraw from the earliest stage activities as partners experience the need to invest large amounts of fund monies quickly. The relative performance advantages of later stage funds, including private equity investments, will exacerbate this long term trend in Europe. In order to support this rational trend by their venture capital firm members, national venture capital industry associations will increasingly work with government to ensure that business angels receive public support. Such a cooperative industry stance supports the supply of potentially attractive businesses to their venture capital firm members (at later rounds of finance) as well as deflecting government concern of the limited impact of institutional venture capital on national innovation and entrepreneurship programs. Business Angel Networks will be able to exploit this opportunity to argue successfully for greater support (operating grants, coinvestment schemes, and so on) for individual investors and (increasingly) legally defined angel groups. Programs supporting networks’ development, information exchange and investor training, are likely to continue to attract public support at regional, national and international levels. Yet, few public-supported programs are likely to invite independent academic evaluation and scrutiny de novo. Hence the importance of Sohl’s call for more support for empirical research into a major financing activity that, in comparison to its institutional venture capital equivalent, can still reasonably be viewed as terra nullis. What have we learned from public involvement in private venture capital activity? One can argue with some authority that the evidence of government learning in the arena of early-stage risk capital finance is rather poor. Detractors of government’s role could repeatedly point to unviable small fund sizes in public supported programs; the willingness of governments still to manage their own business angel programs outside the incentives and disciplines of the market; the imperfect integration between governments’ entrepreneurial agendas, their fiscal programs and investors’ interests;32 the still underdeveloped role of informal investors; and the poor financial returns on public supported funds. The vigorous growth over the last quarter of a century when venture capital has

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grown to become a major asset class is not reflected in equal successes for public involvement in new enterprise financing. However, the choices which government faces are not often easy or unambiguous. Governments with responsibilities for departmental portfolios of often competing interests have to determine if they wish to intervene in order to correct market imperfections or to realign incentives in a manner congruent with their policy goals. They have to decide how attractive a flourishing venture capital industry would be to the domestic economy, and what can sensibly be done to promote its realization. Yet, while there is considerable and growing governmental activity in the arena of early-stage risk capital investment, the body of knowledge on which this activity is based remains sparse. Lerner (1999) has commented on the absence of theory in guiding public venture capital activity. Similarly, Jeng and Wells (2000) note that just as later and early-stage venture capital investment behaviors are diﬀerent and not necessarily influenced by the same factors, so likewise are public and private venture capital activities diﬀerent. These authors note that we are still relatively poorly informed as to the appropriate role of government in venture capital activity. We lack both a canon of theoretical understanding (and guidance) as well as a diversity of exemplar programs from which we can benchmark progress. Gilson (2003) takes a similar view that governments often undertake programs without a clear understanding as to the full consequences of their actions. In addition, political cycles and investment cycles are rarely likely to be synchronized. There appears a growing academic consensus that sanctioning government intervention is a decision that should only be taken with considerable caution, and perhaps only when private venture capital markets are patently failing. Circumstantial evidence of the large number of sub-optimal, publicly supported venture capital programs operating across the world including the US would suggest that academics’ concerns with the logic of public intervention have frequently been ignored by policy makers (Bazerman, 2005; Rynes and Shapiro, 2005). Yet, to suggest little has been learned and acted upon would be too pessimistic a diagnosis. The ubiquity of entrepreneurial finance programs at local, regional, national and, increasingly, international levels of government are now so omnipresent that some learning is inevitable. There is a burgeoning corpus of research knowledge from scholars based in the entrepreneurship, innovation, management and economics subject areas.33 However, the communication and accommodation of research lessons into contemporary policy actions at national level is still capable of considerable improvement (Söderblom and Murray, 2006). Further, and of equal importance, government usually works in the least attractive areas of a financial market. The public exchequer becomes involved because of the absence of private investors. Accordingly, the situation of diﬃcult investment choices and poor returns is virtually guaranteed. Governments should not be criticized for poor returns per se. Rather, a more apposite question is whether they should rationally hazard public monies by attempting to undertake investment activities in areas so commonly abandoned by informed, experienced and profit-seeking commercial interests. These comments should not be seen as an apologia for harassed policy makers. There is regrettably little evidence that robust research findings are acted upon in new policy formation and execution. It is inevitable that partially informed program designs will have real (and avoidable) costs. Sometimes, in the absence of institutional venture capital research programs, government may too readily accept the convenient results of management consultants or venture capital industry association.34

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To summarize the factors that policy makers may consider in their eﬀorts, a set of broad guidelines based on our imperfect contemporary knowledge is oﬀered: ●

●

●

●

●

●

●

Institutional or informal venture capital programs should harness private investors’ interests and experience as agents of government program goals. Any deviation from this norm should be rigorously evaluated prior to agreement. There are trade-oﬀs between venture capital or business angel program outcomes. Policy makers should be explicit as to the ‘value’ of diﬀerent objectives, for example return on capital, innovation, employment, regional investment and so on in both launching and evaluating programs. There are major economies of scale and scope in venture capital fund activities. Program outcomes should be modeled and simulations tested prior to committing public funds to unviable fund structures. The levels of unmanageable uncertainty at the very earliest stages of venture capital investment in novel technologies may be such that it may not be sensible to allocate resources by markets alone. Venture capital should be seen as only one of a range of financing options that may also include merit-based grants and other support. The premium for managerial and investor experience is high in informed, professional labor markets. Program designers need to reflect on how such tacit knowledge may be best harnessed to address the challenges of early-stage investment. The USA has provided venture capital communities worldwide with a huge stock of experience and expertise. Much of this learning may be valid and relevant outside North America. Some of it will be usable in other and diﬀerent national contexts. It is implausible that a globalizing venture capital industry will, over time, be reliant on one absolute and exclusive model of success. All new venture capital programs involving public funds should have a formal (and independently validated) evaluation model built into the program design stage.

Future academic research opportunities Venture capital studies have reached their adolescence – a period of rapid but awkward growth. In a subject area originally colonized by entrepreneurship and small business scholars, the field has burgeoned (in parallel with a wider interest in entrepreneurship since the early 1980s) to include other managerial disciplines and, above all, economics. While venture capital studies embrace the theories and methodologies of economics, finance, organizational behavior and so on, policy studies by their very nature are pragmatic in purpose. Governments wish to know how to change or improve systems to achieve tangible and cost eﬀective outcomes – preferably quickly and by incremental and non-disruptive changes. Such utilitarianism still sits uncomfortably with some scholars holding purely theoretical interests in venture capital finance. This is not unreasonable. However, for others, the ability to research and influence the actual processes of government in an area with little established public expertise provides both intellectual and professional rewards. With this latter group in mind, the following questions are presented as some domains in which our research knowledge is still wanting. ●

Does the equity gap actually exist? If so, at what levels of finance, who is aﬀected, and are the adverse consequences material?

144 ●

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● ●

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Handbook of research on venture capital Measured by the criteria of venture capital fund survival and acceptable investment returns, are early-stage (seed and start-up) activities a long term viable proposition both within and outside the USA? What policy and operational conditions need to be in place to secure such desired commercial outcomes? Business angels are seen as an alternative to institutional venture capital providers at the earliest stages of investment. Is such an assumption empirically valid? By what means can business angels succeed in early-stage market conditions that are presently hostile to venture capital success? What actions under governments’ control (for example tax incentives, equity enhancement, investor training, network support, and so on) are most eﬀective in stimulating the investment activities of current and potential business angels? By what means can business angels and venture capital firms most eﬀectively work together to support high potential young firms? By what means should public/private ‘hybrid’ venture capital programs be evaluated in order to both capture the economic and social objectives of all participating investors and to allow meaningful cross-program comparisons? Venture capital has evolved to become one of a range of ‘alternative asset classes’ by which financial institutions may seek to engineer the risk/reward profiles of their investment portfolios. The actors involved and the decision processes by which such institutional portfolios are designed remains a ‘black box’. How may researchers address the dearth of empirical studies focusing on the nature of institutional investor decision making? As venture capital activity has internationalized so has the policy response. How may academics best respond collectively to international and comparative studies of venture capital activity? We now have an international and multi-disciplinary body of research into venture capital studies that has chronicled the introduction and growth of risk capital activity across a large number of developed economies in Europe, North America and beyond. Emerging economies in Asia, South America and Eastern Europe are showing considerable interest in the putative role of venture capital in supporting the genesis and growth of new enterprises and industries. How may academics feature in the processes by which emerging economies learn eﬀectively from extant venture capital experience?

While academic scholars have much to oﬀer their policy colleagues, it cannot be assumed that the potential complementarity of their interests will guarantee research access or funding. Scholars will have to earn policy makers’ respect and active support. Experience shows that this is not an easy task. Similarly, while academics are often tribal in their disciplinary interests (see Sapienza and Villanueva’s chapter), policy clients frequently prefer inter-disciplinary teams that will address big issues with strong evaluation and execution recommendations. The skill for the academic is to be able to meet legitimate executive needs while still being able to undertake studies capable of scholarly validation via peer review. Arriving at such mutually acceptable outcomes is not easy and will require a level of trust building and mutual understanding between academics and policy makers that is still largely in its infancy. Entrepreneurship and venture capital scholars are going to have to be equally as entrepreneurial in the crafting of venture capital policy

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research ideas as the creators and funders of the new enterprises on which their discipline is founded. Notes 1. 2.

3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.

18. 19. 20. 21. 22. 23. 24.

Contemporary venture capital evaluations by government have included programs in Finland (2002; 2006), UK (2003), and Ireland (2005) as well as New Zealand in 2005. Only the Finnish and New Zealand evaluation is in the public domain (Maula and Murray, 2003; 2007; Lerner et al., 2005). We have tended to use the terms ‘knowledge-based firms’ and ‘new technology-based firms’ interchangeably. While this is a sensible shorthand in the context of this chapter, new technology-based firms should be seen as a specialist category of knowledge-based firms. They both share a reliance on tacit and intangible assets for their competitive advantage. As Lerner (2002) has noted, the US similarly has financed a considerable amount of public venture capital actions both at federal and state levels. This involvement continues to be material. Each of these economies has already experienced considerable inward investment by private venture capital and private equity firms. However, these commercial interests are rarely at the level of new enterprises. See www.indiavca.org. BVCA statistics only record start-up deals and not seed investments: 208 companies received start-up investment in 2005. Brazil, India and China. In practice, early stage investors rarely seek interest payments but if successful are (ultimately) rewarded by a significant capital gain multiple at exit. See Pickering (2002) for a valuable government policy maker/insider’s view of six UK reports on funding tech-based Small and Medium Sized Enterprises. While senior policy makers are usually very aware of the limitations of transferring models to new contexts, this complexity does not stop politicians framing the question as noted. The statement is curious in that it implies a modest historic role for public policy in the US experience. If funds are ranked by the proportion of seed investments to total investments, a UK fund does not appear until position 59. The Directory of Support Measures (EC, 2003c) lists seven measures by which the state can assist SMEs: Reception, facilities and basic information, referral; Professional information services; Advice and direct support; SME-specific training and education; Finance; Premises and environment; Strategic services. There is some more encouraging evidence that early-stage investing in Europe after 2001 is showing more positive returns and that performance is not aﬀected by location once fund structural characteristics are controlled (Lindstrom, 2006). Over the last 25 years, Northern European countries have arguably had a stronger tradition of direct investment activity via public agencies than the more market-driven Anglo-Saxon models of the US and the UK. Despite Rocha and Ghoshal’s (2006) concern with the adversarial presumption of agency theory, it is a powerful concept that has considerable salience to venture capital studies. The managers of a venture capital fund which is structured in the industry standard format of a Limited Liability Partnership are called ‘general partners or GPs. Similarly, the investors into such a fund are called the ‘limited partners’ or LPs. Both parties have a range of specific rights and responsibilities which are the subject of considerable, and complex, legal documentation. Over the period 1959–2002, this program was responsible for raising $37.7 billion for some 90 000 businesses (US Small Business Administration, 2003). See the Small Business Services’ notes for the proposed Enterprise Capital Fund www.sbs.gov.uk/ SBS_Gov_files/finance/waterfall.pdf. European Venture Capital Association valuation guidelines exist to set a basis for objective performance comparison between funds. Communication with Yigal Erlich, the Government Chief Scientist of Israel at the time of the program’s inception and now CEO of the Yozma Group, Tel Aviv. The seven emulating countries cited by Mr Erlich are: Australia, Czechoslovakia, Denmark, Korea, New Zealand, South Africa and Taiwan. Finnish 2003 and Irish 2005 evaluations were on venture capital programs that, while involving state investment, could not easily be classified as hybrid funds using the term as understood by the OECD. The public access of Finnish evaluations is an honorable exception to the rule. In this chapter no diﬀerence will be drawn between business angels and informal investors on the simplistic assumption that they are both categories of private individual who provide risk capital (and loans) for non-family enterprises.

146 25. 26. 27. 28. 29. 30. 31. 32. 33. 34.

Handbook of research on venture capital In Europe in 2006, a private equity fund, Permira, launched an international fund of approximately €10 billion. At least four venture capital funds of over $10 billion are scheduled for launch in 2007. University endowment programs and investment trusts for high net worth family dynasties have played an important early role in the development of the US venture capital industry (Bygrave and Timmons, 1992). See http://www.lse.co.uk/financeglossary.asp?searchTerm&iArticleID1646&definitionbusiness_exp ansion_scheme. The Venture Capital Trust program which allowed retail investors to access venture capital funds and provided another source of capital for young businesses was similarly launched in April 1995 (see http://www. hmrc.gov.uk/guidance/vct.htm). The Netherlands had a broadly similar tax incentive program for private investors starting in 1996 and known as the ‘Aunt Agatha scheme’. Research suggests that male informal investors outnumber female investors by about 5:1. There is a dearth of large scale, quantitative ‘matched sample’ empirical studies whereby the outcomes of BA investment on recipient firms can be compared to the outcomes of alternative investment channels on comparable enterprises. Government’s low interest policies have helped fuel a property boom that has arguably been a direct substitute for personal investors to informal investments in new enterprise. See, for example, the contemporary UK and Irish economies. See the international Norface program on Venture Capital Policy Research Seminars (www.norface.org) instituted by Murray in 2005. Most national venture capital associations have research departments producing analyses of the benefits of venture capital activities albeit from a clearly articulated position of interest.

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PART II INSTITUTIONAL VENTURE CAPITAL

5

The structure of venture capital funds Douglas Cumming, Grant Fleming and Armin Schwienbacher

Introduction Venture capital funds perform a vital intermediary role in the financing of entrepreneurial firms and the spurning of new technology and knowledge in an economy. These funds can take a variety of diﬀerent organizational and legal forms, including limited partnerships, investment trusts, corporate subsidiaries, financial institution subsidiaries and government funds. The variety of forms is reflective of the way in which the venture capital market has developed over the last forty years, becoming increasingly institutionalized and internationally active. Academic research has followed these market developments in a quest to analyse and explain how institutional markets emerge, what structures characterize them, and how venture capitalists behave. The research literature on the structure of venture capital funds is still relatively young. And yet the topic is important because the structure of venture capital funds lies at the heart of the way in which the institutional venture capital market works. The institutional market involves professional venture capitalists investing on behalf of their investors in entrepreneurial firms. The structure of these relationships is a combination of explicit and implicit contracts that regulate and guide how venture capital finance, skills and expertise is delivered to entrepreneurs. In some cases, venture capitalists are loosely governed by covenants through limited partnerships, and ‘live or die’ by their investment success. In other cases, more formal bureaucratic structures impinge on the delivery of venture capital. Our review of the research on the structure of venture capital funds brings together theoretical and empirical studies in analysing and explaining how these structures are designed, and vary across geographical markets. As we shall describe, the earliest literature in this area focused largely on explaining how and why venture capital funds were structured as limited partnerships. The focus in this work was on the USA and was driven by empirical observations. Only later have we witnessed the literature deepen through empirical work on markets outside the USA, and through research on the economic–theoretic foundations of the structure of venture capital funds. The literature on contract design as it pertains to venture capital fund structure now makes an important contribution to a range of disciplines including economics, finance and organizational theory. The structure of venture capital funds also impacts how venture capitalists go about their craft. Important issues include: to what extent does structure influence a venture capitalist’s strategy and the type of businesses receiving finance? And what if the structure of venture capital funds leads to diﬀerent behaviour by rational venture capitalists? Is there more or less risk taking, willingness to add value to companies, or indeed, investment success? Important policy and economic lessons can be gleaned from studying how venture capital fund structures vary within a country and between countries, and the implications for the delivery of finance to entrepreneurial firms. 155

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This chapter reviews literature on the structure and governance of diﬀerent types of venture capital funds with a focus on the institutional structures designed to alleviate agency problems associated with financial intermediation in venture capital finance. As venture capital limited partnerships (VCLPs) are the most common type of venture capital fund in many developed economies, our analysis uses the VCLP structure as a benchmark upon which other types of venture capital funds are compared. It is important to note here, however, that the VCLP structure is not necessarily the best type of structure in all situations. Seminal papers on the VCLP structure describe the role of venture capitalists as financial intermediaries between investors and entrepreneurial firms. As investors do not have the time and skills to structure venture capital contracts, screen potential investees, and add value to investees so that they are brought to fruition in an initial public oﬀering (IPO) or acquisition exit, investors contract with venture capitalists such that venture capitalists act on their behalf in carrying out the process of entrepreneurial investment. We examine research on this process and contrast VCLPs with other structures. We then turn to review literature and evidence on why fund structure matters. As discussed above, fund structure may impact strategy, types of firms receiving finance, incentives for venture capitalists, the venture capitalist’s behaviour in the investment selection and management process, and investment returns. The variation in structural forms observed in the market are due, in our view, to the way in which contracting parties solve agency problems given diﬀerentiated objective functions. The relationship between the structure of venture capital funds and behaviour of venture capitalists is fundamental to our understanding of the nature of the venture capital market. This chapter is organized as follows. The next section provides a short history of the development of institutional venture capital markets, with particular attention to the change in fund structures. Next, we will review research surrounding the structure and governance of venture capital funds, and then our attempt is to show evidence on why venture capital fund structure matters, in terms of the types of investments made and the returns to such investments. Finally, we will present our conclusions and oﬀer some areas of future research. The development of institutional venture capital markets Research on the structure of venture capital funds has always been motivated by the empirical observations that venture capital markets around the world were using various organizational forms to finance entrepreneurial firms. The growth in the body of literature on the subject can best be understood in the context of how markets themselves developed. Research did not emerge due to a paradigmatic shift in economics and finance, the development of new research techniques, or cross-fertilization of ideas from related disciplines. Rather, it was impetus to understand the increasing importance of professional venture capital firms in the economy, and the way in which parties contract between each other to create new businesses that characterized the seminal articles. The history of institutional venture capital markets has been well documented by Fenn et al. (1997) and Gompers and Lerner (2001a). The literature focuses on the emergence of venture financing in the post-second world war period in the USA through American Research and Development (ARD), listed closed-end funds spawned by the ARD, the first limited partnerships in the late 1950s, and federally supported Small Business Investment Companies (SBICs). Even today, the historiography provides few insights into

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the institutional developments in non-US markets, or of the experiments in corporate venturing that were to become important developments in the venture capital industry in later years. While the lineage of institutional markets is not well developed in the literature, all researchers point to marked changes in the level of capital committed to the US venture capital markets in the 1970s and early 1980s that form the basis of today’s industry. The consensus is that this change was motivated predominately by the changes to legislation in the US pension system in 1979 permitting pension fund managers to invest in riskier assets such as venture capital (Gompers and Lerner, 1998). For Europe, the entry of new venture capital firms from the 1970s (the founding rate of firms) has been positively related to density, suggesting that a critical mass is also needed to spurn industry growth (Manigart, 1994). The growth and development of venture capital markets is illustrated best through data on venture capital. The capital committed data in Figure 5.1a shows the total amount of capital committed to venture capital funds in the three major regions – USA, Europe and the Asia-Pacific. The US venture capital industry has always dominated global capital available from institutional venture capital funds. Figure 5.1a shows total capital committed each year between 1968 and 2005 for the three major regions – USA, Europe and the Asia-Pacific. There were steady commitments to US funds in the 1980s, and a noticeable increase from the mid-1990s. International markets in Europe and the Asia-Pacific only increased in importance in the late 1990s. Capital commitments peaked in 2001 in all three regions. The information technology ‘bubble’ and associated venture capital overshooting (Gompers and Lerner, 2000) led to large falls in new capital flowing into the industry until 2004–2005. Figure 5.1b measures the relative development of institutional venture capital markets using USA as the benchmark. The graphs express capital committed per year in Europe and 110 000 USA

100 000

Europe

Asia-Pacific

90 000 80 000 US$m

70 000 60 000 50 000 40 000 30 000 20 000 10 000 2004

1998

1992

1986

1980

1974

1968

0

Figure 5.1a Total venture capital commitments 1968–2005: USA, Europe and Asia-Pacific

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Handbook of research on venture capital 0.60 Europe

Asia-Pacific

0.50 0.40 0.30 0.20 0.10

2005

2000

1995

1990

1985

1980

0.00

Source: Thomson Venture Economics; Authors’ calculations

Figure 5.1b Relative venture capital market development 1980–2005: Europe and Asia-Pacific vs USA Asia-Pacific as a percentage of US capital raisings. The European market grew rapidly in the 1980s to be almost 50 per cent of US raisings, although it has fallen recently to 30 per cent. The Asia-Pacific has shown steady increase to 30 per cent of the US market per year. The data in Figures 5.1a and 5.1b illustrate that institutional venture capital markets have become larger in each of the three major world regions since the 1980s (note that the data here is annual capital commitments, not cumulative assets under management). Another notable trend has been changes in the way in which venture capital funds are structured. Contracting out investment management to third party venture capitalists (via VCLPs) uniformly became the dominant form of venture capital fund structure. Table 5.1 provides summary statistics on this trend, by showing the relative importance of, and changes in, diﬀerent types of venture capital funds in the US, Europe and Asia-Pacific countries between 1980 and 2004. The data illustrate several trends that are insightful in explaining how the research has developed. First, from the 1980s VCLPs raised by independent venture capital firms have been the most common structure in the market. It is not surprising then that this form has attracted substantial research attention. VCLPs were 75 per cent of the new funds formed in the USA in the 1980s, with this increasing to 84 per cent by 2002 to 2004. Even today, we know much more about the operations of VCLPs operated by independent venture capital firms than we do about any other structure, although we have only recently seen research on non-US VCLPs. Second, the late 1990s witnessed corporations and financial institutions establishing venture capital funds to a much greater extent than previously. These ‘captives’ were part of the venture capital fund-raising ‘bubble’ of the period, and although their proportion of all funds raised did not change greatly, the

159

IND Funds

CORP Funds 91 51 94 12

FIN Funds 236 274 1152 225

All Funds 135 170 703 150

IND Funds 3 8 80 8

CORP Funds

All European Countries

24 39 230 75

14 24 141 50

2 2 16 8

4 5 27 10

0.182 0.117 0.116 0.129

43 32 134 29

FIN Funds

14 56 171 50

1.000 1.000 1.000 1.000

112 391 856 150

All Funds

11 40 119 30

0.759 0.714 0.695 0.600

85 279 595 90

IND Funds

– 2 11 4

– 0.020 0.063 0.080

– 8 54 12

CORP Funds

2 8 23 9

0.107 0.138 0.136 0.180

12 54 116 27

FIN Funds

All Asia-Pacific Countries

Source:

Thomson Venture Economics; Authors’ calculations

Note: This table describes the relative importance of diﬀerent types of VC fund structures over time. IND: independent fund (VCLP), CORP: corporate VC fund, FIN: financial-aﬃliated VC fund. ‘All VC funds’ include all 3 types as well as others. Time periods are based on vintage year; i.e., year funds were established.

Average Number of New VC Funds per year by Period: 1980–1989 96 66 8 9 1990–1996 103 78 4 9 1997–2001 361 268 24 19 2002–2004 125 106 4 4

Relative Importance of Diﬀerent VC Fund Types (in Per cent of all New VC Funds) by Period: 1980–1989 1.000 0.691 0.079 0.095 1.000 0.572 0.013 1990–1996 1.000 0.756 0.042 0.071 1.000 0.620 0.029 1997–2001 1.000 0.744 0.067 0.052 1.000 0.610 0.069 2002–2004 1.000 0.843 0.035 0.032 1.000 0.667 0.036

Total Number of New VC Funds by Period: 1980–1989 957 661 76 1990–1996 718 543 30 1997–2001 1804 1342 120 2002–2004 376 317 13

All Funds

United States

Venture capital fund structures around the world

Vintage Year (Aggregated in Periods)

Table 5.1

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number of venture capital funds in the category increased between 400–600 per cent. Now researchers were faced with a new structural form whereby venture capital was provided to firms through more bureaucratic structures. Thirdly, the internationalization of venture capital has prompted research on the ways in which legal systems, culture and institutions impact structure. While the USA continued to be the home of the most new funds raised each year, Europe and Asia has increased in importance. Indeed, there are now more funds raised outside the USA than inside the USA, providing impetus to crosscountry research and the arrival of new researchers from various nationalities contributing to the literature. There is no doubt that new developments in the venture capital market will, over time, have additional stimulatory impact on the growth of the literature. To date, the market trends described above have meant that research covers three major types of venture capital fund structure: VCLPs, captive funds (financial institutions and corporate venture capital funds), and government funds (under the guise of government venture capital support programmes). We will examine each of these structures in turn. The structure of venture capital funds The development of institutional venture capital markets and the rise of venture capital as an important form of finance provided researchers with a fertile topic of analysis. Of particular importance was the way in which parties contracted to solve agency problems in the investment management process. In this section we review the work that pioneered our understanding of fund structures. We first discuss research examining venture capital limited partnerships. We then turn to more recent work on captive venture funds and government sponsored funds. An overview of the research discussed in this section is provided in Table 5.2. Venture capital limited partnerships (VCLP) The characteristics of VCLP Venture capital limited partnerships are the contractual outcome of negotiations between the general partner (the venture capital firm run by investment professionals) and the limited partners (investors). Two features of the formation of a VCLP have been documented – fund raising and contract negotiation. In terms of fund raising, limited partners are institutional investors that invest in a range of assets across the risk spectrum (depending upon their asset–liability structure). Venture capital and private equity forms a relatively small part of institutional investors’ asset portfolio. Investors (typically) aim to have up to 10 per cent of their capital to the venture capital (funds focused on early stage investments) and private equity (funds focused on late stage, turnaround and buy-out investments) asset class, depending on economic and institutional conditions (Gompers and Lerner, 1998; Jeng and Wells, 2000; Mayer et al., 2005). Endowments and foundations (long term, intergenerational asset pools) have traditionally allocated much higher proportions of their assets (often above 25 per cent) to venture capital and private equity. Gompers and Lerner (1998) and Jeng and Wells (2000) show that pension funds are dominant investors, while other investors include life insurance companies, corporations, commercial and investment banks, universities, endowments, foundations, and wealthy individuals. In an international study, Mayer et al. (2005) focus on fund raising in Germany, Israel, Japan and the UK, and show that banks are the

161

Publicly owned corporation

Captive (division/business unit)

Individual partners through a private company, endorsed by a government programme

Individual partners through a private company

Independent VC firm (VCLP)

Government sponsored fund (various structures)

Typical ownership of the firm

Government finances (and sometimes matching private sector capital from third party investors)

Balance sheet funds; business development or R&D budgets

Third party investors including pension funds, endowments, fund-offunds, life insurance companies, individuals

Source of funds

Key features of the structure of venture capital funds

Type of VC fund & structure

Table 5.2

Public policy goals including development of the local venture capital industry; accelerating economic growth and employment; commercialization of technology

Strategic goals including access to new technologies and/or products; limiting competitive threats; financial returns

Financial returns (return on investment, IRR)

Objectives

Limited life; single fund raising; contract covenants often with geographic, company type and investment stage restrictions

Unlimited life; formal administrative control and informal control through corporate culture

Limited life; multiple fund raisings; contract covenants; limited liability

Contract features

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major source of funds in all considered countries, but particularly in Germany and Japan. Pension funds are more important in the UK than elsewhere. The motivation for limited partners to invest in VCLPs derives from portfolio theory. Gompers and Lerner (2001a) and Lerner et al. (2005) found that investors can increase overall portfolio return through a justifiable increase in associated risks so long as they select venture capitalists that perform, over their life time, above the observable median fund return. Obtaining the required allocation and exposure, however, is not a simple matter. While institutional investors desire a set exposure to venture capital, this exposure is not achieved immediately upon committing capital to a venture capital fund (Cumming et al., 2005). Capital commitments are drawn down over time through capital calls when the fund managers have selected entrepreneurial firms to invest in, and as such, it typically takes a number of years before an institutional investor has reached their targeted exposure to venture capital and private equity. Once exposure is achieved the investor must continue to commit new capital to venture capital in order to maintain a ‘steady state’ exposure position. Institutions with long term, steady state programmes have been shown to outperform other investors in achieving returns (Lerner et al., 2005). The second feature of the formation of a VCLP is the negotiation of covenants in the partnership agreement. This area was first studied by Sahlman (1990) and Gompers and Lerner (1996; 1999). The structure of VCLPs is designed to mitigate information asymmetries and agency problems associated with fund managers investing money in entrepreneurial firms on behalf of institutional investors. The VCLP is structured as a contractual relationship between limited partners and the general partner under partnership law, although it should be noted that not all countries around the world have codified partnership laws conducive to venture capital. The VCLP has a finite horizon of (typically) 10 years, with an option to continue for 1–3 years (if the remaining companies need to be exited). This contractual arrangement is eﬃcient, as it facilitates the time required to select entrepreneurial firms in which the VCLP will invest and bring that investment to fruition (either in the form of an IPO or an acquisition). The time of first investment until exit in an entrepreneurial firm can take between 2–7 years. Venture capital fund managers start fund raising for subsequent funds in the later part of the life of their existing fund(s), and may operate more than one VCLP simultaneously (subject to covenants, as discussed below). In industry practice, the collection of funds that comprise a venture capital organization is sometimes referred to as a ‘venture capital firm’ (whereas a ‘venture capital fund’ is a single fund that is part of a venture capital firm). The economics associated with VCLPs are designed to secure interest alignment under conditions of hidden information and hidden action. Venture capital fund managers are compensated in a way that provides them with a fixed management fee (1–3 per cent of committed capital per year) and a carried interest performance fee (20–30 per cent of profits over return of capital). The fixed management fee is designed to provide enough capital to run the fund and pay the fund manager prior to any exit. The performance fee is designed to align the incentives of the VCLP managers with their institutional investors. Gompers and Lerner (1999) show younger inexperienced fund managers typically negotiate higher fixed fees at the expense of lower performance fees, as their ability to earn performance fees is uncertain. Moreover, more recent studies have evidenced deviations from the ‘2 and 20 rule’ of venture capital manager compensation (that is 2 per cent management fees and performance fee of 20 per cent of the profits) in recent years (Litvak, 2004b).

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VCLPs have three key legal advantages. First, they avoid (or at least mitigate) double taxation of profits as would take place if the structure were a corporation. Second, they allow for unlimited liability of the fund managers (the general partner), while allowing for limited liability of the institutional investors (the limited partners). The fund manager is involved in the day-to-day operation of the fund, and can make decisions without interference from the institutional investors (or otherwise the institutional investors risk losing their limited liability status). This autonomy is a marked advantage over corporate venture capital funds, as discussed below. Third, unlike a corporation (where covenants are imposed by statute), VCLPs are structured by contract, which is completely flexible and negotiated to specifically suit the best interests of the parties. Covenants governing the VCLPs The covenants contained in VCLP set out the ‘rules of behaviour’ for long term relationships. Theory on the design of these covenants is in its infancy. Lerner and Schoar (2004) examine the extent to which venture capital managers may want to include specific covenants in the LP agreements in order to screen better investors for their fund (that is more ‘liquid’ investors that are long term oriented, with secure sources of capital). The central hypothesis is that the manager benefits from having their investors participate in follow-up funds, since it provides a signal to other investors that LPs are happy with the manager. Therefore, the latter may prefer to keep out liquidityconstrained investors in early funds, since these investors may not participate in follow-up rounds for reasons other than how well the fund performed. Their study leads to empirical predictions with respect to the particular design of partnership agreements. In terms of empirical studies on covenants, the seminal work was undertaken by Gompers and Lerner (1996; 1999), who analyse the covenants used to govern VCLPs in the US. Subsequent work (Schmidt and Wahrenburg, 2003; Cumming and Johan, 2005) considers similar evidence in an international context. One type of covenant among VCLPs is the restriction on the fund manager regarding investment decisions. First, fund managers are restricted on the size of investment in any one portfolio company. Without such a restriction, a fund manager might lower his or her eﬀort costs associated with diversifying the institutional investors’ capital across a number of diﬀerent entrepreneurial firms. It also limits excessive risk-taking by venture capital managers as it forces them to diversify. Second, fund managers are typically restricted from borrowing in the form of bank debt, as it would increase the leverage of the fund and impose extra risks on institutional investors. Third, there are restrictions on co-investment by another fund managed by the same fund manager, as well as restrictions on co-investment by the fund investors, which limit conflicts of interest managing the fund. Fourth, there are restrictions on the re-investment of capital gains obtained from investments brought to fruition to ensure realized capital gains are returned to institutional investors. A second category of covenants relates to types of investment and ensures that the institutional investors’ capital is invested in a way that is consistent with their desired risk/return profile. Restrictions include investments in other venture funds, follow-on investments in portfolio companies of other funds of the fund manager, public securities, leveraged buy-outs, foreign securities, and bridge financing. Without such restrictions, the fund manager could pursue investment strategies that better suit the interests of the fund managers regardless of the interests of the institutional investors. In practice, covenants tend to be defined in relatively broad language in order to give flexibility to venture capital

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managers. However, private equity oﬀering memoranda used by venture capital firms to raise funds typically include more detailed investment objectives in terms of stage of development, industry focus and geographical scope. Any deviation from these investment objectives is traditionally called ‘style drift’. Cumming et al. (2004) study such style drifts in a sample of US data, and show drifts are related to fund age (first-time fund managers are less likely to drift due to potential reputation costs), and to changes in market conditions between the time funds were raised and funds are invested. Other forms of covenants are discussed in Gompers and Lerner (1996; 1999), Litvak (2004b), Lerner and Schoar (2004) for US evidence, and Schmidt and Wahrenburg (2003) and Cumming and Johan (2005) for international evidence. Overall, the flexible nature of contractual covenants used to govern VCLPs, and the autonomy of VCLP managers vis-à-vis their institutional investors, are viewed to be a major reason behind the successful development of the US venture capital market (Gompers and Lerner, 1996; 1999). Lerner and Schoar (2004) show that an eﬀective way to punish venture capital managers is to not participate in follow-on funds of a venture capital firm. This provides an adverse signal to other fund providers about the quality of the venture capital firm. The manager then faces a ‘lemons’ problem when he has to raise funds for a subsequent fund from outside investors. New investors cannot determine whether the manager is of poor quality. Where prior institutional investors no longer participate in follow-on funds of the venture capital firm, other potential institutional investors of the fund may infer that the existing investors believe that the venture capital fund managers are of low quality. Thus, VCLP covenants bind the behaviour of the venture capitalist but it is rare for the sanctions involved in VCLPs to be invoked by investors. Punishment is more likely to take place through the investor exiting the relationship when the next fund is oﬀered for investment. Captive venture capital funds Captive venture capital funds are funds that are partly or wholly owned by parties other than the venture capital professionals. Captives may be aﬃliated to banks, securities firms, larger diversified financial institutions or a division/unit of a corporation. The ownership structure of the captive venture capital fund means that its legal and organizational structure diﬀer from VCLPs in several crucial ways. First, captive funds primarily derive capital from their parent and invest on behalf of the parent. There is no limited life fund structure in the agency relationship. Second, governance of venture capitalists within the captive fund is materially diﬀerent from governance as contracted through the covenants in the VCLP. Rather, the company acts as a large (and often sole) shareholder controlling the fund. Third, venture capitalists invest in entrepreneurial firms in order to satisfy objective functions that may contain financial and non-financial goals. Finally, the behaviour of venture capitalists is influenced by the structure of the fund in terms of risk investing, portfolio construction and eﬀort (we examine this last diﬀerence later on in this chapter). Research on bank venture capital funds is still in infancy. Banks supply their venture capital divisions with capital from the balance sheet of the bank, allocating a notional commitment amount (for example capital per year to be invested). Thus, fund raising is diﬀerent in process to professional venture capital firms under the VCLP structure (Gompers and Lerner, 1999; Cumming et al., 2005; Dushnitsky and Lenox, 2005; Cumming and MacIntosh, 2006). Banks intermediate between depositors and private

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companies requiring longer term debt and equity. The investment objective for banks is to match longer term liabilities in their capital structure with debt and equity investment in private equity. As the major, or only capital provider to an entrepreneurial firm, there is no conflict between debt and equity in the bank’s view. Also, banks aim to sell additional services into the portfolio company (for example advisory services, capital raising and arranging fees) in order to ‘service’ their client and generate income from the investment. Thus, the investment objectives are measured through a range of key performance indicators that may include non-return variables. Again, this is in stark contrast to VCLPs where return maximization is the sole objective. Banks establish venture capital companies as separate divisions providing development capital to clients/prospective clients. Governance takes place through the internal administration process that is used by the corporation in all divisions (rather than having governance tailored to the venture capital fund and its particular circumstances). Deviations from the venture capitalist’s role and responsibilities inside the bank venture capital fund (for example conflicts of interest, hidden action) are dealt with like any other cases in the bank, as venture capitalists are employees governed by labour contracts. Given hierarchical internal labour markets it is less likely to see opportunistic behaviour in the venture capital unit (the payoﬀ to such behaviour is low), and it is less costly for the bank to sanction inappropriate behaviour (implying for the venture capitalist that the probabilistic costs of detection and punishment are high). Corporate venture capital companies are organized to provide corporations with balance sheet investments for strategic advantages (see Gompers and Lerner, 1999; Hellmann, 2003; Riyanto and Schwienbacher, 2005). In the late 1960s and 1970s, more than 25 per cent of Fortune 500 companies attempted to create corporate venture capital programmes. Corporate venture capitalists comprised 12 per cent of all US venture capital investment in 1986; 5 per cent of all US venture capital in 1992, 30 per cent of all US venture capital in 1997 (Gompers and Lerner, 1999), 15 per cent of all US venture capital in 2000 (Dushnitsky and Lenox, 2005), and 6 per cent of all US venture capital in 2003 (VC Experts, 2003). Similarly, corporate venture capital comprised approximately 5 per cent of the Canadian venture capital market in 2003 (Cumming and MacIntosh, 2006). Large corporations use separate entities such as corporate venture capital funds (as a wholly-owned subsidiary) to structure such operations (see for example Chesbrough, 2002). Like banks, corporations usually establish a division/unit to invest committed amounts into venture capital investments. The investment objective is to maximize a widely defined objective function that relates to broad corporate goals, the securing of new technologies for competitive advantages (real options), and controlling competitive threats. Captive venture capitalists are paid less, and have less pay-per-performance sensitivity than limited partnership venture capitalists (Gompers and Lerner, 1999; Birkinshaw et al., 2002). Captive venture capitalists also have much less autonomy than limited partnership venture capitalists (Gompers and Lerner, 1999). As such, captive venture capital managers that show signs of success are often recruited away from the captive venture capital organization to work for limited partnerships. Government venture capital funds Government venture capital programmes Government-backed venture capital company programmes have been popular around the world as governments support the development

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of national venture capital markets servicing all stages in the entrepreneurial investment process (see for example programmes operating in the USA (SBIC), the UK, Israel (Yozma), Scandinavia, Belgium (SRIW and GIMV), Australia (Innovation Investment Fund), and New Zealand (Venture Investment Fund)). Typically, these programmes provide government funding alongside private sector funding (sometimes with an option to ‘buy out’ the government at a lower rate of return, providing a leverage eﬀect). The investment objective is usually to alleviate perceived market failure in the supply of seed/early stage venture capital, where information asymmetries are highest and suboptimal capital is allocated by private sector investors (Jaaskelainen et al., 2004). Government venture capital funds are often driven by policy objectives associated with welfare outcomes to enhance the market structure, improve financing options to younger firms, increase employment, foster innovation and support economic growth (Kortum and Lerner, 2000; Jaaskelainen et al., 2004). From a theoretical perspective, government programmes have been shown to be Pareto improvements, leading to net positive economic benefits to an economy (Keuschnigg, 2003; Kanniainen and Keuschnigg, 2004). The structure of government funds involves covenants on the sector/stage geographic conditions, on investment behaviour (for example regional, state or country limitations, technology focus, stage focus), a commitment to wider policy goals such as knowledge transfer, commercialization of technology from universities, encouraging international linkages with companies, and development of local venture capital industry. Public policies towards venture capital Broadly classified, public policies towards venture capital come in one of two primary forms: (1) law, and (2) direct government investment schemes. Capital gains taxes are widely recognized as being one of the most important legal instruments for stimulating venture capital markets (Poterba, 1989a; 1989b; Gompers and Lerner, 1998; Jeng and Wells, 2000) (but there are other legal instruments for venture capital markets; see Armour and Cumming, 2005). Poterba (1989a; 1989b) shows US venture capital fund raising increased from $68.2 million in 1977 to $2.1 billion in 1982 as there was a reduction in the capital gains tax rate from 35 per cent in 1977 to 20 per cent in 1982. Venture capitalists invest with a view to exit. As entrepreneurial firms typically do not have cash flows to pay interest on debt and dividends on equity, venture capitalists invariably invest with a view towards an exit and the ensuing capital gains. The most profitable forms of exit for high quality entrepreneurial firms are typically IPO and acquisitions (Gompers and Lerner, 1999; Cumming and MacIntosh, 2003b; Cochrane, 2005). Therefore, tax policy in the area of capital gains taxation is particularly important for venture capital finance (for theoretical work on tax policy, venture capital and entrepreneurship, see Keuschnigg and Nielsen, 2001; 2003a; 2003b; 2004a; 2004b; Kanniainen and Keuschnigg, 2004; Keuschnigg, 2003; 2004). Da Rin et al. (2005) and Armour and Cumming (2005) examine the eﬀectiveness of several public policy measures. As conjectured by Black and Gilson (1998), the creation of active IPO markets in Europe appears to be an important measure for fostering an eﬀective venture capital market. Other measures that increase the extent to which venture capital flows to high-tech and early-stage investment opportunities are tax benefits and reduced labour and bankruptcy regulation. A second form of government support is via direct government created venture capital funds. Lerner (1999; 2002) discusses the ways in which government funds can be successfully implemented to work alongside private venture capitalists. One of the most important

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items identified by Lerner (2002) is the need for government funds to partner with, and not compete with, private venture capital funds. It is also important for government funds to work towards areas in the market where there exists a clear and identifiable market failure in the financing of companies due to, for example, structural impediments in the market that have given rise to a comparative dearth of capital. Further, Lerner (2002) suggests it is useful for government funds to be structured in ways that minimize agency costs associated with the financing of small and high-tech firms. For example, it is useful for fund managers to have covenants controlling investment mandates and compensation incentives to add value to all of their investee companies; such covenants and compensation mechanisms have worked extremely well in mitigating agency problems among private limited partnership venture capital funds (Gompers and Lerner, 1996; 1999). Government programmes around the world Countries around the world have adopted diﬀerent forms of direct government investment programmes in venture capital and private equity. For example, the US has adopted the Small Business Innovation Research (SBIR) Programme, administered by the US Small Business Administration (SBA). The SBIR programme is the largest government support programme for venture capital in the world. SBIRs have invested over $21 billion in nearly 120 000 financings to US small businesses since the 1960s. Investee companies include such successes as Intel Corporation, Apple Computer, Federal Express and America Online. SBIRs are operated like private venture capital funds and are operated by private investment managers. The diﬀerence between a private venture capital fund and an SBIR is that the SBIR is subject to statutory terms and conditions in respect of the types of investments and the manner in which the investments are carried out. For example, there is a minimum period of investment for one year, and a maximum period of seven years for which the SBIR can indirectly or directly control the investee company. The SBIR does not distinguish between types of businesses, although investments in buy-outs, real estate, and oil exploration are prohibited. Investee companies are required to be small (as defined by the SBA) which generally speaking is smaller than those firms that would be considered for private venture capital financing. SBIRs also face restrictions as to the types of investment in which they may invest. Capital is provided by the SBA to an SBIR at a lower required rate of return than typical institutional investors in private venture capital funds. Excess returns to the SBIR flows to the private investors and fund managers, thereby increasing or leveraging their returns. Lerner (1999) shows early stage companies financed by the SBIR have substantially higher growth rates than non-SBIR financed companies. This programme has been quite eﬀective in spurring venture capital investment and creating sustainable companies (Lerner, 1999). A key feature of this programme is that it complements and partners with, and does not compete with, private sector venture capital investment. Similarly, the Government of Australia adopted the Innovation Investment Fund (IIF) Programme in 1997. As in the US SBIR programme, a key feature of the Australian IIF programme is that it operates like a private venture capital fund. There have been nine IIFs created in Australia, for which the ratio of government to privately sourced capital must not exceed 2:1. Investments will generally be in the form of equity and must only be in small, new-technology companies. At least 60 per cent of each fund’s committed capital must be invested within five years. Unless specifically approved by the Industry Research and Development Board of the Government of Australia, an investee company must not

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receive funds in excess of $4 million or 10 per cent of the fund’s committed capital, whichever is the smaller. Prior to the introduction of the IIF programme in 1997, there was scant start-up and early stage venture capital investment in Australia. Cumming (2006a) finds that IIFs are fostering the development of the Australian venture capital and private equity industry in a statistically and economically significant way. In short, the US SBIR and Australian IIF are indicative that there is tremendous potential for governments to foster innovation and economic development through public subsidization of venture capital. Policy makers in Canada have adopted a unique form of government venture capital fund known as the Labour Sponsored Venture Capital Corporation, or LSVCC (Cumming and MacIntosh, 2006). The UK has adopted a similar type of fund known as the Venture Capital Trust (VCT) (Cumming, 2003). Both the Canadian LSVCC and the UK VCT are mutual funds listed on stock exchanges, and not operated like private venture capital funds as in the case of US SBIRs and Australian IIFs. The LSVCC and VCT investors are individuals, and they receive substantial tax incentives to contribute capital to this class of funds (by contrast, a mix of government and private funds are used in partnership to support Australian IIFs and US SBIRs). In exchange for the tax subsidy, LSVCC and VCT managers agree to adhere to a set of statutory covenants that constrain their investment decisions and activities. The dominant presence of government subsidized LSVCC funds in Canada is in sharp contrast to the US venture capital market. Prior work has shown that LSVCCs distort eﬃcient venture capital investment duration (Cumming and MacIntosh, 2001) and eﬃcient exit strategies (Cumming and MacIntosh, 2003a; 2003b) in Canada relative to the US. Further, LSVCCs crowd out private venture capital funds (Cumming and MacIntosh, 2006). LSVCCs have much larger portfolios of investee companies per fund manager than private independent venture capitalists in Canada (Cumming, 2006b), and distort the selected security in Canada (Cumming, 2005a; 2005b). Overall, government support programmes for venture capital have had mixed success. In countries where the government venture capital fund competes with private venture capital funds (as in Canada), the policy objectives of the government programme has not been met. Where the government programme complements the private market and fills a gap in the private provision of capital (as in the US and Australia, for example), the programmes have been quite successful. Summary Research on the structure of venture capital funds is consistent with the view that VCLPs are the most appropriate structure for the financing of entrepreneurship and innovation in most areas of venture capital (Gompers and Lerner, 1996; 1999; Schmidt and Wahrenburg, 2003; Cumming and Johan, 2005). As we showed in Table 5.2, these venture capital funds are owned by the individual investment professionals and make contracts (VCLPs) with third party investors. The delineation of activities between the parties is well laid out, and the goals are clear. Entrepreneurial firms receive finance from venture capitalists who are motivated to help the company to grow in order to maximize shareholder value and investment returns. Indeed, the continuation of the venture capitalist’s franchise depends upon successful support of entrepreneurial companies. The structure of the VCLP facilitates long term autonomous investment structures and appropriate compensation arrangements.

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Captive venture capitalists, by contrast, are structured in a more bureaucratic way with specific corporate objectives given that they are located within a diﬀerent ownership structure (for example publicly traded corporations). The captive venture capital division provides venture capitalists with little autonomy and the organizations are much less stable. Goals may be unclear, conflict, and include the potential negative eﬀects of limiting entrepreneurial company growth to protect the competitive position of the corporation. Finally, the ownership of the venture capital fund by a corporation means that while its structure is open-ended (which is more suitable than a VCLP for long term risk capital), there may be less certainty over the life of the fund as the corporation changes strategy or faces financial pressures in other areas of the business. Government venture capital funds have had mixed success depending on the design of the programme, which varies significantly across countries. Successful government programmes take the best structural characteristics from VCLPs and complement this with specific features to minimize market distortions. Why venture capital fund structure matters We have seen that venture capital fund structures vary within a market, and across geographies. In this section we review the theoretical literature on why venture capital fund structure matters for the value-added provided by venture capitalists to investee firms, as well as for generating returns. We then examine empirical evidence. Theoretical research on venture capital fund structure and venture capital behaviour The main strand of theoretical research focuses on micro-level analysis and uses agency theories and mechanism design to produce insights into the functioning of venture capital markets. Venture capital-specific theories are relatively new, and the first ones certainly were written after empirical research on venture capital started. The functioning of the venture capital market has been used as motivation ground for many analyses in incomplete contracting and control theories (for example Hellmann, 1998). The theoretical research in venture capital has largely focused on the relationship between the venture capital fund manager and the entrepreneur, taking a single investment perspective. Only recently has there been attention directed to the relationship between limited partners (LPs) and the venture capital fund manager (general partner, GP). A small number of theoretical works have contributed to a better understanding of tradeoﬀs that a venture capital fund manager faces, and how these are resolved in order to align the manager’s incentives with LPs’ interests. This is particularly important for venture capital funds since LPs cannot easily liquidate their positions once they have invested (or only at very high costs). This reason, and the fact that LPs by definition cannot interfere in the day-to-day process of the fund, makes the contract design of partnership agreements a crucial aspect of a well-functioning fund. When examining decisions made by venture capital managers, a number of papers utilize information economics theories such as the signalling and learning hypotheses. These are especially useful when examining the decisions made by venture capitalists when approaching the fund raising process for their next fund (for example Gompers, 1996; Cumming et al., 2005). The signalling hypothesis refers to fund manager actions that seek to demonstrate to institutional investors that they are of high quality. A central variable along these lines is the degree to which the manager (or the firm she runs) is already well-established or still young. In the latter case, it is assumed that fund providers

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have little information about the true quality of the manager and try to infer her quality from information signals. Two possible signals that have been investigated are exit decisions (‘grandstanding eﬀect’ as examined in Gompers, 1996) and investment decisions (that is whether the manager style drifted while investing, as examined in Cumming et al., 2004). For the context of establishing fund compensation arrangements, Gompers and Lerner (1999) find evidence in favour of learning. However, other evidence shows signalling is important for both exits (Gompers, 1996) and investment decisions (Cumming et al., 2004). Investment decisions are also closely tied to the structure of a venture capitalist’s portfolio. Recent papers have therefore moved from a single investor model to take a portfolio perspective of venture capital investments. Kanniainen and Keuschnigg (2003; 2004) and Keuschnigg (2004) examine the tradeoﬀ between the number of portfolio companies (that is portfolio size) and the amount of eﬀort each investment receives. Clearly, a manager that needs to monitor more companies has less time for each of them. Their resulting comparative static analysis provides a clear departure from earlier papers (for example Gompers and Lerner, 1999) that did not consider the number of portfolio companies. Similarly, examination of the interaction between portfolio companies within a venture capital fund shows that venture capital managers do not choose each company individually but may have incentives to take a portfolio perspective. Fulghieri and Sevilir (2004) argue that venture capital fund managers may let related projects compete in their early stages, and stop the less promising one afterwards so that resources and human capital can be redeployed to the most promising one. Under certain conditions, this provides better incentives to entrepreneurs and venture capital fund managers. Their work has empirical implications for size and focus on venture capital funds. Along similar lines, Kandel et al. (2004) study the ineﬃciency arising due to the limited duration of funds. This forces the venture capital fund manager to liquidate the fund’s asset at a given time in the future. Given that LPs cannot observe the quality of the venture capital manager’s investments, they may not reward the manager appropriately at liquidation time of the fund. This in turn provides incentives to the GP to favour short-term projects at the expense of value maximization of the fund. Other papers have expanded the standard principal–agent framework to two-side moral hazard. This strand of the literature recognizes the fact that both players, entrepreneur and venture capital manager, need to bring in eﬀort (for example Casamatta, 2003; Schmidt, 2003; Repullo and Suarez, 2004). Among other things, this extension has led to a better understanding of the widespread use of convertible securities in venture capital finance. In sum, theoretical work is consistent with the view that venture capital fund structure is important for the screening of new potential investments and the governance provided by venture capitalists to the investee firms. The next subsection describes empirical evidence consistent with this view. Empirical research Empirical research has found that the structure of venture capital funds and the contracts that govern the relationship with suppliers of capital influence the behaviour of professionals and their investment strategy and style. While the next chapters of this book focus on investment decisions by venture capital companies, we emphasize here some research

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findings specific to diﬀerences in the structure of venture capital funds. Research on how structure influences behaviour has been organized into a small number of themes, as detailed below. Fund structure, types of investment and value-added advice The first set of evidence on how structure matters relates to the eﬀect that the source of funds has on the use of funds by the venture capital. The basic proposition derives from the fact that as agents, venture capitalists are often contracted to invest to provide defined investment outcomes that may yield both financial and non-financial benefits to the capital provider. The diﬀerences in venture capital behaviour driven by structure include types of entrepreneurial firms supported, portfolio structure, governance and value-added by the venture capital. As pointed out by Mayer et al. (2005), in principle the source of funds is irrelevant to the investment decision (similar to Modigliani and Miller’s irrelevance theorem) as long as all venture capital funds pursue a sole objective of maximizing profits of their own funds. Mayer et al. (2005) provide evidence from a large cross-country data set (Germany, Israel, Japan and the UK) that the use of venture capital varies by source, attributable in large part to diﬀerentiated objective functions. Venture capitalists sourcing capital from banks and pension funds invest in ‘low technology’ entrepreneurial firms in later stages (that is more established firms) than individual and corporate backed venture capitalists. Similarly, Cumming et al. (2007) show that Japanese bank venture capitalists act diﬀerently from independent VCLPs by investing in later stage companies. The structure of venture capital companies also impacts the governance structure of portfolio companies. Cumming et al.’s study shows that individual owner-manager structures (typically VCLPs) give rise to much smaller portfolios of entrepreneurial firms and more advice to entrepreneurs. In contrast, bank aﬃliated funds hold larger portfolios (measured by number of entrepreneurial firms per manager) and provide investees with less value-added advice. This negative link between value-added per investee and number of firms in the portfolio is examined theoretically by Kanniainen and Keuschnigg (2003) and empirically by Cumming (2006b). Because venture capitalists invest time and eﬀort in advising their portfolio firms, as opposed to just providing funds, increasing the number of firms in the portfolio dilutes the quantity and quality of the advice provided. The relation between portfolio size per manager and venture capital advice, however, is not linear. Complementarities among venture capital and entrepreneur eﬀort, and complementarities among diﬀerent entrepreneurial firms in the portfolio, among other things, make the relation between portfolio size and advice rather complex (see also Kanniainen and Keuschnigg, 2003; 2004; Fulghieri and Sevilir, 2004; Keuschnigg, 2004; Cumming, 2006b). Our discussion so far has looked at the variation across types of venture capital fund structure. But even within structures diﬀerences in behaviour are evident, most clearly seen in VCLPs operated by venture capitalists of varying experience. Gompers (1996) shows that younger funds tend to exit through an IPO earlier as a way to signal their quality to fund providers prior to raising a new fund. Moreover, Cumming et al. (2004) find that the VCLP structure and the need for independent venture capital funds to raise capital every few years aﬀect the investment decisions of managers, not only exit decisions. Their analysis shows that younger funds are less likely to deviate from their stated objectives (that is style drift less) prior to raising a new fund in order to signal their managerial quality. Incomplete information from the arm’s length relationship between

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capital suppliers and the venture capital means that both grandstanding and style drift act as a signalling device. Fund structure and financial returns (direct and indirect) The financial returns to venture capital investing have been most commonly linked with the state of finance markets and the legal conditions underpinning the structure of VCLPs. The stronger public finance markets and legal protection for investors are in the VCLP, the higher are financial returns to investment. Black and Gilson (1998) argue that there is a strong link between active stock markets and active venture capital markets, as the former allow investors to divest their most successful deals. An international study of venture capital in the Asia-Pacific region by Cumming et al. (2006) provides evidence that a more important factor than active stock markets is the quality of a country’s legal system, which is a central mechanism to mitigate agency problems between outside shareholders and entrepreneurs. Legality aﬀects exits because legality aﬀects the new owners’ ability to resolve problems resulting from information asymmetries in the sale of the firm (consistent with La Porta et al., 1997; 1998; Shleifer and Wolfenzon, 2002). The venture capitalist’s goal is to maximize capital gains upon sale of the entrepreneurial firm. All else being equal, the new investor(s) will pay the most when information asymmetries are lowest. IPOs are less costly exit routes relative to private exits (acquisitions, secondary sales and buybacks) among countries with a higher legality index and stronger investor protections, and should therefore be observed more frequently in countries with higher legality indices (Cumming et al., 2006). Hege et al. (2003) find a significant performance gap (measured by IRR of individual investments) between Europe and the United States. US venture capital funds outperform their European counterpart in the financing of entrepreneurial firms funded at the early stage. Their analysis is consistent with the idea that either European ventures are of lower quality or US venture capitalists are better at screening business plans. Indirect financial benefits to venture capital funds are more important in non-VCLP structures. Studies have shown that, for instance, large corporations set up their own funds for strategic reasons (Siegel et al., 1988; Winters and Murfin, 1988; Yost and Devlin, 1993; Chesbrough, 2002; Santhanakrishnan, 2002) so that the companies financed by the corporate venture capital fund fit within the corporation’s objectives. Some studies document that the use of corporate venture funds is most likely when complementarity gains are highest (Lemelin, 1982; Dushnitsky and Lenox, 2005; Dushnitsky, 2004). Gompers and Lerner (1998) find that corporate venture capital fund investments in companies with ‘strategic fit’ to the mother company perform at least as well as investments by independent venture capital funds. Moreover, Riyanto and Schwienbacher (2005) develop a theoretical framework where they study the incentives of large corporations to set up corporate venture capital funds in order to generate demand for their own products. The article also mentions a number of real cases where this indeed took place. Given these positive externalities for corporate investors, they need to be taken into account in investment decisions of corporate funds. Hellmann (2002) analyses the strategic role of venture investing, that is either a corporate venture financing or an independent venture financing. The use of corporate venture capital mitigates the potential hold-up problem at the R&D stage. In contrast, Riyanto and Schwienbacher (2005) take another perspective. They focus on the corporate investor’s active role in utilizing corporate venture financing strategically as a commitment to compensate the entrepreneur for potential opportunistic

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behaviour in the product market. It therefore helps to avoid a potential ex post hold-up problem in the product market (instead of at R&D stage). Future research directions This chapter has examined the structure and governance of diﬀerent types of venture capital organizations, including limited partnerships, captive venture capitalists and government venture capital programmes. This chapter has also examined the relation between organization structure and governance provided by venture capitalists to investee firms, and has shown that prior research is consistent with the view that returns are aﬀected by venture capital fund structures. Agency relationships between capital providers and venture capitalists are solved eﬃciently through a range of organizational configurations. We have reviewed the state of research on these forms of venture capital. We oﬀer here our views on future research directions. 1. Internationalization of venture capital The past ten years has witnessed the increased internationalization of the venture capital industry, especially given the presence of large institutional investors (see Megginson, 2004, for a review of work on non-US markets). Work on Europe and the Asia-Pacific (Lockett and Wright, 2002) show the potential provided by analysis of the international aspects of venture capital. The internationalization phenomenon raises a number of new research questions, listed below: ● ● ● ●

How have, and how will, venture capital markets evolve around the world? Will there be a convergence towards a single venture capital model? How will increasing financial integration aﬀect the structuring of transactions in venture capital-backed companies? How does internationalization impact venture capital firm structure and its managers’ investment decisions? Will the growth of new markets with diﬀerent legal systems (such as China and India) lead to diﬀerent styles of venture capital investing?

2. Single VCLPs versus fund-of-funds The professionalization of venture capital investing has led to new structures being adopted by institutional investors to access quality venture capitalists. To date there has been little research on the venture capital fund-of-funds industry, although Lerner et al. (2005) discuss variations in investment returns across diﬀerent types of limited partners. The research on hedge fund-of-funds has led academic attention on the intermediation process in newer asset classes. ● ● ●

How do venture capital fund-of-funds invest? How are venture capital fund-of-funds managers incentivized? Do funds-of-funds produce better returns than building a portfolio as a single investor?

3. Listed venture capital funds Financial innovation in the retail funds management sector has led to listed venture capital funds (and fund-of-funds) providing investment options for retail investors. Listed

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venture capital funds face a diﬀerent set of information and liquidity factors. Research could examine: ● ●

Are venture capital outcomes diﬀerent when the vehicle is listed? What is the impact of listed structures on the types of venture capital investments, venture capital behaviour and investment returns?

4. Business culture and venture capital fund structure The international growth of venture capital has seen traditional ways of venture capital investing merge with non-Western business cultures. Indeed, family-controlled venture capital has been a feature of the development of many economies (for example northern Italian business groupings, Chinese business diaspora). We have seen that the research on captive venture capital funds is still in its infancy. Culture is also important in this area, and future work should look towards disciplines such as psychology, organizational behaviour, anthropology and economic/business history. ● ● ●

How does organizational culture impact venture capitalist behaviour? Are non-Western venture capital firms diﬀerent in their outcomes? Approach to investing? Use of non-contractual aspects (for example trust) of transactions? How does the Western style of venture capital become integrated into the new global venture capital world?

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La Porta, R., F. Lopez-De-Silanes, A. Shleifer and R. Vishny (1997), ‘Legal determinants of external finance’, Journal of Finance, 52, 1131–50. La Porta, R., F. Lopez-De-Silanes, A. Shleifer and R. Vishny (1998), ‘Law and finance’, Journal of Political Economy, 106, 1113–55. Lemelin, A. (1982), ‘Relatedness in the patterns of interindustry diversification’, Review of Economics and Statistics, 64(4), 646–57. Lerner, J. (1999), ‘The government as a venture capitalist: the long-run eﬀects of the SBIR program’, Journal of Business, 72, 285–318. Lerner, J. (2002), ‘When bureaucrats meet entrepreneurs: the design of eﬀective “public centure capital” programmes’, Economic Journal, 112, F73–F84. Lerner, J. and A. Schoar (2004), ‘The illiquidity puzzle: theory and evidence from private equity’, Journal of Financial Economics, 72, 3–40. Lerner, J. and A. Schoar (2005), ‘Does legal enforcement aﬀect financial transactions? The contractual channel in private equity’, Quarterly Journal of Economics, 120, 223–46. Lerner, J., A. Schoar and W. Wong (2005), ‘Smart institutions, foolish choices? The limited partner performance puzzle’, Working Paper, Harvard University. Litvak, K. (2004a), ‘Governance through exit: default penalties and walkaway options in venture capital partnership agreements’, Working Paper, University of Texas Law School. Litvak, K. (2004b), ‘Venture capital limited partnership agreements: understanding compensation arrangements’, Working Paper, University of Texas Law School. Lockett, A. and M. Wright (2002), ‘Venture capital in Asia and the Pacific Rim’, Venture Capital, 4, 183–95. Manigart, S. (1994), ‘The founding rate of venture capital firms in three European countries (1970–1990)’, Journal of Business Venturing, 9(6), 525–41. Maula, M.V.J. and G. Murray (2004), ‘Corporate venture capital and the exercise of the options to acquire’, R&D Management, forthcoming. Mayer, C., K. Schoors and Y. Yafeh (2005), ‘Sources of funds and investment strategies of VC funds: evidence from Germany, Israel, Japan and the UK’, Journal of Corporate Finance, 11, 586–608. Megginson, W.L. (2004), ‘Towards a global model of venture capital?’, Journal of Applied Corporate Finance, 16, 8–26. Poterba, J. (1989a), ‘Capital gains tax policy towards entrepreneurship’, National Tax Journal, 42, 375–89. Poterba, J. (1989b), ‘Venture capital and capital gains taxation’, in L.H. Summers (ed.), Tax Policy and the Economy, Cambridge, MA: MIT Press, pp. 47–67. Repullo, R. and J. Suarez (2004), ‘Venture capital finance: a security design approach’, Review of Finance, 8, 75–108. Riyanto, Y. and A. Schwienbacher (2005), ‘The strategic use of corporate venture financing for securing demand’, Journal of Banking and Finance, forthcoming. Sahlman, W.A. (1990), ‘The structure and governance of venture capital organizations’, Journal of Financial Economics, 27, 473–521. Santhanakrishnan, M. (2002), ‘The impact of complementarity on the performance of entrepreneurial companies’, unpublished manuscript, Arizona State University. Sapienza, H.J., S. Manigart and W. Vermeir (1996), ‘Venture capitalist governance and value added in four countries’, Journal of Business Venturing, 11, 439–69. Schmidt, K.M. (2003), ‘Convertible securities and venture capital finance’, Journal of Finance, 58, 1139–66. Schmidt, D. and M. Wahrenburg (2003), ‘Contractual relations between European VC funds and investors: the impact of bargaining power and reputation on contractual design’, CFS Working Paper No. 2003/15. Shleifer, A. and D. Wolfenzon (2002), ‘Investor protection and equity markets’, Journal of Financial Economics, 66, 3–27. Siegel, R., E. Siegel and I.C. MacMillan (1988), ‘Corporate venture capitalists: autonomy, obstacles and performance’, Journal of Business Venturing, 3, 233–47. VC Experts (2003), ‘Sources of capital: strategic or industry investors – corporate venture capital’, http:// vcexperts.com/vce/library/encyclopedia/documents_view.asp document_id1333, accessed 18 March 2006. Winters, T.E. and D.L. Murfin (1988), ‘Venture capital investing for corporate development objectives’, Journal of Business Venturing, 3, 207–22. Yost, M. and K. Devlin (1993), ‘The state of corporate venturing’, Venture Capital Journal, June, pp. 37–40.

6

The pre-investment process: Venture capitalists’ decision policies Andrew Zacharakis and Dean A. Shepherd

Introduction The venture capital process can be thought of as a series of activities or stages that each new venture works through from the time the venture is first proposed up until the time when the venture capital firm successfully exits from the venture and takes its profit. For example, Tyebjee and Bruno (1984) proposed a model of the venture capital process with five such stages: (1) deal origination – seeking potential investments; (2) deal screening – quick review of business plans and/or oral proposals, both solicited and unsolicited; (3) deal evaluation – for those deals that pass the screen, more in-depth due diligence to validate business model and prospects; (4) deal structuring – establishing and negotiating the terms of the investments; and (5) post-investment – value-added activities such as serving on the board, assisting with follow-on investment and liquidity events. Preinvestment activities refer to all venture capital tasks up to and including the signing of an investment contract: soliciting new venture proposals for submission to the venture capital firm, determining whether these proposals meet the firm’s broad screening criteria, conducting due diligence (more extensive research to determine the likely success of the venture), and then negotiating and structuring a relationship with the entrepreneur. In this chapter we focus on the screening phase of the pre-investment process – specifically, what decision criteria are important to the investment decision and how this decision process works – while post-investment activities will be discussed in detail in the next chapter by De Clercq and Manigart (Chapter 7). The venture capitalist’s most valuable asset is his time. Gorman and Sahlman (1989) find that venture capitalists spend 60 per cent of their time on post-investment activities. On average, a venture capitalist commits 110 hours per year to assisting and monitoring one venture investment (Gorman and Sahlman, 1989). While venture capitalists spend most of their time and eﬀort on post-investment activities, that time and eﬀort is ineﬃcient if the venture capitalists make investments in marginal ventures. In fact, Roure and Keeley (1990) assert that success can be predicted from information contained in the business plan. Therefore, improving the investment decision can improve the venture capitalist’s performance. Better understanding how venture capitalists make decisions and more importantly, how they can improve their decision process will lead to more eﬃcient use of their time and higher overall returns (Zacharakis and Meyer, 2000). Thus, the vast majority of research on the pre-investment process has focused on how venture capitalists select those ventures that they back. Deal flow and due diligence are under-researched (see Smart, 1999, for one of the few studies on due diligence) and while work on valuation (for example Keeley and Punjabi, 1996; Kirilenko, 2001; Seppä and Laamanen, 2001) and contracts is common (for example Gompers and Lerner, 1996; Kaplan and Stromberg, 2004; Cumming, 2005), it views the topic from an economic rational perspective (that is what is 177

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the optimal valuation to motivate and align the entrepreneur’s eﬀorts with the venture capitalist’s objective of achieving high ROI and deriving an appropriate contract to minimize the threat of opportunism). While we limit the scope of this chapter to the investment decision, we do believe that the decision process during the selection phase impacts both due diligence and negotiation. As such, there is room to explore how venture capital decisions influence these phases. Venture capitalists diﬀer in the screening criteria they use to select ventures including type of industry, company stage of development, geographic location, and size of investment required. For example, venture capitalists often specialize by industry (Sorenson and Stuart, 2001). A venture capitalist interested in biotechnology will look at criteria diﬀerently than venture capitalists interested in retail; proprietary protection may be of more importance for instance. Likewise, venture capitalists focused on early stage deals may place more emphasis on the team – can the entrepreneur execute on the opportunity – since there is little past history of the venture to evaluate. Later stage venture capitalists can assess the team’s capabilities based upon what the venture has achieved in its earlier stages. While venture capitalists with diﬀerent objectives emphasize diﬀerent criteria, the basic categories still hold (the entrepreneur, the market size and growth, the product, the competition, and so on), but how the criteria are used or weighted diﬀers. The primary goal of this chapter is to review the progression of venture capital research on investment selection in the screening phase and primarily takes an information processing perspective to do so. It is our belief that the field is becoming more sophisticated in both its methods and questions asked. We have moved beyond simple surveys and interviews asking venture capitalists how they select which ventures to back, to tests of how venture capitalists actually make decisions and how contextual and process factors influence that decision. As is true with all fields of inquiry, the more we learn, the more questions that arise. Thus, this chapter not only looks backwards, but suggests ways forward. The chapter progresses as follows: first, we review the early research on venture capital decision making followed by an overview of how verbal protocols and conjoint analysis have helped us answer basic questions, such as what criteria do venture capitalists use in the decision and how do they use those criteria. The following section looks at context of the decision. Industrial organization economics, the resource based view and institutional theory suggest how context might influence the decision. Next, we examine how biases and heuristics impact the venture capital process. The basic question underlying process is whether biases and heuristics are eﬃcient means for boundedly rational decision makers to pick the best ventures, or whether they lead to sub-optimal decisions. Much of the research to date assumes that venture capital decision making is relatively homogeneous, but more recently researchers are looking at factors that lead to heterogeneity in the decision process. At the end of each of the major sections of our review, we raise several new research questions and avenues to explore them. The evolution of research on pre-investment venture capital Venture capital research has progressed and become more sophisticated. This section highlights the move from simple surveys and interviews which rely on accurate introspection to verbal protocols and conjoint analysis. Verbal protocols are real-time ‘think aloud’ observations of the venture capitalist screening a potential deal. As such, they allow researchers to track what and when information is used in the decision. Conjoint analysis

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moves beyond verbal protocols to a controlled experiment which allows researchers to capture the relative importance of diﬀerent decision criteria. Venture capitalists’ espoused decisions Venture capitalists are conspicuously successful at predicting new venture success (Hall and Hofer, 1993; Sandberg, 1986) and numerous studies have investigated their decision making. The majority of research on venture capitalists’ decision making has produced empirically derived lists of venture capitalists’ ‘espoused’ criteria which are the criteria venture capitalists report they use when evaluating new venture proposals, including early seminal articles by Tyebjee and Bruno (1984) and MacMillan and colleagues (MacMillan et al., 1985; 1987). Tyebjee and Bruno (1984) articulated four categories – market potential, management, competition and product feasibility – and MacMillan et al. (1985) grouped their 27 criteria into six categories – the entrepreneur’s personality, experience, characteristics of product/service, characteristics of market, financial considerations and venture team. This early research consistently finds that the entrepreneur and team are the most important decision criteria in distinguishing between successful and failed ventures. For example, MacMillan et al. (1985) find that 6 of the top 10 criteria relate to the entrepreneur and team. The findings of these early studies fit the mantra espoused by Georges Doriot, the father of venture capital and founder of the first modern venture capital firm ARD, that he’d rather ‘invest in an “A” team with a “B” idea than a “B” team with an “A” idea’ (as noted in Timmons and Spinelli, 2003). This early research provided a context in which to understand and evaluate venture capitalists’ decision making, but it was prone to recall and post hoc rationalization biases (Zacharakis and Meyer, 1995). Zacharakis and Meyer (1998) find that venture capitalists aren’t accurate in self-introspection. In other words, post hoc studies may not truly capture how venture capitalists use decision criteria. Verbal protocol analysis of venture capitalists’ decisions Next there were studies by Sandberg et al. (1988), Hall and Hofer (1993), and Zacharakis and Meyer (1995) that attempted to overcome prior post hoc study flaws by using verbal protocols. Verbal protocols are real time experiments where venture capitalists ‘think aloud’ as they are screening a business plan (Ericsson and Crutcher, 1991). Thus, venture capitalists aren’t required to introspect about their thought processes which removes recall and post hoc rationalization biases (Sandberg et al., 1988). Moreover, the verbal protocol approach provides richer understanding of the decision process whereas post hoc methods focus on the decision outcome (Hall and Hofer, 1993). Verbal protocols, for instance, not only allow the research to capture what criteria venture capitalists use, but in which order they consider diﬀerent criteria and how much time they spend evaluating each criterion, which gives us a relative sense of the importance of diﬀerent criteria. Results from verbal protocol studies suggest that venture capitalists’ insight into their decision processes may be less than perfect. For example, Hall and Hofer (1993) find that the venture capitalist pays relatively little attention to entrepreneur/team characteristics and even less attention to strategic issues of the new venture proposal. Instead, the most important factor centred on the market and product attributes, which is congruent with the findings of Zacharakis and Meyer (1995). Such findings appear to contradict most post hoc studies which find that the entrepreneur is typically the most important factor.

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Zacharakis and Meyer (1995) suggest that the discrepancy may be attributable to the screening stage on which verbal protocol research has focused. Specifically, venture capitalists may assess whether the entrepreneur meets minimum qualifications during the screening stage, and reserve final judgment for later evaluation (see Smart’s, 1999 study on how venture capitalists evaluate the entrepreneur during due diligence). While verbal protocols are rich in the amount of data collected from each venture capitalist, they are time consuming as the researcher needs to observe each venture capitalist as he actually reviews a plan. As such, these studies are limited by the small sample sizes that can be easily accommodated. Nonetheless, the discrepancy between verbal protocols and earlier post hoc studies spurred a new wave of real time experiments that can more eﬃciently manage larger samples. Conjoint analysis and policy capturing of venture capitalists’ decision policies Conjoint analysis and policy capturing move beyond survey methods used to identify decision criteria and verbal protocols used to assess how and when criteria are used. Conjoint analysis is a ‘technique that requires respondents to make a series of judgments, assessments or preference choices, based on profiles from which their “captured” decision processes can be decomposed into its underlying structure’ (Shepherd and Zacharakis, 1997, p. 207). Policy capturing is a type of conjoint analysis. The research supports the notion that venture capitalists aren’t very good at introspecting about their decision process (Zacharakis and Meyer, 1998). Conjoint studies (Zacharakis and Meyer, 1998) support verbal protocol research (Hall and Hofer, 1993; Zacharakis and Meyer, 1995) indicating that market issues might be more important than entrepreneur characteristics. In general, real time studies find that venture capitalists tend to overweight less important factors and underweight more important factors when they ‘espouse’ lists of decision criteria they say they use in their assessments (Zacharakis and Meyer, 1998; Shepherd, 1999). Furthermore, the accuracy of introspection decreases the more information that the decision maker faces (Zacharakis and Meyer, 1998). This leads venture capitalists to remember more salient information as being more important than it actually was. The finding is particularly pertinent to the venture capital process as information inundates the venture capital decision context. For example, there is information about the entrepreneur (for example entrepreneur’s industry and startup experience), market (for example size and growth), product/service (for example proprietary protection), among other categories. Not only is there a lot of available information, but much of it is of a subjective nature. For example, venture capitalists often discuss the ‘chemistry’ between themselves and the entrepreneur. The deal often falls through if the chemistry is not right. Such intuitive, or ‘gut feel’ (MacMillan et al., 1987; Khan, 1987), decision making is diﬃcult to quantify or objectively analyse. The added complexity from subjective information further clouds the decision making process and invites decision makers toward more biases that impede their ability to introspect accurately. Due to the complexity of the decision and the venture capitalists’ intuitive approach, venture capitalists have a diﬃcult time introspecting about their decision process (Zacharakis and Meyer, 1998). In other words, venture capitalists do not have a comprehensive understanding of how they make the decision. This lack of understanding may lead to sub-optimal decision strategies and subject venture capitalists to biases that may lead to sub-optimal decisions. Conjoint analysis and policy capturing allows us to gain a deeper understanding of the venture capital decision process (Shepherd and Zacharakis, 1999). Not only can researchers

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capture how important each decision criterion is to the decision relative to other decision criteria (Zacharakis and Meyer, 1998), but it also allows for examining contingent decision processes (Zacharakis and Shepherd, 2005). Thus, the research in venture capital decision making has followed a natural progression from identifying decision criteria through post hoc surveys (for example Tyebjee and Bruno, 1984; MacMillan et al., 1985) to understanding how that information is utilized during the actual decision via verbal protocols (Sandberg et al., 1988; Hall and Hofer, 1993; Zacharakis and Meyer, 1995) to controlled experiments which can pull out the similarity/diﬀerences between venture capitalists (Zacharakis et al., 2007), the relative importance of diﬀerent decision criteria (for example Muzyka et al., 1996) and more complex, contingent decision policies (Shepherd et al., 2000; Zacharakis and Shepherd, 2005). The following sections will elaborate on how the venture capital decision making research has used experiments to test theory on both the content venture capitalists’ decision policies and the decision process. Theory development and experiments for empirical testing In this section we continue our review of conjoint analysis and focus on the theory development in increasing our understanding of both the content of venture capitalists’ decision policies and the process by which they make those decisions. Theory development and content tested using experiments Riquelme and Rickards (1992) pioneered conjoint analysis in the study of venture capital decision making. They ran a series of pilot tests on 14 venture capitalists and concluded that conjoint analysis is an eﬀective means of studying the venture capital process. Shortly thereafter, Muzyka et al. (1996) used conjoint experiments to explore the importance of a long list of criteria (35 investment criteria) that venture capitalists had identified as being important when making their decisions. They used a conjoint experiment that required 73 venture capitalists to each make 53 pair-wise trade-oﬀs with multiple levels. The criteria fell into seven groupings: (1) financial; (2) product-market; (3) strategic-competitive; (4) fund; (5) management team; (6) management competence; and (7) deal. They found that venture capitalists ranked in the top seven criteria all five management team attributes, product market criteria appeared to be only moderately important, and fund and deal criteria were at the bottom of the rankings. This study led Muzyka and his colleagues (1996, p. 274) to conclude that the venture capitalists interviewed would prefer to select an opportunity that oﬀers a good management team and reasonable financial and product-market characteristics, even if the opportunity does not meet the overall fund and deal requirements. It appears, quite logically, that without the correct management team and a reasonable idea, good financials are generally meaningless because they will never be achieved.

While pair-wise conjoint studies identify which criteria might be more important than other criteria, it still suﬀers post hoc recall biases as the venture capitalists are not making real time investment decisions, but thinking about how they believe they used the criteria listed on past decisions. More recently, experimental methods such as metric conjoint analysis and policy capturing have been used to test theoretically derived hypotheses on the content of venture capitalists decisions in a real time investment decision. For example, Shepherd and colleagues used an industrial organization economics (IO) perspective of strategy to investigate the

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types of information venture capitalists utilize when evaluating new ventures (including its strategy and experience) and how venture capitalists use this information to assess new venture survival (Shepherd, 1999) and profitability (Shepherd et al., 2000). Specifically, Shepherd (1999) used the IO strategy and population ecology literatures to develop a model of new venture survival that centred on the importance of uncertainty. This study found that in assessing the probability of survival venture capitalists consider the new venture’s timing, lead time, educational capability, industry related competence and the nature of the environment in terms of stability of the key success factors and competitive rivalry. These results suggested considerable consistency between the proposed theoretical framework and the decision policies of venture capitalists. In investigating venture capitalists’ assessments of profitability, the theory development work of Shepherd et al. (2000) suggested contingent relationships between the criteria that were previously used to explain the probability of survival. Specifically, they found that the relationship between timing of entry and venture capitalists’ assessment of profitability is moderated by key success factor stability (environmental stability), lead time and educational capability. Zacharakis and Shepherd (2005) used theory from the resource-based view (RBV) of strategy to hypothesize that venture capitalists use non-additive decision policies when making their investment decision – interactions between leadership experience and other internal resources, and between leadership experience and environmental munificence are reflected in venture capitalists’ decision policy. A policy capturing experiment found that although venture capitalists always prefer greater general experience in leadership, they value it more highly in large markets, when there are many competitors, and when the competitors are relatively weak. It also found that previous start-up experience of the venture’s management team may substitute for leadership experience in venture capitalists’ decision policy. The above research has used theory to hypothesize content that is then tested using experiments to understand whether venture capitalists’ decision policies are consistent with theory, or if they deviate, what the nature of that deviation is. These studies are illustrative of the increasing sophistication in venture capital decision making research. Specifically, these studies go beyond the simple main eﬀects studies of the past and ask not only what criteria venture capitalists use, but how these criteria interact with other criteria in the venture capitalist’s decision. These investigations produce a decision policy for the sample as a whole yet there are theoretical reasons that under certain circumstances venture capitalists should diﬀer in their decision policies. The next level of sophistication moves beyond building base models that describe the general venture capital decision, to when venture capitalists might deviate from this base model. In other words, newer research needs to examine the heterogeneity of venture capital decision making. Recent experimental research on the content of venture capitalists has focused on explaining variance in the decision policies across venture capitalists. Based on institutional theory that various economic institutions structure the incentives of human exchange diﬀerently, Zacharakis et al. (2007) proposed that venture capitalists from diﬀerent countries (US – mature market economy, South Korea – emerging economy, and China – transitional economy) would use diﬀerent information when formulating their decisions. Using policy capturing experiments on 119 venture capitalists across these three countries, they found that venture capitalists in rules-based market economies rely upon market information to a greater extent than venture capitalists in emerging economies,

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and also found that Chinese venture capitalists more heavily weigh human capital factors than either US or Korean venture capitalists. We expect that more research will use theory to explain variance in decision policies across venture capitalists. Future research opportunities into venture capital decision making content Beginning with Riquelme and Rickards (1992) and Muzyka et al. (1996), there has been substantial progress in theoretically based conjoint experiments that allow us to understand the extent to which our theories are reflected in the way that venture capitalists make decisions. The theoretical approaches to date have relied heavily on strategy research to derive criteria. This makes sense because both are interested in assessing firm performance. However, we believe that there are opportunities to move beyond theories of strategy to drive theory-based conjoint studies intent on better understanding the content of venture capitalists’ decision policies. For example, much has been made about the management team. There are likely opportunities to explore theories of psychology and team behaviour to derive criteria which we believe that venture capitalists may use in assessing the ‘quality of the management team’. How motivated are entrepreneurs? Will they maintain their motivation and eﬀort when things get tough? How do they handle stress? Perhaps theories from economics will provide the opportunity for more fine-grained experimental work to understand how venture capitalists assess potential competition. Are venture capitalists always equally concerned about competition? Do venture capitalists weigh the risk of new entrants less heavily in their investment decisions when the potential portfolio company is in a highly munificent and/or highly dynamic environment? Is competition sometimes viewed positively, such as with new entrants legitimating an emerging market? There are ample opportunities to take one of the criteria that have been tested above and use theory to explore it in finer detail and then test it using conjoint analysis. To date, research has focused primarily on the screening stage and venture capitalists looking at early stage deals. There is reason to expect that decision criteria, or at least the relative importance of decision criteria, might diﬀer across both venture capital process stage and the venture’s development stage. For example, Smart (1999) finds during the due diligence stage that venture capitalists quiz entrepreneurs on a number of ‘what if’ scenarios to see how they might react to diﬀerent situations new ventures are likely to face, especially for early stage ventures. For later stage ventures, Smart finds that venture capitalists spend more time evaluating the entrepreneur’s achievements within the current venture to that point in time. Research along these lines could be expanded and tied to the type of entrepreneur content venture capitalists explore at diﬀerent stages of the venture capital process. Likewise, the relative emphasis on other content areas may change based upon the venture capitalist’s process stage and the venture’s development stage. There is also reason to expect that venture capitalists’ criteria diﬀer based upon the venture’s industry. These avenues of future research extend the base model of venture capital decision making and are the next logical step in the development of this line of research. Theory development in process and experiments Using information processing theory (Anderson, 1990; Lord and Maher, 1990) has helped the venture capital decision making stream to develop by allowing us to predict and understand how venture capitalists make decisions, and when those decisions may be suboptimal, biased and contain errors. The following sections delineate why we need to

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understand the ‘process’, how information processing theory helps us understand the process, especially as it pertains to mean for managing all the information, potential biases to the process and so on. Why understanding process is important While understanding the content of the venture capitalist’s decision is crucial to improving those decisions, it is also critical to understand the process by which venture capitalists make decisions. Decision makers are not perfectly rational, but boundedly rational (Simon, 1955; Cyert and March, 1963). It is impossible for venture capitalists to evaluate all information fully as their decision environment is particularly rich in information (Zacharakis and Meyer, 1998) and highly equivocal in nature (Moesel et al., 2001). Venture capitalists must interpret information at the environmental level (industry trends, economic conditions, and so forth), the business model level (can the venture capital financing enable the company to grow to a point where the venture capital can extract a return on investment), and the team level (can the entrepreneur team execute). Information richness, or as Zacharakis and Meyer (1998) call it, ‘information noise’, leads venture capitalists to economize on their decision process in order to manage the sheer volume of information. Thus, venture capitalists will use heuristics, both consciously and unconsciously, that filter out certain information and allow the venture capitalists to focus on other information. However, what information venture capitalists pay attention to impacts their decision process and may result in decision biases. Information processing theory Cognitive science, the study of how people make decisions, has provided a fruitful source for theories that have been applied to the venture capital decision process. Barr et al. (1992) delineate a simple information processing model that describes decisions as a function of what information attracts the manager’s attention, how that information is interpreted, and what actions follow from that interpretation. The expert decision making model (Lord and Maher, 1990) best fits the venture capital environment (Shepherd et al., 2003). Expert models can be characterized as fitting between a truly rational decision model where all information and alternatives are considered and evaluated to a limited capacity model which recognizes the cognitive limits of decision makers (Cyert and March, 1963). Experts learn which factors best distinguish between successful and unsuccessful ventures (Shepherd et al., 2003), although this is often on an unconscious level (Zacharakis and Meyer, 1998). Venture capitalists possess a multitude of mental models which can be called into action depending upon the situation (that is based on past experience with industry, or past experience with lead entrepreneur, and so on (Zacharakis and Shepherd, 2001)). Thus, when the venture capitalist perceives a somewhat familiar situation which requires action, an appropriate mental model is summoned from long term memory (Moesel et al., 2001). In unfamiliar situations, the venture capitalist uses an evaluation strategy (a mental model of how to approach new situations) to formulate the information into a mental model which is then manipulated to make a decision. However, the venture capitalist’s mental model of the situation influences what and how the information surrounding the situation is perceived; the mental model acts as a filter which preserves limited cognitive processing capacity (Moesel et al., 2001; Zacharakis and Shepherd, 2001). An example might better illustrate the mental model concept. Imagine two venture capitalists examining the same proposal. The first venture capitalist is very familiar with the industry and, in fact, also

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has extensive knowledge of the team. As such, the venture capitalist is likely to base her/his judgment on these two chunks of information. Other important information that doesn’t fit neatly within this configuration receives limited consideration. The second venture capitalist, on the other hand, is not familiar with the industry or the entrepreneurial team. In this case, the venture capitalist doesn’t possess a mental model based on the larger chunks of information. The venture capitalist assesses the entire array of information and uses various decision strategies to make her/his decision. For example, s/he may use a satisficing strategy (Simon, 1955) and assess whether the proposal meets the minimum criteria on each decision factor. With information processing theory as a theoretical lens, a number of pertinent issues have been studied in the venture capitalist decision process. Primarily, what heuristics do venture capitalists employ to make decisions in an information rich environment? And, what factors might bias venture capitalist decision making? It is our estimation that we have only begun to scratch the surface on these issues. Heuristics Heuristics, or ‘rules of thumb’, are sub-optimal decision strategies in that the decision maker does not fully utilize all available information (Tversky and Khaneman, 1974; Simon and Houghton, 2002). Since decision makers have limited cognitive capacity, they rely on heuristics to conserve cognitive resources (Simon, 1981). Whereas biases impact decision eﬀectiveness by directing the decision maker’s attention to salient information, heuristics provide a ‘road map’ on how and which information is used to make a decision. Eisenhardt (1989) suggests that heuristics allow decision makers to derive decisions based upon fragments of information about various attributes and alternatives surrounding the decision. In other words, heuristics are mental models that make certain information factors more salient than others. Therefore, while heuristics ‘are always eﬃcient, and at times valid, these heuristics can lead to biases that are persistent, and serious in their implications’ (Slovic et al., 1977, p. 4). Hitt and Tyler (1991) add that although heuristics ease cognitive strain, they often lead to systematic biases. The new venture environment encourages heuristic use as entrepreneurs and venture capitalists face information overload, high uncertainty regarding success, novel situations, and time pressure (Baron, 1998). Baron (1998) points out that under certain contextual factors, such as time constraints, heuristic strategies may lead to better decisions than would occur under the rational model. Busenitz (1999) adds that speed may be critical in an entrepreneurial environment where a new venture needs to launch while the ‘window of opportunity’ is open. Although heuristic research has focused mostly on entrepreneur decision making, much of it is relevant to venture capitalists as they participate in a similar environment (Moesel et al., 2001). The underlying principle is that heuristic eﬀectiveness is a question of cost versus benefit (Fiske and Taylor, 1991). Is the time spent reaching an optimal decision more valuable than the approximate decision reached by using a time saving heuristic? Part of the answer depends on which heuristic the decision maker is using. Based upon Payne et al.’s (1988) categories, it is likely that venture capitalists use noncompensatory strategies (that is they don’t evaluate all the information surrounding an alternative when making a decision); they do not have the time, or the cognitive capacity to use all information surrounding a proposal (Moesel and Fiet, 2001). Venture capitalists are also likely to use an alternative versus an attribute-based approach (Payne et al., 1988)

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as they typically review ventures as they are presented to them. Under an alternative approach, the venture capitalist evaluates each proposal in isolation, typically looking to reject the venture idea because it fails on one or more of the attributes. Since each proposal is evaluated in isolation, the venture capitalist may be inclined to compare it to past ventures. Comparing the current venture to other transacted deals is a representative heuristic; the tendency to generalize from small, non-random samples (Busenitz, 1999). In the venture capitalists’ case, they tend to compare current ventures under consideration to deals that they have made (or passed on) in the past (Zacharakis and Meyer, 2000). While using a representative heuristic saves time, it can lead to sub-optimal decisions in that the decision maker generalizes from a small, non-random sample and thereby is likely to underestimate the risk of failure (Busenitz, 1999; Keh et al., 2002). The underestimation risk is heightened in conjunction with the recall bias in that people tend to recall past successes and forget past failures (Dawes et al., 1989). Venture capitalists also tend to use satisficing heuristics (Zacharakis and Meyer, 2000) which means that as they evaluate a venture they are looking for reasons to quickly dispatch it as a poor investment choice. The rationale for such a heuristic is quite simple as most venture capitalists are inundated with entrepreneurs seeking funding. Quickly screening out deals allows venture capitalists to spend more time on other activities that can increase returns, such as post-investment work with portfolio companies. Thus, considering the time constraints that venture capitalists face, satisficing is both eﬃcient and eﬀective by enabling venture capitalists to focus their time on those ventures that have the greatest perceived potential. The downside of satisficing and representative heuristics is that they may lead to a ‘herding’ phenomenon (Gompers et al., 1998). Venture capitalists may chose to invest in those ventures which are most like the ventures that other venture capitalists have funded, such as was the case in the dot.com boom and bust. This can lead to overcrowding in the market space with lots of ‘me-too’ competitors that damage the overall sector dynamics and increase the failure rate within that space. Biases Biases are those salient factors that cause the venture capitalist to evaluate situations diﬀerently by aﬀecting which mental models are used for any particular decision (Zacharakis and Shepherd, 2001). For example, a venture capitalist’s experience within an industry may cause the venture capitalist to evaluate available industry information more rigorously because s/he knows the industry well (that is industry indicators and benchmarks); an availability bias. On the other hand, it may cause the venture capitalist to evaluate the other aspects of the proposal less rigorously such as product and entrepreneur attributes. The point is that such knowledge biases the venture capitalist; the venture capitalist evaluates or uses diﬀerent mental models for this proposal than a venture capitalist who is unfamiliar with the industry. In other words, the venture capitalist deviates from his/her base decision model. Just because mental models bias decisions does not mean that they result in errors (Barr et al., 1992). However, these biases most likely prevent decision makers from reaching optimal solutions (in the rational model sense) because they may reduce the amount of information and alternatives considered. The number of potential biases to any decision is enormous. Table 6.1 lists several biases that aﬀect decision making eﬀectiveness. Only a few of the listed biases have received attention in the venture capital literature. The others provide an opportunity to research their impact, if any, on venture capitalist decision making.

The pre-investment process Table 6.1

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Biases to decision making

Bias

Description

Availability

Easy recall of well-publicized or chance events which means that decision maker focuses more on available events in the decision process, and neglects unavailable information Problems structured by an individual’s prior experience Absolute cue frequency is used versus the relative occurrence Concrete data dominates abstract data Belief that two variables covary when in fact they do not covary Evaluation biased by sequence, presentation mode, qualitative versus quantitative mixture, perceived display ‘logic’, and context Inability to apply judgments consistently Failure to revise decisions when presented with new evidence Underestimation of joint probabilities and growth rate Previously successful alternatives are applied to solve a problem Prediction results from upward or downward adjustment of a cue value Evaluation based upon a similar class of events Small samples are believed representative A rule can be used if it can be ‘justified’ Predictions fail to recognize regression toward the mean Simplification and ignoring data Information overload and time pressures reduce consistency Belief that your decisions are correct more often than is actually the case Induces panic judgments or reduced attention Conformity or distortion of judgments Increase decision confidence but not accuracy Judgment process requirements or choice aﬀects outcome Measurement scale aﬀects response perceptions Preferences aﬀect the assessment of events Perceived control resulting from activity concerning the outcome Observed outcomes provide incomplete feedback for correction Higher probability of event following unexpected similar chance outcomes Success is attributed to skill; failure to chance Failure to recall past details leads to logical reconstruction Plausible explanations can be found for past surprises

Selective perception Frequency Concrete information Illusory correlation Data presentation Inconsistency Conservatism Non-linear extrapolation Habit Anchoring/adjustment Representativeness Law of small numbers Justifiability Regression bias Best guess strategy Complex environment Overconfidence Emotional stress Social pressures Consistent data sources Question format Scale eﬀects Wishful thinking Illusion of control Outcome irrelevant ‘Gambler’s fallacy’ Success/failure attributions Recall fallacies Hindsight bias

Source: Adapted from Hogarth and Makridakis, 1981.

Overconfidence is one bias that has received attention in the venture capitalist realm. Using a conjoint experiment, Zacharakis and Shepherd (2001) find that venture capitalists are overconfident (96 per cent of the 51 participating venture capitalists exhibited significant overconfidence) and that overconfidence negatively aﬀects venture capitalists’ decision accuracy (the correlation between overconfidence and accuracy was 0.70). The experiment controlled for the amount of information each venture capitalist reviewed and

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the type of information reviewed. The study finds that more information leads to increased overconfidence. What this means is that venture capitalists believe more information leads to better decisions, yet they don’t necessarily use all that information and their overall decision accuracy is lower. Likewise, venture capitalists’ confidence increases when they view information criteria with which they are more familiar and comfortable. Finally venture capitalists are more overconfident in their failure predictions than success predictions. As such, Zacharakis and Shepherd (2001) posit that overconfident venture capitalists may limit their information search (although they believe that they are fully considering all relevant information) and focus on salient factors (for example how similar this deal is to a past successful deal) despite other information factors that would suggest this deal might fail. Unlike Busenitz and Barney (1997) who suggest that overconfidence can have positive ramifications for entrepreneurs – they will launch the venture in the first place and then work harder to make sure the venture succeeds – overconfidence in venture capitalists is likely to be mostly a negative in that it is overconfidence in decision making ability and it may not lead to increased eﬀort to help failing ventures succeed, especially when venture capitalists often attribute failure to outside, uncontrollable events (Zacharakis et al., 1999). Future research opportunities on the venture capital decision process Beyond the above studies, there does not appear to be much other work on heuristics and biases that impact the venture capital decision process. Research on heuristics in the entrepreneurship literature, however, has focused on those used by entrepreneurs, and has relatively ignored venture capitalists’ decision making. Although only a small number of heuristics have received the attention of entrepreneurship scholars, there are others that may be pertinent. We suggest these as a source of future research. Finally, heuristics can have both positive and negative outcomes. Much more research, along the lines of Baron (1998) and Busenitz (1999), can shed light under which conditions heuristics are better or worse. The topic of biases has received more attention when looking at entrepreneurs’ decision making. As noted above, Baron (1998) asserts that the new venture context creates an environment ripe for decision biases. Baron (1998) suggests that entrepreneurs are prone to counterfactual thinking; the tendency to think about ‘what might have been’. He proposes that entrepreneurs are more likely to regret actions not taken (for example a missed opportunity), rather than the mistakes they may have actually made. A counterfactual bias may also have a strong impact on venture capitalists. Anecdotally, we read about venture capitalists who bemoan passing up investments in big winners, such as Amazon or Google. This regret may increase the tendency to take bigger risks without fully evaluating all the information around a venture decision because the venture capitalist doesn’t want to miss out again. It may also lead to chasing bubbles, as venture capitalists see others succeed in a particular space and feel that they need to get in there or lose out (for example the dot.com bubble). This counterfactual thinking and any number of the biases listed in Table 6.1 provide fertile ground for extending our knowledge of venture capital decision making. Future research opportunities to examine heterogeneity in venture capital decision policies Now that the field has a strong grasp of the core venture capital decision making process, it is time to dig into aspects that lead to variance from that core process, such as heuristics

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and biases. For instance, we suspect that there are a number of demographic and psychographic factors that might lead to diﬀerence susceptibility to use certain heuristics and biases. For example, Shepherd et al. (2003) find that experience has a curvilinear impact on decision accuracy. After 14 years of venture capital experience, decision accuracy declines. Shepherd et al. (2003) suggest this is likely to be due to a number of biases that lead to venture capitalists economizing their decision process; relying more on gut feel (Khan, 1987). Simon and Houghton (2002) find that smaller, younger entrepreneurial firms exhibit more biases than larger more established firms. It is reasonable to assume that size and age factors might cause venture capital firms to act diﬀerently. For example, Gompers (1996) argues that younger venture capital firms push ventures to IPO or other liquidity events prematurely – called grandstanding – in order to gain credibility in the eyes of potential limited partners when raising another follow-on fund. We propose that new research start digging into these biases and heuristics to paint a deeper picture of the venture capital decision process. There is also room to examine how context aﬀects venture capitalist biases. Einhorn (1980) highlights a number of factors that can hinder eﬀective decision making: 1. 2. 3. 4. 5. 6. 7. 8.

Information from the environment which is not clean; environmental noise disguises information relevance; feedback on past decisions which is often incomplete or distorted; the relationship between decision rules and their outcomes which is frequently non-linear; placing information into an appropriate category which can be diﬃcult due to ‘fuzzy’ category definitions; the need to consider several decision rules at once; decision rules which often have counterintuitive or unexpected relationships with the outcome; certain actions by that person, after the decision has been made, which influence the outcome of his/her decision; and judgments which, at times, must be made under pressure.

All of these factors are prevalent in the venture capital decision domain and create an opportunity to assess how they impact the venture capitalist decision. For example, are venture capitalists diﬀerently susceptible to these conditions? Are these conditions stronger in certain industries than others? Do they diﬀer across countries? Conclusion This chapter focuses on venture capitalists’ pre-investment activities, namely, their assessment and investment decisions. The implications from the research to date are many. For example, we have learned that venture capitalists are poor at introspecting about their own decision processes (Zacharakis and Meyer, 1998). This lack of insight makes it diﬃcult for venture capitalists to learn from past decisions and to improve future decisions. Moreover, it is diﬃcult to articulate and train junior associates if the venture capitalist doesn’t understand his own decision process. Shepherd and Zacharakis (2002) suggest that modeling a venture capitalist’s decision process can help him gain this insight and can

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also be used as a training tool. Zacharakis and Meyer (2000) find that models of the venture capital process, or actuarial aids, improve the venture capitalist’s decision accuracy. They suggest that such actuarial aids can be used by junior associates to screen ventures, thereby freeing up the venture capitalist’s time for other activities. We have also called for more research into decision heuristics. Heuristics can be eﬃcient and eﬀective especially for time constrained venture capitalists. Yet, venture capitalists need to understand which heuristics they use and when diﬀerent heuristics are most eﬀective. While a satisficing heuristic allows venture capitalists to screen proposals quickly, strictly following the heuristic may mean that venture capitalists reject potentially attractive deals because they fail to pass a hurdle on a relatively minor attribute. Creating a venture ‘scorecard’ where the venture capitalist rates and records each proposal on the attributes that they believe to be most pertinent helps ensure that venture capitalists don’t overweight the importance of a negative evaluation on a relatively minor attribute or underweight a positive evaluation on a relatively more important attribute. The scorecard also creates a history that minimizes post hoc recall and rationalization biases and thereby provides a feedback source that can help venture capitalists learn and improve their decision process (Zacharakis and Meyer, 1998). While some research has investigated potential biases and their impact (Zacharakis and Shepherd, 2001), more research into biases will further benefit venture capitalists. The key implication is that venture capitalists should be aware that they, as is true for all decision makers, are prone to biases that might lead to sub-optimal decisions. Venture capitalists can take steps to minimize the potentially negative impact of biases. Some methods, such as the weekly partners meeting, are built into the venture capital process (Shepherd et al., 2003). During such meetings, a venture capitalist should articulate why they like a particular venture and the other partners should challenge some of the underlying assumptions. This will help all the venture capitalists identify areas where they might be biased, such as overweighting a salient attribute like the entrepreneur. Unfortunately, this meeting only helps venture capitalists avoid biases that might incline them to back a venture that isn’t as attractive as it seems. Venture capitalists should consider also presenting a deal that they didn’t like and to articulate why. While it is true that venture capitalists reject far too many deals to present all of them to the partner’s meeting, picking an occasional rejection will help them learn if they have any biases that are causing them to reject potentially promising ventures prematurely. In conclusion, this chapter has presented a historical perspective of research in the area with pioneering works interviewing and surveying venture capitalists to gain deeper insights into their reported decision policies. With more sophisticated methods, more recent research has focused on real time methods of data collection from which decision policies can be composed (for example verbal protocol analysis) or decomposed (for example conjoint analysis and policy capturing). Along with the use of experiments to decompose venture capitalists’ decisions into their underlying structure, research has been more theory driven. Theory has been used to hypothesize which attributes are used in venture capitalists’ decision policy and how they are used, to hypothesize diﬀerences in decision policies across venture capitalists; and to better explain the process of constructing a decision policy. In a short period scholars of venture capitalists’ pre-investment activities have made great strides, but there is much still to learn. We look forward to reading future research on this important topic.

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References Anderson, J. (1990), Cognitive Psychology and its Implications, New York: W.H. Freeman. Baron, R. (1998), ‘Cognitive mechanisms in entrepreneurship: why and when entrepreneurs think diﬀerently than other persons’, Journal of Business Venturing, 13, 275–94. Barr, P., J. Stimpert and A. Huﬀ (1992), ‘Cognitive change, strategic action, and organizational renewal’, Strategic Management Journal, 13, 15–36. Busenitz, L. (1999), ‘Entrepreneurial risk and strategic decision making: it’s a matter of perspective’, The Journal of Applied Behavioral Science, 35(3), 325–40. Busenitz, L. and J. Barney (1997), ‘Diﬀerences between entrepreneurs and managers in large organizations: biases and heuristics in strategic decision making’, Journal of Business Venturing, 12, 9–30. Cumming, D. (2005), ‘Agency costs, institutions, learning, and taxation in venture capital contracting’, Journal of Business Venturing, 20(5), 573–622. Cyert, R. and J. March (1963), A Behavioral Theory of the Firm, Engelwood Cliﬀs: Prentice Hall. Dawes, R., D. Faust and P. Meehl (1989), ‘Clinical versus actuarial judgment’, Science, 243, 1668–74. Einhorn, H. (1980), ‘Learning from experience and sub-optimal rules in decision making’, in T. Wallsten (ed.), Cognitive Processes in Choice and Behavior, Hillsdale, NJ: Erlbaum, pp. 1–20. Eisenhardt, K. (1989), ‘Making fast strategic decisions in high velocity environments’, Academy of Management Journal, 32, 543–76. Ericsson, K. and R. Crutcher (1991), ‘Introspection and verbal reports on cognitive processes – two approaches to the study of thinking: a response to Howe’, New Ideas In Psychology, 9(1), 57–71. Fiske, S. and S. Taylor (1991), Social Cognition, New York: Random House. Gompers, P. (1996), ‘Grandstanding in the venture capital industry’, Journal of Financial Economics, 42(1), 133–56. Gompers, P. and J. Lerner (1996), ‘The use of covenants: an empirical analysis of venture partnership agreements’, Journal of Law and Economics, 39(2), 463–98. Gompers, P., J. Lerner, M. Blair and T. Hellman (1998), ‘What drives venture capital fundraising’, Brookings Papers on Economic Activity, 149–204. Gorman, M. and W. Sahlman (1989), ‘What do venture capitalists do?’, Journal of Business Venturing, 4(4), 231–48. Hall, J. and C. Hofer (1993), ‘Venture capitalists’ decision criteria and new venture evaluation’, Journal of Business Venturing, 8(1), 25–42. Hitt, M. and B. Tyler (1991), ‘Strategic decision models: integrating diﬀerent perspectives’, Strategic Management Journal, 12, 327–51. Hogarth, R. and S. Makridakis (1981), ‘Forecasting and planning: an evolution’, Management Science, 27(2), 115–38. Kaplan, S. and P. Stromberg (2004), ‘Characteristics, contracts, and actions: evidence from venture capitalist analyses’, Journal of Finance, 59(5), 2173–206. Keeley, R. and S. Punjabi (1996), ‘Valuation of early-stage ventures: option valuation models vs. traditional approaches’, Journal of Entrepreneurial and Small Business Finance, 5(2), 114–38. Keh, H., M. Foo and B. Lim (2002), ‘Opportunity evaluation under risky conditions: the cognitive processes of entrepreneurs’, Entrepreneurship: Theory & Practice, 27(2), 125–48. Khan, A. (1987), ‘Assessing venture capital investments with noncompensatory behavioral decision models’, Journal of Business Venturing, 2, 193–205. Kirilenko, A. (2001), ‘Valuation and control in venture finance’, Journal of Finance, 56(2), 565–87. Lord, R. and K. Maher (1990), ‘Alternative information-processing models and their implications for theory, research, and practice’, Academy of Management Review, 15(1), 9–28. MacMillan, I., R. Siegel and P. Subba Narasimha (1985), ‘Criteria used by venture capitalists to evaluate new venture proposals’, Journal of Business Venturing, 1(1), 119–28. MacMillan, I., L. Zeman and P. Subba Narasimha (1987), ‘Criteria distinguishing unsuccessful ventures in the venture screening process’, Journal of Business Venturing, 2(2), 123–37. Moesel, D. and J. Fiet (2001), ‘Embedded fitness landscapes – part 2: cognitive representation by venture capitalists’, Venture Capital, 3(3), 187–213. Moesel, D., J. Fiet and L. Busenitz (2001), ‘Embedded fitness landscapes – part 1: how a venture capitalist maps highly subjective risk’, Venture Capital, 3(2), 91–106. Muzyka, D., S. Birley and B. Leleux (1996), ‘Trade-oﬀs in the investment decision of European venture capitalists’, Journal of Business Venturing, 11(4), 273–87. Payne, J., J. Bettman and E. Johnson (1988), ‘Adaptive strategy selection in decision making’, Journal of Experimental Psychology: Learning Memory and Cognition, 14(3), 534–52. Riquelme, H. and T. Rickards (1992), ‘Hybrid conjoint analysis: an estimation probe in new venture decisions’, Journal of Business Venturing, 7(6), 505–18. Roure, J.B. and R.H. Keeley (1990), ‘Predictors of success in new technology based ventures’, Journal of Business Venturing, 5, 201–20.

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Sandberg, W. (1986), New Venture Performance, Lexington, MA: Lexington. Sandberg, W., D. Schweiger and C. Hofer (1988), ‘The use of verbal protocols in determining venture capitalists’ decision processes’, Entrepreneurship: Theory & Practice, Winter, 8–20. Seppä, T. and T. Laamanen (2001), ‘Valuation of venture capital investments: empirical evidence’, R&D Management, 31(2), 215–30. Shepherd, D. (1999), ‘Venture capitalists’ assessment of new venture survival’, Management Science, 45(5), 621–32. Shepherd, D. and A. Zacharakis (1997), ‘Conjoint analysis: a window of opportunity for entrepreneurship research’, in J.A. Katz and R.H. Brockhaus (eds), Advances in Entrepreneurship, Firm Emergence and Growth, Volume 3, Greenwich, CT: JAI Press, pp. 203–48. Shepherd, D. and A. Zacharakis (1999), ‘Conjoint analysis: a new methodological approach for researching the decision policies of venture capitalists’, Venture Capital, 1(3), 197–217. Shepherd, D.A. and A.L. Zacharakis (2002), ‘Venture capitalists’ expertise: a call for research into decision aids and cognitive feedback’, Journal of Business Venturing, 17(1), 1–20. Shepherd, D.A., R. Ettenson and A. Crouch (2000), ‘New venture strategy and profitability: a venture capitalist’s assessment’, Journal of Business Venturing, 15(5/6), 449–68. Shepherd, D., A. Zacharakis and R. Baron (2003), ‘Venture capitalists’ decision processes: evidence suggesting more experience may not always be better’, Journal of Business Venturing, 18(3), 381–401. Simon, H. (1955), ‘A behavioral model of rational choice’, Quarterly Journal of Economics, 69, 99–118. Simon, H. (1981), Sciences of the Artificial, Cambridge, MA: MIT Press. Simon, M. and S. Houghton (2002), ‘The relationship among biases, misperceptions, and the introduction of pioneering products: examining diﬀerences in venture decision contexts’, Entrepreneurship: Theory & Practice, 27(2), 105–24. Slovic, P., B. Fischhoﬀ and S. Lichtenstein (1977), ‘Behavioral decision theory’, Annual Review of Psychology, 28, 1–39. Smart, G. (1999), ‘Management assessment methods in venture capital: an empirical analysis of human capital valuation’, Venture Capital, 1(1), 59–82. Sorenson, O. and T. Stuart (2001), ‘Syndication networks and the spatial distribution of venture capital investments’, American Journal of Sociology, 106(6), 1545–88. Timmons, J. and S. Spinelli (2003), New Venture Creation: Entrepreneurship for the 21st Century, 6th edn, Boston: McGraw-Hill, Irwin. Tversky, A. and D. Khaneman (1974), ‘Judgment under uncertainty: heuristics and biases’, Science, 185, 1124–31. Tyebjee, T. and A. Bruno (1984), ‘A model of venture capitalist investment activity’, Management Science, 30(9), 1051–66. Zacharakis, A. and G. Meyer (1995), ‘The venture capitalist decision: understanding process versus outcome, Frontiers of Entrepreneurship Research, 15, 465–78. Zacharakis, A. and G. Meyer (1998), ‘A lack of insight: do venture capitalists really understand their own decision process?’, Journal of Business Venturing, 13(1), 57–76. Zacharakis, A. and G. Meyer (2000), ‘The potential of actuarial decision models: can they improve the venture capital investment decision?’, Journal of Business Venturing, 15(4), 323–46. Zacharakis, A. and D. Shepherd (2001), ‘The nature of information and venture capitalists’ overconfidence’, Journal of Business Venturing, 16(4), 311–32. Zacharakis, A. and D. Shepherd (2005), ‘A non-additive decision-aid for venture capitalists’ investment decisions’, European Journal of Operational Research, 162(3), 673–89. Zacharakis, A., J. McMullen and D. Shepherd (2007), ‘Venture capitalists’ decision making across three countries: an institutional theory perspective’, Journal of International Business Studies, forthcoming. Zacharakis, A., G. Meyer and J. DeCastro (1999), ‘Diﬀering perceptions of new venture failure: a matched exploratory study of venture capitalists and entrepreneurs’, Journal of Small Business Management, 37(3), 1–14.

7

The venture capital post-investment phase: Opening the black box of involvement Dirk De Clercq and Sophie Manigart

Introduction It is well documented that venture capital is a special form of financing for an entrepreneurial venture, in that the venture capital firm is an active financial intermediary. This is in sharp contrast with most financial intermediaries such as banks, institutional or stock market investors that assume a passive role. Once the latter invest in a company, they may monitor the performance of the company periodically but they seldom interfere with the decision making. In order to overcome the huge business and financial risks and the potential agency problems associated with investing in young, growth oriented ventures (often without valuable assets but with a lot of intangible investments), venture capital firms specialize in selecting the most promising ventures and in being involved in the ventures once they have made the investment. In this chapter we focus on the post-investment, but pre-exit phase of the venture capital cycle. More specifically the principal theme of this chapter is to provide an overview of relevant aspects and research findings pertaining to the period after the venture capital firm (or venture capitalist) has made the decision to invest in a particular portfolio company (or entrepreneur). We hereby focus on the interaction between a venture capitalist and the entrepreneur, rather than on financial events as follow-on financing rounds or exit. In essence, this overarching theme involves two important issues that will be addressed. A first objective of this chapter pertains to categorizing the existing literature into research that has focused on venture capitalists’ involvement in monitoring activities vis-à-vis entrepreneurs and research on the potential for venture capitalists to add value to their investees. Once an investment is made, the venture capitalist monitors the entrepreneur in order to reduce the chance that the latter appropriates the funds to pursue her personal interests. Next to monitoring, the venture capitalist helps in the decision making, so as to enhance value creation in the venture. In the earlier studies on venture capitalist involvement in portfolio companies, no clear distinction was made between monitoring and value adding, however. Research focused on understanding what venture capitalists do (for example Tyebjee and Bruno, 1984; MacMillan et al., 1988; Rosenstein, 1988), defining their roles and extent of involvement. Early evidence showed that there was a lot of variation with respect both to what venture capitalists do (that is content-related) and the extent of their involvement (that is process-related) (Gorman and Sahlman, 1989; MacMillan et al., 1988), without explaining the diﬀerence. Subsequent research examined the conditions under which venture capitalists become more involved in their portfolio companies, especially with respect to variations in the characteristics of the portfolio companies. For example, the impact of greater agency risk (Barney et al., 1989; Sapienza and Gupta, 1994; Sapienza et al., 1996), business risk (Barney et al., 1989), and task uncertainty (Sapienza and Gupta, 1994) on venture capitalists’ interactions with the CEOs of 193

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their portfolio companies was acknowledged. More recently, research acknowledges that the extent and impact of venture capitalists’ monitoring and value adding is not only driven by portfolio company characteristics, but also by the venture capitalists’ characteristics. The resource dependence theory, and the resource endowments of both venture capitalists and entrepreneurs, such as their human, social or intellectual capital (for example Baum and Silverman, 2004; Dimov and Shepherd, 2005) have been used to explain the nature, level and eﬀectiveness of the interaction between venture capitalists and entrepreneurs. Recently, attention has also been paid to the nature and intensity of venture capitalists’ involvement in diﬀerent parts of the world, showing that their behavior shows commonalities, but diﬀerences as well (for example Sapienza et al., 1996; Bruton et al., 2005). In this chapter, we summarize some of the major research findings with regard to the monitoring and value-adding role played by venture capitalists. A second objective of this chapter pertains to highlighting recent research that has started to open the ‘black box’ of the venture capitalist – entrepreneur relationship. More specifically, while early research discussed how entrepreneurs can benefit from their venture capital providers, and how venture capitalists attempt to maximize the returns from their investments, the specific question of how value added is created between the two parties was somewhat under-studied, both with respect to what type of information is exchanged (that is content-related issues), and how the parties interact with one another (that is process-related issues). In this chapter, we will therefore include the findings from some recent research on the type of interactions that take place between venture capitalists and entrepreneurs. We emphasize that we will neither discuss how venture capitalists decide to invest in a venture (see Chapter 6 by Zacharakis and Shepherd), nor what the outcome of their monitoring and value adding activities is in terms of venture capitalists’ exit routes and investment performance, nor the return to the entrepreneur (see Chapter 8 by Busenitz and Chapter 9 by Leleux). The chapter is structured as follows. In a first section, we compare the literature that describes the role of monitoring and value adding in venture capitalist–entrepreneur relationships. More specifically, we discuss the research that focuses on the importance for the venture capitalists to monitor their investments, thereby relying on the agency framework. We also discuss the research on the importance of value added in the post-investment process, and describe the various value-adding roles that can be played by investors. In the subsequent section, we report the findings from research that attempts to open the ‘black box’ of how value is added, and we focus on several issues pertaining to the content and process of the interactions that take place between venture capitalist and entrepreneur. With respect to content, we report research findings pertaining to the role of venture capitalists’ experience, the knowledge exchange between venture capitalists, and the knowledge exchange between venture capitalist and entrepreneur. With respect to process, we discuss research findings pertaining to the role of trust, social interaction, goal congruence, and commitment, and we show in particular how these components have been applied to the context of venture capitalist–entrepreneur relationships. Figure 7.1 provides an overview of the diﬀerent issues that are discussed in this chapter. The role of monitoring and value added in venture capitalist–entrepreneur relationships The early research on the post-investment relationship between venture capitalist and entrepreneur has pointed to the undertaking of monitoring and value adding activities by

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Monitoring

Entrepreneur

Venture capitalist Value added

Content: – VC experience – Knowledge exchange between VCs – Knowledge exchange between VC and entrepreneur

Figure 7.1

Process: – Trust – Social interaction – Goal congruence – Commitment

Conceptual framework

venture capitalists. Whereas these two broad types of activities overlap with one another, and in fact may represent complementary roles, the assumption underlying these activities is quite diﬀerent. More specifically, the focus on monitoring relates to venture capitalists’ attempt to correct potential harmful behavior by entrepreneurs, and the focus on value added relates to venture capitalists’ attempt to increase the upside potential of their investments. In the following paragraphs, we provide an overview of the literature on monitoring and value added. Monitoring and information asymmetry Prior research has indicated that an important aspect of the venture capitalist–entrepreneur relationship pertains to the former’s monitoring of the latter’s actions. Monitoring pertains to the procedures that are used by the venture capitalist to evaluate the entrepreneur’s behavior and performance in order to keep track of her investment (Sahlman, 1990; Sapienza and Korsgaard, 1996; Wright and Robbie, 1998). Given their equity ownership, venture capitalists have strong incentives to monitor entrepreneurs’ actions, as entrepreneurs’ and venture capitalists’ goals are not always perfectly aligned. Venture capitalists therefore receive strong control levers, sometimes disproportionate to the size of their equity investment (Lerner, 1995). For instance, venture capitalists often receive convertible debt or convertible preferred stock that carries the same voting rights as if it had already been converted into common stock (Gompers, 1997), or they receive a relatively great board representation in order to allow the replacement of the entrepreneur as chief executive oﬃcer if performance lags (Lerner, 1995). The venture capitalists’ involvement in monitoring activities stems from the presence of goal incongruencies coupled with information asymmetry between the two parties. First,

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venture capitalists and entrepreneurs may not always have the same goals. For example, firm survival or generating a personal income, rather than value creation, may be of primary importance for the entrepreneur, but not for the venture capitalist. Alternatively, venture capitalists aim for early exit, while entrepreneurs may have more long term aspirations. Moreover, information asymmetries mean that the venture capitalist and entrepreneur have access to private information that is not available to the other party. For example, entrepreneurs often have a better insight into their own capabilities and the level of eﬀort they want to put in the venture, compared to external investors. Also, entrepreneurs often have a good insight into the nature of technological developments. Venture capitalists, on the other hand, may have a better insight into the potential market acceptance and competition, given that they invest in a portfolio of companies (Cable and Shane, 1997). Goal incongruencies, together with unequal distribution of information, may lead to agency problems of adverse selection or moral hazard (see hereafter). They are thus important when both parties negotiate about establishing an investment agreement (see Chapter 8), as well as after the investment decision has been made (Sapienza and Gupta, 1994). The presence of information asymmetry may be particularly high in the case of high-tech investment deals in which the entrepreneur has an in-depth knowledge about the specifics of an innovative technology. Given the information opaqueness surrounding technological ventures and the intangibility of most of their investments, close monitoring by venture capitalists is, albeit not easy, essential in order to understand the actions of the entrepreneur (Sapienza and De Clercq, 2000). In order to explain the impact of information asymmetry on venture capital behavior, agency theory has been used by many early researchers as their central framework to explain venture capitalist behavior (for example Sapienza and Gupta, 1994; Lerner, 1995; Sapienza et al., 1996). The center of agency theory is the agency relationship in which one party (the principal) delegates work to another party (the agent), who performs that job as defined in a contract (Eisenhardt, 1989). Interestingly, recently researchers have argued that both the entrepreneur and venture capitalist can play the role of ‘agent’. In the following paragraphs we provide an overview of this research. Entrepreneur as agent Most early research on venture capitalist behavior has depicted the venture capitalist as the principal and the entrepreneur as the agent (Eisenhardt, 1989; Sapienza and Gupta, 1994). That is, from the venture capitalist’s perspective, an important question may evolve from the question of how to ensure that entrepreneurs do not take actions that jeopardize the venture capitalists’ chances to generate maximum financial returns. According to agency theory, two types of agency problems may arise, that is ‘adverse selection’ and ‘moral hazard’. First, the term ‘adverse selection’ pertains to the uncertainty the venture capitalist faces with respect to the entrepreneurs’ capabilities to meet pre-set expectations (Eisenhardt, 1989), and therefore is an important issue in the venture capital selection process (see Chapter 6). For instance, an entrepreneur may end up not having the required competencies to grow her venture successfully (Wright and Robbie, 1998). Second, and more importantly in terms of the post-investment relationship, ‘moral hazard’ problems pertain to a party’s potential shirking behavior and unwillingness to make suﬃcient eﬀorts, even if it has the capability to meet pre-set expectations (Eisenhardt, 1989). For instance, from the venture capitalist’s perspective, there is a danger

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that the entrepreneur, once she has received the money, may alter her behavior in ways that mislead the investor. The entrepreneur, being an inside member of the company as well as the controlling oﬃcer, has access to company information that is not necessarily readily available to the venture capitalist (Cable and Shane, 1997). Many aspects may be hidden from the venture capitalist, such as the actual progress of product development or even the entrepreneur’s hidden motives for having created the company. Other examples of entrepreneurs’ defective behavior might be their purchasing of a larger than necessary computer for their enjoyment, charging personal trips to the company, or even activities that might be business related (for example product decisions) but not consistent with the venture capitalist’s wishes (Cable and Shane, 1997; De Clercq and Sapienza, 2001). In other words, this stream of research explains that opportunities abound for the entrepreneur to act in a manner that increases her personal wealth or that is consistent with her personal goals, but jeopardizes the company’s well-being, whereby the venture capitalist’s money is not utilized as desired. This behavior will lead then to higher costs for the venture capitalist, since she needs to supervise and monitor the entrepreneur’s activities. One possibility for the venture capitalist to reduce moral hazard problems is by writing appropriate contracts at the time of investment, thereby aligning the interests of the entrepreneur and the venture capitalist (Kaplan and Strömberg, 2003). One example is to use convertible securities, such as convertible debt or convertible preferred equity (Gompers, 1997; Cumming, 2005). The use of staged investing, where venture capitalists have the opportunity to withdraw from an investment and thus motivate the entrepreneur to behave ‘honestly’, is also a commonly used method (Sahlman, 1990; Wright and Robbie, 1998). Given that contracts are inherently incomplete and cannot foresee all future states of nature, venture capitalists closely monitor their portfolio companies formally by taking a seat on the Board of Directors of their portfolio companies (Rosenstein, 1988; Rosenstein et al., 1993), and informally through periodical check-ups of the day-to-day activities and through interim financial reports (Gompers, 1995; Mitchell et al., 1995). Interim financial reporting by the entrepreneur is indeed an important monitoring device, included in the investment agreement (Rosenstein, 1988). Informal control may also include the use of codified rules, procedures and contract specifications that specify desirable patterns of the entrepreneur’s behavior. The Board of Directors is the formal governance mechanism utilized by venture capitalists in most countries. Boards of Directors can vary widely in their size and operation, however. There is evidence that Asian boards are, on average, larger in size, and have a larger percentage of insiders compared to US boards, while Continental European boards are smallest (Bruton et al., 2005). Furthermore, Kaplan and Strömberg (2003) showed that US venture capitalists have on average a quarter of all board seats, but they control the board in 25 per cent of their portfolio companies. Control over the board is more common when the business risk is higher, that is when the company has no revenues yet or when the company operates in a volatile industry (Kaplan and Strömberg, 2003). Interestingly, it has also been found that venture capital board members are, on average, not of better quality than other external board members, except if the lead venture capital investor is ‘top quality’ (Rosenstein et al., 1993). Evidence on the nature, extent and impact of monitoring activities of venture capitalists is surprisingly scarce, however. There is some evidence that venture capitalist monitoring is

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an attempt to reduce agency problems, as monitoring intensity is highest for companies with high information asymmetries and potential agency problems. For example, companies that just entered the venture capital portfolio and poorly performing companies are followed more closely by venture capitalists (Beuselinck et al., 2007). Furthermore, it appears that the agency framework may be more applicable in the context of Anglo-Saxon compared to Continental European venture capital investments, as recent research has indicated that venture capitalists exert more monitoring eﬀorts in the former case than in the latter case (Beuselinck et al., 2007). Finally, the importance of monitoring has also been discussed in the context of venture capitalists’ syndication, that is the simultaneous investment by at least two venture capitalists in the same entrepreneur (for example Lockett and Wright, 2001). For instance, it has been shown that lead investors exert more monitoring eﬀort in a syndicate than non-lead investors (Lockett and Wright, 2001). The last finding opens an avenue of further research, namely how non-lead syndicate investors monitor the lead venture capitalist. Understanding the monitoring process is important not only from an academic perspective. From the venture capitalist’s perspective, more monitoring not only reduces agency problems, but also entails larger costs with respect to time allocation (Barney et al., 1989; Gorman and Sahlman, 1989; Giﬀord, 1997). Greater governance may therefore not always be cost-eﬃcient (Sapienza et al., 1996). MacMillan et al. (1988, p. 37) already observed that ‘a relevant issue in need of examination is the opportunity cost of [greater] involvement.’ We believe that the research to date has not yet fully addressed the trade-oﬀ between greater monitoring and cost eﬃciency. Furthermore, it is possible that post-investment monitoring by the venture capitalists may be substituted by more rigid contractual arrangements or equity control as agreed upon prior to the investment decision (Beuselinck and Manigart, 2007). From the entrepreneur’s perspective, more monitoring by venture capitalists increases the information production of the portfolio firm, leading on the one hand to enhanced decision making but on the other hand also to increased information reporting costs. Research indicates that venture capitalist monitoring has positive outcomes for portfolio companies and their stakeholders. It leads to the establishment of more eﬀective corporate governance rules in portfolio companies and subsequently to a higher quality of reported accounting figures both in the US (Hand, 2005) and in Europe (Mitchell et al., 1995; Beuselinck and Manigart, 2007). Venture capitalists’ monitoring eﬀects are especially beneficial for more mature portfolio companies. From the perspective of external parties such as banks, employees, suppliers and customers, enhanced monitoring leads to qualitatively improved and more extensive external reporting of portfolio companies (Beuselinck and Manigart, 2007). Venture capitalist as agent Alternatively, some researchers have suggested that venture capitalists can be the agents of entrepreneurs. For instance, Cable and Shane (1997) criticized the representation of the venture capitalist–entrepreneur dyad as an agency problem, in that this framework ‘does not incorporate the possibility of opportunistic behavior by the principal’ (Cable and Shane, 1997, p. 147). Also, Sahlman (1990) reported that a venture capitalist is often responsible for almost nine investments and sits on five boards of directors. Therefore, post-investment activities – such as the search for further financing, or assistance in strategic decision making – that venture capitalists undertake

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for one portfolio company, cannot necessarily be undertaken for all portfolio companies, such that venture capitalists are often not able to allocate an optimal amount of time to each entrepreneur (Giﬀord, 1997). It has furthermore been suggested that venture capitalists are sometimes inclined to ‘under-invest’ in their portfolio companies. That is, venture capitalists often prefer to stage their investments because this reduces the amount of money invested at the earliest stages of venture development when investment risk is highest. This practice may not necessarily be bad for entrepreneurs as it enables them to retain a higher fractional ownership. It nevertheless poses the risk that if their venture does not develop as planned, entrepreneurs may run out of money and be in a poor negotiation position to raise additional money (De Clercq et al., 2006), thereby potentially facing high levels of dilution. Furthermore, it has been argued that venture capitalists may sometimes be inclined to distribute a firm’s profits rather than to reinvest these profits in the company as limited partners have the right to get returns on their investments before venture capitalists can secure a profit (Sahlman, 1990). This venture capitalist behavior can prevent an entrepreneur from bringing her company to a next growth stage. Finally, prior research has shown that some venture capitalists may seek a premature IPO in their portfolio companies in order to gain reputation and report enhanced performance when raising new funds. This ‘grandstanding’ behavior is more likely to happen among young venture capitalists that want to establish a reputation in the venture capital community (Gompers, 1996). Also, venture capitalists are inclined to take companies public near market peaks, even if this is not necessarily the optimal timing for the entrepreneurial company (Lerner, 1994). In short, it has been argued that venture capitalists’ actions can be contradictory to the best interests of an entrepreneur in terms of their allocation of time and eﬀort, re-investment decisions, or the timing of a portfolio company going public. Concluding note Some researchers have suggested that the literature on venture capital monitoring and its assumptions regarding information asymmetry and opportunism, should be complemented with research that views the venture capitalist–entrepreneur relationship from a more positive angle (Sapienza and De Clercq, 2000; Arthurs and Busenitz, 2003). For instance, it has been suggested that stewardship theory may provide a framework complementary with agency theory for examining the venture capitalist–entrepreneur relationship (Davis et al., 1997; Arthurs and Busenitz, 2003). The starting point in this alternative approach is the identification of situations in which the interests of the venture capitalist and the entrepreneur are aligned, and both parties commit themselves to the development of a trustful relationship. In other words, the application of agency theory to the venture capitalist–entrepreneur relationship may be appropriate only when the two parties have diverging goals (Arthurs and Busenitz, 2003). Furthermore, the fact that both venture capitalist and entrepreneur hold informational advantages over one another may be related to the very nature of, and diﬀerence in, the activities these parties engage in. That is, venture capitalists and entrepreneurs essentially specialize in the development and contribution of diﬀerent types of knowledge (Cable and Shane, 1997). By virtue of their repeated experience with the monitoring of start-ups and growing companies, venture capitalists may often have a better idea of their portfolio companies’ value than the entrepreneurs themselves. Alternatively, entrepreneurs are

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specialized in detecting new opportunities in the environment and combining resources to exploit these opportunities in an original fashion (Kirzner, 1973). For instance, hightech entrepreneurs may possess specialized technical knowledge and skills that are diﬃcult if not impossible to be replicated. Although entrepreneurs’ wish to hide negative information from their investors combined with their superior insight into the viability of new technology may make defective behavior appear to be a likely option, the wisdom of hiding information for opportunistic purposes is of questionable practical value, since doing so directly threatens the viability of the company itself as well as the venture capitalist’s trust and support (Sapienza and Korsgaard, 1996; Cable and Shane, 1997). Furthermore, although information asymmetry may lead to defective behavior, it also includes the potential for benefits to be derived for both parties. This issue will be discussed later in this chapter. Value adding Whereas venture capitalists’ monitoring activities mainly focus on how venture capitalists can minimize potentially harmful behavior by entrepreneurs, venture capitalists may try to increase the value of their portfolio company through value-adding activities after the investment decision has been made. The literature on the post-investment process starts from the dominant assumption that venture capitalists do add value and highlights the question of how they increase the upside potential of their investments. An early stream of research has emphasized the value-adding activities venture capitalists engage in with respect to their investment deals. More specifically, this research has discussed the beneficial role of the value-adding beyond financial capital that is provided by venture capitalists to their portfolio companies (Sapienza, 1992; Fried and Hisrich, 1995; Sapienza et al., 1996; Busenitz et al., 2004). From the entrepreneur’s point of view, the presence of added value beyond pure financial support compensates for the high cost of venture capitalist money (Manigart et al., 2002). Interestingly, Seppa (2002) and Hsu (2004) showed that entrepreneurs are willing to accept significantly lower valuations and thus face higher dilution when they expect that the venture capitalist will contribute more to the development of their venture, more specifically when the venture capitalist has a better reputation. In early research on value added, all venture capitalists were treated homogeneously or, if diﬀerences between venture capitalists were acknowledged, they were not clearly explained (for example MacMillan et al., 1988). For example, a distinction was made between three categories of venture capitalists, the ‘inactive’ investors, the ‘active advice givers’, and the ‘hands-on’ investors (MacMillan et al., 1988; Elango et al., 1995), with the latter category attaching most importance to value-adding activities. In contrast, other research has emphasized that ‘not all venture capital is the same’, and has started to explain the diﬀerences in venture capitalist value-adding behavior. It has been suggested that the roles venture capitalists play in their portfolio companies diﬀer depending on the characteristics of the venture capitalist or venture capital firm itself (for example reputation – Gompers, 1996) or of the portfolio company (for example its stage of development – Sapienza, 1992). In the following paragraphs we give a short overview of what we believe are two important sub-streams in the value added literature, that is research on the ‘classic’ value-adding roles, and research on how venture capital reputation may influence venture capitalist involvement.

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Value-adding roles Providing non-financial assistance to portfolio companies and thereby improving the risk–return mix, is an essential task of a venture capitalist as a financial intermediary (Gupta and Sapienza, 1992; Amit et al., 1998). Research consistently stresses three key roles played by venture capitalists in their relationship with entrepreneurs: (1) a strategic role as generators of and sounding boards for strategic initiatives, (2) an operational role as providers of key external contacts for locating managerial recruits, professional service providers, key customers, or additional financing, and (3) a personal role as friends, mentors and confidants (Sapienza et al., 1994). Venture capitalists see their strategic roles as having the greatest importance (Fried et al., 1998), their interpersonal roles as next in importance, and their operational roles as being relatively less important to helping their portfolio companies realize their full potential. Interestingly, some conflicting results have been found with regard to the value added proposition. Whereas some researchers have found support for the non-financial value added by venture capitalists (for example MacMillan et al., 1989; Sapienza, 1992; Hellman and Puri, 2000; 2002), other research has suggested that venture capitalists may not necessarily add value (for example Gomez-Mejia et al., 1990; Steier and Greenwood, 1995; Manigart et al., 2002). One of the reasons for the inconsistency of findings may be that many studies examining venture capitalist value added have a survival bias in that the surveyed samples contain relatively more success stories (Manigart et al., 2002; Busenitz et al., 2004). Furthermore, it has been suggested that the value-adding intensity varies across venture capitalists, across portfolio companies or across regions of the world. For instance, as can be expected, venture capitalists related to a financial institution or with a financial background have been found to place more emphasis on their financial role (Bottazzi and Da Rin, 2002). Furthermore, venture capital managers with business rather than financial experience spend more time with their portfolio companies, and especially with companies with high business and agency risk (Sapienza et al., 1996). Also, a study examining the level and nature of European venture capital involvement in their portfolio companies found that venture innovativeness and stage had a consistent impact such that greater value added involvement by the venture capitalist occurred for highly innovative ventures and for early stage ventures (Sapienza et al., 1994). Finally, venture capitalists’ value adding behavior may diﬀer depending on the part of the world and therefore the institutional context they operate in (Sapienza et al., 1994; Bruton et al., 2005). For instance, Sapienza et al. (1994) found that venture capitalists in the Netherlands were less involved with experienced CEOs than anticipated, while venture capitalists in the UK were more involved with experienced CEOs. In France, involvement varied less and did not follow a consistent pattern. It has also been found that more value adding is provided by American venture capital managers than by their European or Asian counterparts (Bottazzi and Da Rin, 2002; Bruton et al., 2005). In sum, while the literature generally suggests that venture capitalists do add value, and that this value added is contingent upon factors related to the venture capitalist, entrepreneur or external conditions (for example geographical region), the majority of research to date has to a great extent treated the value-adding role played by venture capitalists as a black box, whereby it is not clear what factors influence the degree to which value is (potentially) added, or even whether value is added. As will be explained later

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in this chapter recent research has begun to open this black box by probing the role of content and process-related issues in fostering the creation of value in venture capitalist–entrepreneur relationships. Venture capital and reputation A more indirect but nevertheless important aspect of venture capitalists’ value-adding potential pertains to their reputation, in that for the entrepreneur the venture capitalist’s reputation may be a critical point in gaining legitimacy in the market place (Gompers, 1996; Black and Gilson, 1998). That is, next to money, monitoring and value adding, venture capitalists may provide enhanced credibility to their portfolio companies, especially when they are highly respected players in the venture capital industry. The venture capitalist’s reputation can have a positive eﬀect on the entrepreneur because a company backed by a venture capitalist with an outstanding reputation may be more capable of attracting customers, suppliers and highly-talented managers (for example Davila et al., 2003) as venture capitalist performance and experience are associated with a greater likelihood of success. Furthermore, venture capitalists’ role as reputational intermediary may be complementary with their role as financier, monitor and provider of value added in that reputation enhances the credibility of the information that the venture capitalist provides and therefore yields a positive signal, not only in the eyes of third parties but also of the entrepreneurs themselves. Prior research has indeed argued that entrepreneurs are more willing to accept the advice from highly esteemed investors (Busenitz et al., 1997; Hsu, 2004). Interestingly, it has also been argued that venture capitalist reputation may potentially have a negative eﬀect for entrepreneurs. More specifically, because of the time constraints venture capitalists are confronted with (Giﬀord, 1997), some venture capitalists may be inclined to treat their own reputation as substitutes for their value-adding services. That is, all else being equal, some venture capitalists with high reputational capital may devote less eﬀort to their investments compared to their less well-known rivals because they – perhaps falsely – assume that their mere reputation will be suﬃcient to create value, regardless of their post-investment eﬀort (De Clercq et al., 2003). For the venture capitalists themselves, reputation may be important because it gives great market power in their ability to close attractive deals, as entrepreneurs of start-up companies are more likely to accept a financing oﬀer made by a venture capitalist with a high reputation, even at lower valuations (Seppa, 2002; Hsu, 2004). Reputation also provides the venture capitalist with the ability to raise new funds and certify ventures to third parties (Gompers, 1996). The consequences of losing a good reputation can therefore be significant. For example, in the aftermath of the market crash in 2001, a number of wellestablished venture capitalists damaged their reputation by over-investing in marginal ventures, and subsequently were unable to raise new funds and were forced out of business (Lerner and Gompers, 2001). Furthermore, because venture capitalist reputation is highly valued by the market, venture capitalists attempt to gain reputations as soon as possible. A primary vehicle for building reputation is going public with a portfolio company because an IPO may serve as a visible (if somewhat imperfect) signal of the venture capitalists’ prowess in selecting, developing, and cashing out of high potential ventures (Stuart et al., 1999). Another way to build reputation is to syndicate with respected venture capitalists (Sorenson and Stuart, 2001), which venture capitalists may seek out of their own interest, rather than in the venture’s best interest.

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Concluding note Overall, prior empirical studies on venture capitalists’ value added have shown that both venture capitalists and entrepreneurs perceive value in active venture capitalist presence in entrepreneurial ventures. The importance of venture capitalists’ value-adding potential has been illustrated by the fact that successful venture capitalists have been found to use a ‘hands-on’ approach on a discriminating and exceptional basis rather than in a universal manner, in that successful venture capitalists intervene in areas where they believe they can make an important economic contribution to their portfolio companies (for example Murray, 1996). However, and as mentioned earlier, despite the empirical evidence that venture capitalist value added is an important aspect of the postinvestment relationship, the literature to date has to a great extent considered the venture capitalist–entrepreneur relationship as a ‘black box’. That is, the notion that value can be added is expected as ‘a fact of venture capitalist practice’, and no clear explanation is given of how exactly value is created. In the next section, we highlight some recent research that has attempted to focus more closely on the type of interactions that take place between the venture capitalist and entrepreneur. In essence, two categories of issues arise with respect to the dynamics that occur between the two parties: (1) the content of the interactions; and (2) the process through which these interactions take place. The role of content and process in venture capitalist–entrepreneur relationship Content-related issues As indicated above, venture capitalists’ active involvement in their portfolio companies represents an important path through which entrepreneurs can benefit. In the following section, we focus on research that has looked particularly at the role of knowledge and learning in venture capital investments. More specifically, we discuss the role of venture capitalists’ experience and knowledge, the importance of knowledge sharing between venture capitalists (either within a given venture capital firm or within an investment syndicate), and the communication that takes place between the venture capitalist and entrepreneur (Figure 7.1). Venture capitalist experience Whereas some venture capitalists may prefer to diversify their portfolio in order to decrease their financial risk, others prefer to specialize and focus on developing specific expertise within a given domain (for example in terms of industry and/or development stage) in order to reduce the uncertainty embedded in their investments (for example Gupta and Sapienza, 1992; Norton and Tenenbaum, 1993; Lockett and Wright, 1999; De Clercq et al., 2001). More specifically, it has been argued that while financial risk management may help reduce a venture capitalist portfolio’s downside, knowledge management may help increase its upside (Dimov and Shepherd, 2005). De Clercq and Dimov (2003) found that investors’ specialization in terms of industry and development stage has a positive eﬀect on their overall portfolio performance. Venture capitalists’ specialized knowledge may make it more diﬃcult for entrepreneurs to hide issues of management incompetence, misbehavior or other crucial information regarding company performance due to the investor’s more in-depth understanding of the company’s business. Furthermore, a positive relationship between specialization and performance may also suggest that specialized venture capitalists may be more eﬃcient in detecting and providing adequate resources (for example potential customers, employees

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or other investors) to portfolio companies depending on their particular industry and stage of development. Other research has suggested that the advantages stemming from investment specialization may be particularly strong in the case of high-tech investments. As high-tech investments are characterized by high levels of informational asymmetry and opacity, specialized venture capitalists may be in a better position to reduce the uncertainty stemming from this asymmetry (Henderson, 1989). It has even been argued that the high informational asymmetries typical for high technology investing create a competitive advantage for venture capitalists if they decide to specialize in these firms (Sapienza and De Clercq, 2000). Going one step further, Hurry et al. (1992) found that Japanese venture capital investments often serve as a learning mechanism to carry the venture capitalist to a new technology, and the success of this learning transition may take precedence over the success of the portfolio company or the goal to produce immediate financial returns to the venture capitalist. In short, prior research suggests that investment specialization may facilitate the acquisition of specific information by the venture capitalist, and this in turn may enable the investor to become more eﬀectively involved in the key decision-making processes of her ventures. Experienced venture capitalists may thus be better equipped to detect deficiencies (to monitor) and to deliver sound advice (to add value) to the entrepreneur. Interestingly, one study found that a venture capitalist’s overall experience is negatively, rather than positively, related to how much the investor learns from a particular portfolio company (De Clercq and Sapienza, 2005). This counter-intuitive finding needs further investigation in terms of what some of the boundary conditions are for venture capitalists to learn from their prior investment experience and how exactly to apply this experience in a constructive manner toward future investments. For instance, it could be that, in some cases, experienced investors adopt dominant logics that filter out new information and are guilty of assuming that their experience obviates the need to communicate with the entrepreneur or other investors (Prahalad and Bettis, 1986). Knowledge exchange between venture capitalists In addition to the knowledge held by an individual venture capitalist, the communication that takes place between venture capitalists may also play an influential role in generating positive investment outcomes. First, the communication between investors working for one and the same venture capital firm may be important. Venture capital firms indeed consist of several general partners and a staﬀ of associates who function as apprentices to the general managers (Sahlman, 1990). As the partners and associates have to some extent varying backgrounds and skills, and each may hold diﬀerent ‘chunks’ of knowledge, entrepreneurs may benefit from investors who foster eﬀective communication routines with their colleagues within the venture capital firm. For instance, intensive knowledge exchange among individual venture capitalists regarding a particular portfolio company may give the venture capital firm as a whole broader access to and deeper insight into knowledge that is important to assist a portfolio company successfully (De Clercq and Fried, 2005). As such, in order for a venture capital firm to exploit its knowledge base optimally, it benefits from combining and integrating knowledge from among various individuals (that is venture capitalists) within the firm. Furthermore, there is an increasing body of research that addresses the importance of knowledge exchange that takes place within venture capital investment syndicates, that is

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the cooperation between individual venture capitalists working for diﬀerent venture capital firms (Lockett and Wright, 2001; De Clercq and Dimov, 2004; Dimov and De Clercq, 2006; Manigart et al., 2006). At a conceptual level, an important aspect of the beneficial eﬀect of syndication pertains to the productive interactions that may take place among syndicate partners (for example Bygrave, 1987; 1988; Lerner, 1994; Brander et al., 2002). From a knowledge perspective, there may be two principal positive outcomes resulting from venture capitalists’ syndication. First, syndication may help facilitate venture capitalists’ selection process in that venture capital syndicates may find better investment targets than each individual venture capitalist would find on her own (Lerner, 1994). Second, syndication may increase the venture capitalists’ value-added potential after the investment decision has been made since syndicate partners can bring complementary knowledge to the table (Brander et al., 2002) and are heterogeneous with respect to their resources (Lockett and Wright, 2001). That is, as diﬀerent syndicate members may have diﬀerent skills relevant to a particular portfolio company (for example detecting new customers, filling top management team vacancies, or bringing the entrepreneur in contact with additional investors), investment syndicates represent a rich variety of knowledge relevant to the entrepreneur. Interestingly, Dimov and De Clercq (2006) found a positive, rather than negative, eﬀect of syndication on the proportion of portfolio company defaults in a venture capitalist’s portfolio. One explanation of this finding is that once a portfolio company loses its promise of high returns, venture capitalists involved in a syndicate may feel a lower responsibility vis-à-vis a prior investment decision when this responsibility is shared with other investors. This may not necessarily be a bad thing as this practice diminishes the likelihood of ‘living dead’ investments in a venture capitalist’s portfolio (Ruhnka et al., 1992). In this regard, further investigation is necessary to examine how venture capitalists’ escalation of commitment, that is their continued involvement with a portfolio company with a disappointing performance, may be attenuated when venture capitalists are being part of a group of investors (Birmingham et al., 2003). Knowledge exchange between venture capitalist and entrepreneur Recent research has suggested that venture capitalists and entrepreneurs are involved in a learning relationship, and that both sides may play alternatively the role of ‘student’ and ‘teacher’ (De Clercq and Sapienza, 2001; Busenitz et al., 2004). More specifically, the potential outcomes from the relationship between venture capitalist and entrepreneur may be highest when the two parties hold complementary knowledge that enforces the other party’s expertise and skills (Murray, 1996). A specific manifestation of the complementarity between the venture capitalist and entrepreneur pertains to the parties’ undertaking of relation-specific investments, that is investments that are specifically targeted at their mutual relationship (Dyer and Singh, 1998). Relation-specific investments by the venture capitalist for example may be to devote considerable time and energy with an entrepreneur to learn the nuances and potential of a specific technology. Likewise, the entrepreneur may develop and utilize reporting procedures specifically aimed at fitting the venture capitalist’s timing and reporting requirements. De Clercq and Sapienza (2001) argued that both venture capitalist and entrepreneur can benefit from such relation-specific investments since these investments enable them to access information and capabilities not widely available in the market. That is, the complementary skills of venture capitalist and entrepreneur can result in an extremely potent combination that leads to enhanced learning for both parties.

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In addition to the nature of the knowledge that is held by venture capitalist and entrepreneur, eﬀective knowledge sharing routines have to be established between the two parties. Communication between venture capitalist and entrepreneur may occur in a variety of formal and informal forms, such as through telephone, email, voice mail, formal meetings and board meetings (Gorman and Sahlman, 1989; Sahlman, 1990). When eﬀective board knowledge-sharing routines are in place, the interaction between venture capitalist and entrepreneur may lead to an improved capacity for both parties to exchange and process knowledge, and this may then lead to optimal learning outcomes (De Clercq and Sapienza, 2005). Furthermore, personal contacts outside board meetings may allow for easier exchange of information, in that such contacts may allow the venture capitalist and entrepreneur to learn more about the other’s idiosyncrasies and to develop a mutual understanding of each other’s goals. Also, the employment of frequent interaction routines between venture capitalist and entrepreneur enhances access to each other’s knowledge base and increases the capability of processing complex knowledge (Sapienza, 1992). More generally, eﬀective communication between venture capitalist and entrepreneur stimulates a greater understanding between the two parties, and ultimately enhances the potential for favorable investment outcomes. Concluding note An important aspect of how venture capitalists add value to their portfolio companies, or how entrepreneurs benefit from their venture capital providers, pertains to the content of the interactions that take place between the two parties. As illustrated in the research cited above, the knowledge held by the individual venture capitalist, the aggregated knowledge held by multiple venture capitalists belonging to the same or diﬀerent venture capital firms, as well as the combined knowledge of investor and entrepreneur all play an important role in the eﬀectiveness of venture capital investments. Overall, the literature indicates that the knowledge-based view and learning theory are appropriate frameworks that help explain why certain venture capitalist–entrepreneur relationships are more eﬀective than others. However, although the literature mentioned above suggests that venture capitalists and entrepreneurs should work together in a complementary fashion in order to more fully exploit their respective knowledge bases, the literature falls short of describing how exactly these advantages could happen. Therefore, more research is needed on the actual activities and procedures that are maintained by the two parties, for example, what are the specific task descriptions outlined for the venture capitalist during and outside board meetings, or what is the content and frequency of the feedback that entrepreneurs provide to their investors? Process-related issues Whereas the previous section focused on the role of knowledge in venture capital finance, we now turn our attention to process-related aspects of the relationship between venture capitalist and entrepreneur. We draw hereby on the increasing body of venture capital research that recognizes the importance of establishing strong social relationships between the two parties rather than focusing solely on behavior based on self-interest and opportunism as advanced by the agency framework. Various theoretical frameworks In essence, the assumptions underlying agency theory deny the establishment of a trusting relationship between exchange partners, and the

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theory is predicated on an extreme form of self-serving behavior (Eisenhardt, 1989). Given the shortcomings related to the agency framework, alternative theories such as game theory (Cable and Shane, 1997) and procedural justice theory (Sapienza and Korsgaard, 1996), have been applied to the context of venture capitalist–entrepreneur relationships. Cable and Shane (1997) argued that the relationship between venture capitalist and entrepreneur can be described as two parties locked together in a game, which if successfully and rationally played together, will yield rewards greater than if appreciated in a contested and untrusting fashion. The authors’ application of game theory to venture capitalist–entrepreneur dyads is interesting in that it explains why the two parties may be motivated towards cooperative behavior, despite their diﬀerent goals. However, this emphasis on the play of games still assumes economic gain as the exchange partners’ sole motivator, and does not take into account the principles underlying relational exchange and trust development. Other studies have included trust as an important construct for describing the governance of venture capitalist–entrepreneur relationships (Sapienza and Korsgaard, 1996; Fiet et al., 1997). The core idea of procedural justice theory is that regardless of the outcome of certain decisions, individuals react more favorably when they feel the procedure used to make the decisions is fair. For instance, it has been suggested that a regular provision of information by the entrepreneur to the venture capitalist may be perceived as a fair component of the investment agreement by the latter, which will subsequently increase the investor’s trust in the entrepreneur. However, whereas procedural justice theory does take into account the role of non-economical aspects in the venture capitalist–entrepreneur relationship, the underlying assumption is still one of protection against each other’s opportunistic behavior. In the following sub-sections, we focus on recent venture capital research that has applied a social exchange perspective for describing venture capitalist–entrepreneur relationships, and we also refer to the broader sociological and management literature from which the application of this framework has been derived. More specifically, we will discuss the importance of the following four process-related components of venture capitalist–entrepreneur relationships: trust, social interaction, goal congruence and commitment (Figure 7.1). The first three components represent key dimensions of the social capital that is potentially embedded in venture capitalist–entrepreneur relationships (Nahapiet and Ghoshal, 1998). More specifically, ‘trust’ pertains to expectations one party has vis-à-vis the other’s behavior (relational dimension), ‘social interaction’ pertains to the overall pattern of connections and the tie strength (structural dimension), and ‘goal congruence’ pertains to the presence of shared interpretations between the parties (cognitive dimension). The fourth dimension, commitment, reflects the relational intensity of the cooperation between two parties, and hence represents a dimension deeper than social capital (Morgan and Hunt, 1994). The importance of the hereafter described research on process-related issues lies in its close connection with the role played by learning and knowledge in venture capitalist–entrepreneur relationships (as pointed out earlier). More specifically, prior research on social capital suggests that knowledge is essentially embedded in a social context, and that knowledge is created through ongoing relationships among economic actors (Nahapiet and Ghoshal, 1998). As such, the literature on processrelated issues provides additional insights into how the outcomes of the venture capitalist–entrepreneur relationship can be further enhanced.

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The role of trust Given the high importance accorded to trust in the dynamics of interfirm relationships (Ring and Van de Ven, 1992; Zaheer et al., 1998), we discuss the role of trust as the first process-related aspect characterizing venture capitalist–entrepreneur relationships. The presence of ‘trust’ has for long been considered an essential determinant of the performance of exchange relationships since the willingness to interact with others is often contingent on the prevalence of trust (Ring and Van de Ven, 1992). From a social exchange perspective, trust involves the presence of positive expectations about another’s motives in situations entailing risk, that is, ‘to trust another party’ essentially means to leave oneself vulnerable to the actions of ‘trusted others’ (Boon and Holmes, 1991). Although the early research in the venture capital area did not explicitly focus on the importance of trust in venture capitalist–entrepreneur relationships, trust has generally been considered as being an important aspect of relationships between investor and investee. For instance, Sweeting (1991) noted that venture capitalists are often quite concerned with whether entrepreneurial team members can be trusted. Further, Sapienza (1989) showed that successful venture capitalists try to build social, trusting relationships with their entrepreneurs. The potential value of trust in venture capitalist–entrepreneur relationships has been argued to derive from the more eﬀective knowledge exchange that takes place between the two parties. For instance, De Clercq and Sapienza (2006) found a positive relationship between the venture capitalists’ trust in their portfolio companies and their perception of the companies’ performance. The authors reasoned that the presence of trust between venture capitalist and entrepreneur creates a context in which both parties are willing to open themselves to the other since the likelihood that the other will act opportunistically is diminished. Interestingly, there is also some evidence that, in some cases, too much trust in venture capitalist–entrepreneur relationships may potentially have a negative side eﬀect. More specifically, at extremely high levels of trust there may be less need felt by the two parties to engage in penetrating discussions and information exchange. In other words, there may be a danger that they scrutinize the other’s decisions less (De Clercq and Sapienza, 2005). This suggests that venture capitalist and entrepreneur should be wary not to develop a level of trust that actually reduces the intensity of processing information in their relationship. The role of social interaction The level of social interaction that takes place between the venture capitalist and entrepreneur (or exchange partners in general) pertains to the social contacts and personal relationships that exist among the parties. The notion of social interaction is not necessarily synonymous with that of trust in that the venture capitalist and entrepreneur may have confidence that the other will not engage in opportunistic behavior, but that they will still interact with one another in a formal rather than informal manner. Prior research has suggested that strong personal contacts between exchange partners may be beneficial as these contacts increase their willingness to be involved with the other for a long period of time (Morgan and Hunt, 1994). Similarly, recent research in the venture capital area has found empirical evidence for a positive relationship between the extent to which venture capitalist and entrepreneur interact with one another in social occasions and the performance of venture capitalist investments (De Clercq and Sapienza, 2006). The rationale for this positive relationship is that thanks to strong social

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contacts the investor may become more motivated in assisting the entrepreneur for reasons diﬀerent from economical ones (Zaheer et al., 1998). Social interaction between venture capitalist and entrepreneur can also expand the nature of the knowledge exchanged in the relationship, in that social interaction increases the transfer of complex, tacit knowledge (Nonaka, 1994). In the venture capital context, tacit knowledge may pertain to the venture capitalist’s ability to detect the knowledge needs of her portfolio companies, or to the entrepreneur’s ability to detect hidden value-adding skills held by the venture capitalist. An implication from this stream of research for entrepreneurs is that their willingness to develop close social relationships with their investors may aﬀect their standing within the venture capital community. That is, an entrepreneur’s reputation with respect to their willingness to engage in open relationships with external partners may function as a signal to the venture capitalist that cooperation with the entrepreneur will be eﬃcient and eﬀective. Put diﬀerently, entrepreneurs may increase their potential access to additional needed funding by building a track record of strong social relationships with investors and other exchange partners. The role of goal congruence Goal congruence refers to the degree to which two exchange partners hold common beliefs regarding their relationship (Nahapiet and Ghoshal, 1998). The notion of goal congruence, or goal incongruence, is closely related to the presence of information asymmetry as described in agency theory (Eisenhardt, 1989). Goal congruence extends the idea of economic actors’ self-interest in that it speaks to the compatibility between two parties’ vision of how their relationship will evolve in the future (Davis et al., 1997). The broader literature on inter-firm relationships has argued for a positive relationship between goal congruence and relationship outcomes in that higher goal congruence facilitates the ability of the partners to interact eﬀectively with one another (Larsson et al., 1998). That is, if two parties share similar goals, they will be more motivated to give the other full access to the own knowledge base because such access will potentially help the other in better achieving the common goals. In the context of venture capital financing, the venture capitalist and entrepreneur may each have unique skills and capabilities, and therefore, diﬀer in terms of their orientation, activities and goals (Cable and Shane, 1997). Several types of goal conflict may hamper the extent of the information exchange between venture capitalist and entrepreneur, and the resulting poor communication may ultimately reduce the potential of the entrepreneur to benefit optimally from the venture capitalist’s input. For instance, a possible goal conflict between the venture capitalist and entrepreneur pertains to the venture capitalist’s expectation that the entrepreneur is willing to give up her absolute independence in order to maximize the expected shareholder wealth through corporate growth (Brophy and Shulman, 1992). However, when the entrepreneur’s main objective is not just future wealth maximization, but also meeting other personal needs, such as approval and independence (Birley and Westhead, 1994), she may not be willing to provide the venture capitalist with useful information that would facilitate high company growth. Furthermore, although both parties may believe to hold similar goals at the time of the investment decision, they may fail to honor their commitment to these goals in the post-investment phase because of divergent interpretations, which may then lead to mutual disappointments and conflict (Parhankangas et al., 2005).

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From a more positive angle, high levels of goal congruence between venture capitalist and entrepreneur should stimulate the parties’ ability to interact eﬀectively with one another. There is indeed empirical evidence for the existence of a positive relationship between the level of goal similarity between the venture capitalist and entrepreneur and the performance of the venture capitalist’s investment (De Clercq and Sapienza, 2006). When the venture capitalist and entrepreneur share the same goals and expectations, it is more likely that they engage in more eﬀective communication because each party has a better understanding of which information is important for each, and how this information may benefit the other’s objectives. The role of commitment Prior research has also emphasized the importance of commitment for relational outcomes. For instance, research on inter-firm relationships has shown that relationship commitment represents an important driver for success in that committed partners exert extra eﬀort to ensure the longevity of their relationship with others, and they engage in closer cooperation (Morgan and Hunt, 1994). In the context of venture capital financing, the commitment of venture capitalist and entrepreneur to their mutual relationship may manifest itself in specific behaviors that reflect the partners’ willingness to invest highly in the relationship, that is their commitment may be reflected in their willingness to undertake significant eﬀorts (Giﬀord, 1997). For instance, venture capitalists may devote more or less time and energy in consulting their network of business relationships aimed at getting specific advice for the entrepreneur. Alternatively, entrepreneurs may show varying eﬀorts in reporting performance data to their investor. In addition, the level of commitment in venture capitalist–entrepreneur relationships may not only pertain to the actual eﬀorts that are undertaken on behalf of the relationship, but also to one’s identification with and feelings vis-à-vis the other (De Clercq and Sapienza, 2006). Commitment therefore also reflects the aﬀective or emotional orientation by the venture capitalist and entrepreneur to their mutual relationship. Signals of commitment by the venture capitalist may increase the value that is created in the venture capitalist–entrepreneur relationship for two reasons. First, a deep commitment held by the venture capitalist vis-à-vis a particular investment can reflect itself in the venture capitalist spending more time in executing various value-adding roles (Sapienza et al., 1994), which may then increase the likelihood that the entrepreneur will benefit from the venture capitalist’s assistance. Second, prior research has indicated that entrepreneurs may be resistant to the advice provided by their venture capital providers. This resistance may be explained by the entrepreneur’s unwillingness to give up control over her company (Sahlman, 1990). However, when the venture capitalist shows a deep concern about and interest in the entrepreneur’s well-being, the latter may be more likely to believe in the loyalty and motives of the venture capitalist, and therefore be less resistant in accepting the oﬀered advice. It has indeed been shown that entrepreneurs are more receptive for the venture capitalist’s advice when the venture capitalist is a highly involved member of the board of directors (Busenitz et al., 1997). Also, De Clercq and Sapienza (2006) found empirical support for the positive relationship between a venture capitalist’s commitment to a particular investment and her perception of success of that investment. Overall, this stream of research shows that venture capitalists benefit from convincing entrepreneurs that they are ‘in the game’ for the long run and are willing to function as committed insiders.

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Interestingly, although there is an important advantage related to venture capitalists’ commitment, the reality does not always allow a venture capitalist to maximize her commitment for each single investment. In this regard, Giﬀord (1997) explained that venture capitalists face a serious time allocation dilemma with regard to the myriad of activities they are involved in, that is devoting attention to their existing portfolio companies, locating and closing new investment deals, and raising new funds. This author argued that venture capitalists often economize on allocating their eﬀort across these activities in ways that are optimal for the venture capitalist herself, but not necessarily optimal for the portfolio companies. More specifically, given that venture capitalists have a tendency to devote as much time as possible to those deals that generate the majority of their returns (Sahlman, 1990; Sapienza et al., 1994), entrepreneurs who are in the highest need for venture capitalist advice may in fact be left in the cold. Ultimately, this conscious choice of reduced involvement may have gruesome consequences for the individual entrepreneur. Concluding note An important aspect of how venture capitalists add value to their portfolio companies, in addition to the content of the knowledge that is exchanged between the venture capitalist and entrepreneur, pertains to the social dynamics that take place in the interactions between the two parties. The literature suggests that process-related issues, such as trust and commitment, may facilitate venture capitalists’ ability to aid a particular entrepreneur through an improved understanding of the entrepreneurs’ operations and needs. That is, good relationships between venture capitalist and entrepreneur may lead to more specific insights into how an investment deal can be optimized, and therefore enhance the potential that the venture capitalist adds value. Also, process-related issues may increase venture capitalists’ value-adding potential because these issues increase the receptivity of the parties vis-à-vis the other’s input and advice. Finally, whereas the literature cited above appeals to the intuitive notion that venture capitalists and entrepreneurs will benefit from more trustful, socially oriented, congruent and committed relationships, further examination is needed with respect to whether in some cases close relationships may actually hurt rather than help. For instance, it is possible that high-quality relationships may lead to groupthink in which the scrutiny with which the two parties judge each other’s actions is diminished. This may then potentially lead to poor decision making (Janis, 1972; De Clercq and Sapienza, 2005). Future research In this chapter we have provided an overview of prior research on the post-investment phase of venture capital investing. We first discussed the literature on the monitoring and value-adding activities undertaken by venture capitalists vis-à-vis their portfolio companies. We then turned our attention to the literature that attempted to better explain the mechanisms underlying the question of how value is added in venture capitalist–entrepreneur relationships. Two types of issues relevant to better understanding value-added were discussed, that is issues pertaining to the content and issues pertaining to the process of the exchange relationship. In the remaining paragraphs, we give some indications of how future researchers can further extend the literature highlighted in this chapter.

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Heterogeneity of monitoring and value-adding activities First, future research should further elaborate on how the heterogeneity of venture capitalists’ monitoring and value-adding activities depends on the combination of venture capitalist characteristics, characteristics of the entrepreneur and venture, and the institutional and social environment in which both parties are embedded. More specifically, a comprehensive framework could be developed and empirically tested in which the various antecedents of venture capitalists’ monitoring and value-adding activities are examined at the same time. For instance, the following venture capitalist characteristics should be included: ●

●

● ● ●

The type of investors in the venture capital fund (for example independent venture capitalists compared to venture capitalists related to a financial institution or a corporate), the structure of the venture capital fund (for example open ended versus closed; quoted or not; the nature of the compensation of the venture capital managers), the investment strategy of the venture capital fund (for example generalist versus specialist; early stage versus later stage or mixed), the human capital of the (team of) venture capitalists, and characteristics of other investors (that is syndicate members).

Furthermore, monitoring and value-adding activities may further be influenced by characteristics of the portfolio company and entrepreneur: ● ● ● ● ●

The business or financial risk of the venture (for example level of innovation; performance level, stage of development), the agency risk (for example depending on information asymmetries), the human capital of the entrepreneur (for example her general or specific human capital), the complementarity and completeness of the entrepreneurial team, and the initial resource endowments of the entrepreneurial venture (for example intellectual capital).

Finally, the institutional and social environment may have an impact on venture capitalist behavior. While institutional forces enforce some broad common ways of working in the venture capital industry worldwide, specific settings and social norms and behavior in diﬀerent parts of the world mean that the US model is not universal. More research is needed to fully understand the specific behavior of venture capitalists depending on institutional and cultural aspects of their environment: ● ● ● ● ● ●

The development of financial markets, the overall level of (minority) shareholder protection, the legal enforceability of contracts, the role of government in economic life, the tolerance for ambiguity, and, in general, the prevailing social norms, and the prevailing norms with respect to inter-firm co-operation.

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Content and process-related issues Future research should also further build on the literature pertaining to how value is added in the venture capitalist–entrepreneur relationship. It could hereby be examined in more detail how the exchanges of specific knowledge and the process of such exchanges aﬀect investment outcomes. For instance, the following topics could be examined in terms of content-related issues: ●

●

●

A longitudinal examination of venture capital performance and organizational learning across a variety of portfolio companies could answer the question of how venture capitalists are able to transfer knowledge from one venture to another. Furthermore, a related question that needs further investigation is: at what point does extensive communication between the venture capitalist and entrepreneur become a burden for learning given the costs associated with extensive information processing? It is well-established that venture capitalists stage their investment across subsequent investment rounds (Sahlman, 1990). The time period in which the undertaking of an additional investment round takes place may be particularly important in terms of the intensity of the interactions that take place between the venture capitalist and entrepreneur. It could be examined how the nature of communication between the two parties diﬀers and evolves across subsequent investment rounds. Another topic pertains to how venture capitalists are better able than others to create conditions and mechanisms that encourage quality interactions with their portfolio companies. For instance, what is the importance of establishing knowledge-sharing routines before the initial investment is made? How can the venture capitalist motivate the entrepreneur to provide useful inside information in a continuous and spontaneous manner, especially when the entrepreneur has not been able to achieve pre-set performance targets?

In terms of process-related issues, the following research questions could be examined: ●

●

What is the combined eﬀect of various process-related factors (for example trust, commitment) and issues related to the knowledge exchange itself (for example the cost, intensity, frequency, openness, or variety of communication) on the learning outcomes that are generated in the dyad. Also, what factors determine the timing for the exchange of information. How does the quality of the venture capitalist– entrepreneur relationship (for example reflected in the level of trust) aﬀect the parties’ willingness and capability to plan early on in the relationship which type of information needs to be exchanged in the subsequent stages of the relationship? It could also be explored how venture capitalists commit their time across the myriad of ventures in their portfolio. Also, how do venture capitalists divide their emotional involvement across multiple portfolio companies based on their perception of how well the portfolio companies have performed? Are venture capitalists always better oﬀ by focusing their eﬀorts on those companies with a high upside-potential rather than on companies which just need lots of hands-on attention and guidance. Which criteria do venture capitalists use to allocate their time optimally across multiple portfolio companies? Also, how do the venture capitalists’ background and experience aﬀect how they allocate their time and resources?

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Classic venture capitalists versus other investor types Finally, whereas the primary focus in this chapter was on the classic (or institutional) venture capitalist, as opposed to the business angel (see Chapters 12 to 14) or corporate venture capitalist (see Chapters 15 and 16), we believe that the literature would also benefit from comparing how the content and process-related issues discussed in this chapter may diﬀer across diﬀerent investor types. In essence, classic (institutional) venture capitalists, business angels and corporate venture capitalists represent complementary sources of finance for entrepreneurs, and each type of investor may have specific characteristics that reflect on the nature of the relationship between investor and entrepreneur (De Clercq et al., 2006). First, given that business angels tend to be more willing than institutional venture capitalists to invest at the very earliest stages (Benjamin and Margulis, 2005), their investments may be characterized by more uncertainty. Consequently, business angel investments may provide a higher opportunity for entrepreneurs to benefit from the knowledge provided by the investor, yet the uncertainty involved in such investments may make the establishment of stable, trustful relationships more challenging. Furthermore, since business angels, compared to institutional venture capitalists, may be more motivated by the intrinsic reward of their involvement in a portfolio company and often do not have a wide portfolio of companies, the time allocation dilemma as described above (Giﬀord, 1997) may be less relevant for business angels. Also, due to the informal nature of angel financing, entrepreneurs who have angel financiers may not enjoy as many reputational benefits as entrepreneurs who have institutional venture capitalists or corporate venture capital investors on board. Furthermore, the nature of possible goal incongruence between investor and entrepreneur may depend on the investor type. For instance, classic (institutional) venture capitalists (and to a lesser extent business angels) may be primarily concerned about increasing the realizable trade value of their ventures since a substantial portion of their compensation is based on capital gains. When harvesting is an important short-term objective, the investor will want to collect as much information as possible that is useful for presentation to potential buyers of the venture. However, the entrepreneur may not be willing to provide the institutional venture capitalist with such information if she has diﬀerent goals for the company. In contrast, a relevant goal for a corporate venture capitalist may be to utilize the portfolio company as an external research and development resource, or to direct the company’s research towards the mother company’s strategic goals (Siegel, 1988). In that case, possible goal conflict between the corporate venture capitalist and entrepreneur may pertain more to how autonomous the entrepreneur can be in terms of the strategic direction in which her company is going. This type of goal incongruence is of a very diﬀerent nature and calls for diﬀerent action, which in turn presents a further route for fruitful research. Acknowledgement We thank the editor (Hans Landström), Lowell Busenitz and participants of the Stateof-the-Art workshop (Lund) for helpful comments on earlier drafts of this chapter. References Amit, R., J. Brander and C. Zott (1998), ‘Why do venture capital firms exist? Theory and Canadian evidence’, Journal of Business Venturing, 13, 441–66.

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Arthurs, J. and L. Busenitz (2003), ‘The boundaries and limitations of agency theory in the venture capitalist/entrepreneur relationship’, Entrepreneurship: Theory & Practice, 28(2), 145–62. Barney, J.B., L.W. Busenitz, J.O. Fiet and D.D. Moesel (1989), ‘The structure of venture capital governance: an organizational economic analysis of relations between venture capital firms and new ventures’, Academy of Management Proceedings, pp. 64–8. Baum, J.A.C. and B.S. Silverman (2004), ‘Picking winners or building them? Alliance, intellectual and human capital as selection criteria in venture financing and performance of biotechnology startups’, Journal of Business Venturing, 19(3), 411–36. Benjamin, G.A. and J.B. Margulis (2005), Angel Capital. How to Raise Early-stage Private Equity Financing, Hoboken, NJ: John Wiley & Sons. Beuselinck, C. and S. 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Kirzner, I. (1973), Competition and Entrepreneurship, Chicago: University of Chicago Press. Lam, S.S. (1991), ‘Venture capital financing: a conceptual framework’, Journal of Business Finance & Accounting, 18(2), 137–49. Landström, H. (1992), ‘The relationship between private investors and small firms: an agency theory approach’, Entrepreneurship and Regional Development, 4, 199–223. Lane, P.J. and M. Lubaktin (1998), ‘Relative absorptive capacity and interorganizational learning’, Strategic Management Journal, 19, 461–77. Larsson, R., L. Bengtsson, K. Henriksson and J. Sparks (1998), ‘The interorganizational learning dilemma: collective knowledge development in strategic alliances’, Organization Science, 9(3), 285–305. Lerner, J. (1994), ‘The syndication of venture capital investments’, Financial Management, 23(3), 16–27. Lerner, J. (1995), ‘Venture capitalists and the oversight of private firms’, Journal of Finance, 50(1), 293–361. Lerner, J. and P.A. Gompers (2001), The Money of Invention: How Venture Capital Creates New Wealth, Boston: Harvard Business School Press. Lind, M.R. and R.W. Zmud (1995), ‘Improving interorganizational eﬀectiveness through voice mail facilitation of peer-to-peer relationships’, Organization Science, 6(4), 445–61. Lockett, A. and M. Wright (1999), ‘The syndication of private equity: evidence from the UK’, Venture Capital, 1(4), 303–24. Lockett, A. and M. Wright (2001), ‘The syndication of venture capital investments’, Omega, 29, 375–90. MacMillan, I.C., D.M. Kulow and R. Khoylian (1989), ‘Venture capitalists’ involvement in their investments: extent and performance’, Journal of Business Venturing, 4, 27–47. Manigart, S., K. De Waele, M. Wright, K. Robbie, P. Desbrières, H. Sapienza and A. Beekman (2002), ‘Determinants of required returns in venture capital investments: a five country study’, Journal of Business Venturing, 17(4), 291–312. Manigart, S., A. Lockett, M. Meuleman, M. Wright, H. Landström, H. Bruining, P. Desbrières and U. Rommel (2006), ‘Venture capitalists’ decision to syndicate’, Entrepreneurship: Theory & Practice, 30(2), 131–54. Mitchell, F., G.C. Reid and N.G. Terry (1995), ‘Post investment demand for accounting information by venture capitalists’, Accounting & Business Research, 25(99), 186–96. Morgan, R.M. and S.D. Hunt (1994), ‘The commitment-trust theory of relationship marketing’, Journal of Marketing, 58, 20–38. Murray, G.C. (1996), ‘A synthesis of six exploratory, European case studies of successfully exited, venture capital-financed, new technology-based firms’, Entrepreneurship: Theory & Practice, Summer, pp. 41–60. Nahapiet, J. and S. Ghoshal (1998), ‘Social capital, intellectual capital, and the organizational advantage’, Academy of Management Review, 23, 242–68. Nonaka, I. (1994), ‘A dynamic theory of organizational knowledge creation’, Organization Science, 5(1), 14–37. Norton, E. and B.H. Tenenbaum (1993), ‘Specialization versus diversification as a venture capital investment strategy’, Journal of Business Venturing, 8, 431–42. Parhankangas, A., H. Landström and G.D. Smith (2005), ‘Experience, contractual covenants and venture capitalists’ responses to unmet expectations’, Venture Capital, 7(4), 297–318. Parkhe, A. (1993), ‘Strategic alliance structuring: a game theoretic and transaction cost examination of interfirm cooperation’, Academy of Management Journal, 36, 794–829. Podolny, J. (2001), ‘Networks as pipes and prisms of the market’, American Journal of Sociology, 107, 33–60. Prahalad, C.K. and R.A. Bettis (1986), ‘The dominant logic: a new linkage between diversity and performance’, Strategic Management Journal, 7, 485–501. Ring, P.S. and A.H. Van de Ven (1992), ‘Structuring cooperative relationships between organizations’, Strategic Management Journal, 13, 483–98. Rosenstein, J. (1988), ‘The board and strategy: venture capital and high technology’, Journal of Business Venturing, 3, 159–70. Rosenstein, J., A.V. Bruno, W.D. Bygrave and N.T. Taylor (1993), ‘The CEO, venture capitalists, and the board’, Journal of Business Venturing, 8, 99–113. Ruhnka, J.C., H.D. Feldman and T.J. Dean (1992), ‘The “living dead” phenomenon in venture capital investments’, Journal of Business Venturing, 7, 137–55. Sahlman, W.A. (1990), ‘The structure and governance of venture capital organizations’, Journal of Financial Economics, 27, 473–521. Sapienza, H.J. (1989), ‘Variations in the venture capitalist–entrepreneur relations: antecedents and consequences’, Unpublished Doctoral Dissertation, University of Maryland. Sapienza, H.J. (1992), ‘When do venture capitalists add value?’, Journal of Business Venturing, 7, 9–27. Sapienza, H.J. and A. Amason (1993), ‘Eﬀects of innovativeness and venture stage on venture capitalist–entrepreneur relations’, Interfaces, 23(6), 38–51. Sapienza, H.J. and D. De Clercq (2000), ‘Venture capitalist–entrepreneur relationships in technology-based ventures’, Enterprise and Innovation Management Studies, 1(1), 57–71.

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Sapienza, H.J. and A.K. Gupta (1994), ‘Impact of agency risks and task uncertainty on venture capitalist–CEO interaction’, Academy of Management Journal, 37(6), 1618–32. Sapienza, H.J. and M.A. Korsgaard (1996), ‘The role of procedural justice in entrepreneur–venture capital relations’, Academy of Management Journal, 39, 544–74. Sapienza, H.J., A.C. Amason and S. Manigart (1994), ‘The level and nature of venture capitalist involvement in their portfolio companies: a study of three European countries’, Managerial Finance, 20(1), 3–17. Sapienza, H.J., S. Manigart and W. Vermeir (1996), ‘Venture capitalist governance and value-added in four countries’, Journal of Business Venturing, 11(6), 439–70. Seppa, T. (2002), ‘Essays on the valuation and syndication of venture capital investments’, Unpublished Doctoral Dissertation, Helsinki University of Technology. Siegel, R. (1988), ‘Corporate venture capitalists: autonomy, obstacles, and performance’, Journal of Business Venturing, 3(3), 233–47. Sitkin, S.B. and N.L. Roth (1993), ‘Reconceptualizing the determinants of risk behavior’, Academy of Management Review, 17, 9–38. Smith, J.K. and L.S. Smith (2000), Entrepreneurial Finance, New York: Wiley. Sorenson, O. and T.E. Stuart (2001), ‘Syndication networks and the spatial distribution of venture capital investments’, American Journal of Sociology, 106(6), 1546–88. Steier, L. and R. Greenwood (1995), ‘Venture capitalist relationships in the venture structuring and postinvestment stages of new firm creation’, Journal of Management Studies, 32, 337–57. Stuart, T.E., H. Hoang and R.C. Hybels (1999), ‘Interorganizational endorsements and the performance of entrepreneurial ventures’, Administrative Science Quarterly, 44, 315–49. Sweeting, R. (1991), ‘UK venture capital funds and the funding of new technology-based businesses: process and relationships’, Journal of Management Studies, 28, 601–22. Tsai, W. and S. Ghoshal (1998), ‘Social capital and value creation: the role of intrafirm networks’, Academy of Management Journal, 41, 464–76. Tyebjee, T. and A. Bruno (1984), ‘A model of venture capitalist investment activity’, Management Science, 30(9), 1051–66. Wright, M. and K. Robbie (1998), ‘Venture capital and private equity: a review and synthesis’, Journal of Business Finance & Accounting, 25(5–6), 521–69. Zaheer, A., B. McEvily and V. Perrone (1998), ‘Does trust matter? Exploring the eﬀects of interorganizational and interpersonal trust on performance’, Organization Science, 9(2), 141–59.

8

Innovation and performance implications of venture capital involvement in the ventures they fund Lowell W. Busenitz

Introduction When entrepreneurs choose to take on venture capital funding, the life and dynamics of a venture change substantially. One of the first structural changes to occur is the implementation of a board of directors of which the founding team usually plays a minority role (Rosenstein et al., 1993). There tends to be a fair amount of interaction between venture capitalists and entrepreneurs that may allow venture capitalists to intervene in various capacities to build and protect an entrepreneurial venture. Venture capitalists may help the venture make key links to customers and suppliers, monitor venture performance, act as a sounding board as well as assist with strategic issues (Timmons and Bygrave, 1986; MacMillan et al., 1989; Fried and Hisrich, 1995; Manigart et al., 2006). Research has only begun to explore whether venture capital involvement beyond their financial involvement adds value to the ventures in which they invest as well as the broader economic development. One impetus for the emergence of the venture capitalist–entrepreneur relationship is that it may enable firms to create value by the sharing of knowledge, combining or gaining access to critical resources and decreasing the time required for a new venture to market its products. Venture capitalists spend approximately one-half of their time monitoring an average of nine funded ventures (Gorman and Sahlman, 1989). A venture capitalist’s ongoing involvement with the entrepreneurial team and the venture will generally impact on the venture in a variety of ways. Some research has found support for a venture capitalist’s non-financial input adding value (MacMillan et al., 1989; Sapienza, 1992) whereas other research suggests that venture capitalists do not tend to add value (Gomez-Mejia et al., 1990; Steier and Greenwood, 1995; Manigart et al., 2002). This chapter presses forward with the following question: does venture capital involvement impact on venture innovation and performance? At least two fundamental issues are embedded in answering this question. First, in addressing whether venture capitalists add value to the ventures in which they invest, earlier research suggests multiple areas of venture capital involvement. For example, does frequency of interaction between venture capitalists and the entrepreneurs that they fund add value? Do venture capital-backed firms perform better during the IPO process? While there are contributions that earlier research has made on this subject, I will argue that future inquiry needs to move beyond these broad questions. More specifically, it is time for research to press forward with governance arrangements, compensation systems, and obtaining follow-on rounds of funding. It is argued that these areas represent promising areas for future research and can help resolve some of the mixed results from earlier research. It seems apparent that venture capitalists do not always add value as the research findings seem quite mixed. 219

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Second, this chapter examines the broader impact of venture capitalist investments. The presence of venture capitalist investing should enhance the overall level of innovation. Whole new industries have been reported to emerge because of venture capitalist investments. While past research has started to probe this area, there is much work that needs to be done here. Finally, this chapter addresses performance issues that come with studying venture capital funding. Given that these ventures are private firms, obtaining legitimate financial numbers clearly represents unique challenges. Given that investors such as venture capitalists look to exit a venture after a season of involvement and, hopefully, growth (venture capital exits are generally projected at approximately 5–6 years), organizational outcomes or exit modes represent a viable metric for analyzing performance. Furthermore, venture capital involvement often involves interactions and relationships with individuals inside the venture, making the evaluations of both venture capitalists and entrepreneurs important. The final section explores these various measurement alternatives and addresses the strengths and limitations of these alternatives. This chapter will proceed in the following manner. The next section addresses activities in which venture capitalists typically get involved with a venture and how they may help or hinder the development of the venture. Second, we discuss the impact that venture capitalists have on innovation and the development of new industries. Third, we will explore performance measurement issues as they relate to venture capital-backed ventures. In so doing, we will address the types of phenomena being researched and the type of performance that is likely to be most appropriate as the dependent variable. Venture capital impact on venture development Venture capitalists are known for potentially adding value to ventures through their knowledge and contacts to enhance supplier and customer relationships, through oﬀering strategic and operational advice, and helping recruit key managers (MacMillan et al., 1989; Sapienza, 1992; Barney et al., 1996). Furthermore, venture capitalists have often established relationships with underwriters (Bygrave and Timmons, 1992) and certify the value of their ventures to those underwriters (Megginson and Weiss, 1991). Thus, venture capital involvement in ventures may represent an important asset that allows for a resource advantage in subsequent phases such as acquisitons and IPOs. In sum, the contributions of venture capitalists to the ventures that they back has found positive support (Sapienza, 1992) as well as little or no support (Daily et al., 2002). Given the mixed findings from previous research, it is time to probe some new areas for future research. We now develop research opportunities for addressing the potential impact that venture capital involvement can have in the form of the governance oversight that they bring to the venture, the financial accountability, the certification of venture capital backing and managing positive exits. By addressing these issues, we seek to provide direction to future research where venture capitalists may add value to the ventures in which they invest through governance and reputation eﬀects. Governance Some venture capital research is addressing internal governance issues in venture capitalbacked ventures (for example Amit et al., 1990; Sahlman, 1990; Bruton et al., 2000). When the entrepreneur (for example the agent) contracts with the venture capitalist (for example

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the principal) for funding, an agency problem can arise as a result of incongruent goals and potentially diﬀerent risk preferences (Eisenhardt, 1989; Bruton et al., 2000). Because of information asymmetry and the venture capitalist’s bounded rationality (Amit et al., 1990; 1993; 1998; Bohren, 1998), the entrepreneur may engage in opportunistic behaviors that would benefit the entrepreneur at the expense of equity investors such as venture capitalists (Gompers and Lerner, 1996). Particularly in US studies, agency theory has emerged as the central paradigm for understanding the venture capitalist–entrepreneur relationship (De Clercq and Manigart address this paradigm more extensively in the preceding chapter). From an agency perspective, the venture capitalist–entrepreneur dynamic does not directly mirror the principal–agent relationship. Rather, it is more like a principal (venture capitalist)/principal and agent (entrepreneur) relationship. In other words, while entrepreneurs are agents of the venture capitalists (principals) who invest, they are also holders of equity and thus principals themselves. With the onset of venture capital investments, the entrepreneur moves from being the sole principal to a partially diluted ownership position. With their investments, venture capitalists are eager to monitor the progress of the venture and the performance of the entrepreneurial team, both from a moral hazard and adverse selection perspective (Barney et al., 1989; Sahlman, 1990). Given their substantial ownership stakes, venture capitalists tend to be heavily involved in governance activities such as board involvement and face-to-face interaction. Research across many countries seem to bear this out (Sapienza et al., 1996). Consequently, venture capitalists tend to have extensive experience in aligning the goals of managers with owners, and given that they spend a fair amount of time monitoring firms in their portfolio, they are likely to be able to provide greater protection compared to those ventures without venture capital backing. On the other hand, we suspect that ventures without venture capital backing will not be as closely monitored and will not have the same level of protection against potential adverse selection and moral hazard type situations. Only a few studies to this point have specifically addressed board of director and governance issues associated with the onset of venture capital investments (for example Rosenstein et al., 1993; Lerner, 1995; Filatochev and Bishop, 2002). This is an underresearched area that needs much more inquiry. The make-up of the board of directors in venture capital-backed versus non-venture capital-backed ventures is proposed as a potentially important area of further inquiry. For example, boards of non-venture capital-backed firms are likely to be dominated by the founding team and perhaps associates or family members. In contrast, venture capital-backed firms are likely to have boards where the founding team and insiders are likely to play a much smaller role. As a condition of investing in the venture, venture capitalists typically want the right to replace members of the existing entrepreneurial team. Should such action be necessary, this can be accomplished by having a greater portion of outsiders on the board. Furthermore, CEO duality (the positions of CEO and Chairman of the Board held by the same individual) are likely to be far less common in venture capital-backed firms than non-venture capital-backed firms. Both the number of outsiders on the board and CEO duality serve as signals of power to correct moral hazard and adverse selection issues in a venture should they arise. In sum, better governance and board of directors should lead to greater venture performance. Regarding the composition of venture capital-backed boards, we also expect that there will be more homogeneity in the boards of non-venture capital-backed firms than venture

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capital-backed firms. More specifically, I suspect that there is more industry experience and more diversity in venture capital-backed boards. Venture capitalists are adamant about moving a firm towards commercialization as soon as possible and generally want as much experience on the board as possible. Non-venture capital-backed ventures tend to attract ‘likes’ and more family members to their boards whereas venture capitalists in and of themselves typically represent significant deviations from founder norms and characteristics. Furthermore, an increase in the equity held by one or two members of the founding team is likely to be associated with insider domination on the board, and the board may be less diverse (Filatochev and Bishop, 2002). In sum, we believe that the governance mechanisms put in place by the boards of venture capital-backed ventures will significantly diﬀer from those of non-venture capital-backed ventures. More importantly, stronger governance should lead to better venture performance. These arguments lead to the following propositions: Proposition 1: Venture capital-backed ventures will have substantially better governance mechanisms in place than will non-venture capital-backed ventures. Proposition 2: Because of the repetition and skill that venture capitalists have in monitoring entrepreneurial ventures, there will be significantly less variance in the governance mechanisms in venture capital-backed ventures than in ventures with non-venture capital-backed ventures. Proposition 3: Stronger governance mechanisms in venture firms will lead to better venture performance. Venture team compensation When entrepreneurs start their ventures, compensation and pay-oﬀ issues are almost always assumed to be at some distance into the future. Often little compensation is taken by the founders from the venture in the early months with the assumption that their ‘sweat’ equity will be rewarded by the long-term success of the venture. Consequently, near-term compensation tends not to be much of an issue until venture capitalists invest. A reduction in the equity stake of the venture and the implications of needing to share the long-term rewards of the venture are projected to create substantial compensation issues. While it seems that this subject has received at best minimal research attention, it is an important issue. I first turn to the research on executive compensation as a platform into this new area for venture capital research. Research on managerial pay has shown how monitoring and reward mechanisms can help to align the interests of managers and shareholders (Jensen and Murphy, 1990; Barkema and Gomez-Mejia, 1998). Furthermore, contingent pay, such as stock options, may motivate managers diﬀerently than non-contingent pay, such as salary and other annual cash compensations (Daily et al., 1998). The use of contingent pay mechanisms more closely aligns managerial incentives with those of investors because managers have a substantial position in the firm whose value is contingent on firm performance (Jensen and Murphy, 1990). In addition, as noted above, the presence of venture capitalists tends to reduce managerial equity stakes in the company. This reduction in equity ownership can lead to less incentive alignment for managers (Fama and Jensen, 1983).

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Non-contingent pay is also a part of the compensation scheme and may be more salient with the advent of venture capital investments. Venture capitalists can realign the entrepreneurial team through greater use of contingent pay mechanisms. Contrary to contingent pay, non-contingent pay is normally expected to generate managerial interest in the shorter term, although the empirical evidence for the eﬀectiveness of cash compensation on increasing firm performance tends to be relatively weak (Jensen and Murphy, 1990; Balkin et al., 2000). Cash compensation provides a stable income stream and mitigates compensation-based risk or rewards (Daily et al., 1998). Thus the incentive eﬀects of non-contingent pay may not help to reduce managerial opportunism. However, Balkin and colleagues (2000) found that non-contingent pay was positively related to firm performance in high technology industries. In reality, too much contingent pay may result in the transfer of too much risk to managers (Beatty and Zajac, 1994) such that they reduce their level of risk-taking (Gray and Cannella, 1997). This may be a particular problem in entrepreneurial ventures. With the onset of venture capital funding, non-contingent pay may represent a mechanism through which managers can be rewarded without transferring too much risk. Furthermore, at lower levels of non-contingent compensation, managers may feel that their income is inequitable and not commensurate with the amount of eﬀort and time that they expend. As a result, lower levels of this type of compensation may encourage undesirable behavior (Kidwell and Bennett, 1993), or the pursuit of excessive perquisites (Jensen and Meckling, 1976) or other utility-maximizing behavior to the detriment of the firm. On the other hand, higher levels of non-contingent pay can help soften the impact of having to give up a significant equity stake in the venture in exchange for venture capital funding. Future research should explore the use of compensation in venture capital versus non-venture capital-backed ventures as well as the importance of each with the advent of venture capital funding. Proposition 4: Venture firms with venture capital backing will have greater protection against managerial opportunism compared to those new ventures without venture capital involvement as evidenced by the greater use of contingent and non-contingent compensation. Proposition 5: Entrepreneurs will view the giving up of partial venture equity more favorably with higher levels of non-contingent pay. It is also likely that compensation schemes will aﬀect the performance of venture capital-backed ventures. Greater contingent pay helps to soften the impact of decreased equity that entrepreneurs are likely to feel with the advent of venture capital funding, leading them to work harder for the overall well-being of the venture. Contingent pay in the form of stock options is also likely to increase long-term venture performance. While the equity portion of entrepreneur ownership contracts with venture capital investments, the availability of stock options potentially increases their stake in ownership. Proposition 6: Greater use of both non-contingent and contingent pay in venture capital-backed ventures will increase the long term performance of the venture.

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Reputation and certification Since entrepreneurs usually start firms in turbulent environments with an unproven product market, a great deal of uncertainty typically surrounds these ventures. Furthermore, there is usually little or no historical information giving a venture little or no ‘track record’ on which to base future projections. It is in this type of context that venture capitalists have the potential to add to the stature and credibility of a venture. Megginson and Weiss (1991) examined venture capital backing in IPO firms and found that their presence lowered both underpricing and the gross spread paid to underwriters. Dolvin (2005) also found support for the certification hypothesis with IPO firms, as venture capital-backed firms had lower issuance costs, increased upward price adjustments, and shorter lock-up periods. Dolvin also found support for venture capital certification among penny stocks. While this prior research on certification in the IPO process is helpful, venture capital certification may also have implications in the earlier days of a venture. Venture capital involvement and certification may make it easier for the venture to establish a relationship with critical buyers and suppliers, obtain additional financing, and develop a better reputation with external constituents. Given the importance of credible commitments (Williamson, 1983; 1991), we argue that the presence of venture capital investments and positions on the venture board of directors will serve in this manner. For example, venture capitalists will not want to harm their reputation in the industry of the new venture (Amit et al., 1998) and will take steps to improve any diﬃculties between transacting parties. This in turn will act to reduce the potential transaction costs (Williamson, 1985) for the parties involved, and will provide additional benefits for the new venture. Thus, we should expect to see greater eﬃciency, especially as it relates to governance costs (Williamson, 1991) in venture capital-backed firms. Proposition 7: Venture capital-backed ventures will have higher levels of credible commitments with transacting parties such as buyers and suppliers than nonventure capital-backed ventures. We also suspect that venture capitalists will have a significant eﬀect with follow-on investors. Given that venture capitalists typically invest in stages or rounds providing enough money for venture firms for roughly a year before additional financing is needed, follow-on investors are critical. The amount of financing needed in subsequent rounds usually increases and if credible investors have been involved in earlier rounds and they continue to support the venture in subsequent rounds, this sends a positive signal and partially certifies the venture as a credible investment for follow-on financing. On the other hand, non-venture capital-backed ventures are likely to have to find a whole new set of investors. This is almost always a very time consuming process. Proposition 8: Once venture capitalists have invested in a venture, the entrepreneurs will spend less time obtaining subsequent rounds of financing than nonventure capital-backed ventures. Reputation and certification characteristics are also likely to lead to performance eﬀects. When quality venture capitalists invest in a venture, this will add to their reputation in a positive way, thus enabling the venture to develop alliances and relationships with

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higher quality firms. The enhanced reputation is also likely to allow the entrepreneurs to spend more time on their own ventures instead of making and further establishing contacts. These issues should have positive eﬀects on venture performance. Proposition 9: Venture capital-backed firms will have better reputations leading to higher venture performance. Concluding remarks One of the longest standing assumptions in the research literature on venture capital involvement is that they add value to the ventures that they invest in. Unfortunately, empirical findings have been quite mixed thus far. This does not mean that venture capitalists do not add value and that researchers should stop examining this area. Rather, the essence of the above arguments is that we need to focus our research in the areas argued above. I have developed arguments for more specifically examining governance arrangements, the compensation of founders and the top management teams as well as the reputation and certification implications of venture capital funding. More focused research should enable us to better address this critical issue. Venture capital impact on innovation With venture capital backing as an alternative becoming more common across the globe, it is often assumed that the presence of venture capital investments is an important contributor to the advancement of innovation and even economic development. The majority of the employment growth of even the most developed economies is coming from smaller and start-up firms, and much of this growth involves technological innovations (Tyebjee and Bruno, 1984). Venture capital is a common source of funding for these ventures that have high-growth potential (Bygrave and Timmons, 1992). However, we still know very little about the impact that venture capitalists have on the ventures they back individually as well as the more collective impact. This section examines exploration and exploitation at the firm level as well as the development of new industries and how venture capitalists impact these issues. Exploration and exploitation Venture capital funding is often closely linked with the pursuit of innovative technologies, with this probably being particularly true in the US. Of course innovation can occur in larger corporations as well as in smaller firms without venture capital funding, but venture capitalists are almost always associated with the funding of innovative ventures. The involvement of venture capitalists in such ventures stems at least in part from the issue that newer technology-based ventures have few funding sources since they do not have an established financial history nor fixed assets on which to anchor their funding. Venture capitalists also invest with a relatively limited time frame. Successful exits (IPOs or acquisitions) have to be anticipated within about five years to be considered for venture capital funding because of the funding cycle of their own limited partners. So while they tend to prefer innovative ventures, they are also very much concerned about their own returns and the quick commercialization or exploitation of the innovations that they are funding. By exploitation, we have reference to implementation, eﬃciency, production and market development (March, 1991; He and Wong, 2004).

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The development of the exploration and exploitation literature has shown that these two approaches to learning and organizational growth can be quite diﬀerent. The strategies, capabilities, organization structures, organizational cultures and the like tend to be quite diﬀerent for the pursuit of exploration versus exploitation. For example, exploration is associated with organic and loosely coupled systems, emerging markets, flexibility and pathbreaking strategies (Brown and Eisenhardt, 1998). Venture capital backing is virtually synonymous with high growth potential ventures, and consequently, with innovative technology seeking to be exploited in the market place. This raises an interesting question: does the pursuit of exploitation when the venture was founded on an innovative idea and has exploration competencies, really enhance the value of the venture or does it pressure a venture to seek capabilities in areas that they will never be able to suﬃciently obtain? It might be that moving from exploration to exploitation may create a conundrum for the venture firm. While venture capitalists mostly prefer to invest in technology-based ventures pursuing an innovation versus an imitator strategy, there is some variance in the stage1 of the venture at which venture capitalists start to get involved (Hellmann and Puri, 2000). Venture capital funding also tends to accelerate the time a venture takes in getting their product to market. In a similar study, Timmons and Bygrave (1986) found that venture capitalists seem to be increasingly interested in funding highly innovative technology ventures versus less innovative technology ventures and that their returns on the highly innovative technology ventures tended to be superior. By extension, venture capital funding may also lead to significantly higher patenting rates (Kortum and Lerner, 2000). Without patenting, the product may be threatened as it seeks to move quickly into the marketplace. These findings indicate that venture capitalists tend to favor innovative ventures as is widely perceived but there is variance on this. In a study of venture capitalists across Austria, Germany and Switzerland, Jungwirth and Moog (2004) found that venture capitalists did vary in their preference for investing in technology-based firms. Venture capital firms that were pursuing a generalist strategy tended to invest in lower technology firms while those venture capitalists pursuing a specialist strategy preferred to invest in high technology firms. On average, the evidence seems to link venture capitalists with technology-based ventures. However, that does not mean that they prefer to back exploration. While ventures pursuing such innovation often hold the most promise, it appears that most venture capitalists tend only to get involved in the later stages where capital requirements are quite large and the distance to successful exits and pay-oﬀs is quite narrow. However, if the opportunity is at too great a distance (roughly five years), they are unlikely to pursue it. Therefore, I argue that venture capitalists are much more likely to be interested in technology-based ventures with exploitation and commercialization already starting or close at hand. If the innovation still requires much work and substantial time before exploitation can be pursued, most venture capitalists will tend to pass on the investment. Most of the exploration will tend to have already been accomplished. This leads to the following proposition: Proposition 10: Venture capitalists tend to invest in technology-based ventures that either have or are ready to develop an exploitation strategy. Consistent with the above proposition, I argue that venture capitalists, on average, tend to be best at helping firms transition from exploration to exploitation. While ventures

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often start with exploration, developing exploitation strategies is likely to be critical for long-term success. In this sense, they may need to become ambidextrous or multi-faceted in their capabilities (He and Wong, 2004). Most organizations struggle with transitions and change. Newer and smaller organizations tend to do it better than anyone else but they can struggle as well. The infusion of venture capital funding along with more intense board involvement that is typically associated with outside funding comes with an infusion of added human capital assets in addition to other changes and dynamics. The net eﬀect is that venture capital funding may well bring with it a growing ability for ventures to pursue exploration issues more quickly. Proposition 11: Ventures receiving venture capital funding will make the transition to the exploitation stage more quickly than non-venture capital-backed ventures. In going a step further, we again suspect that there will be performance implications. Venture capital backing brings with it the urgent need to move ventures towards commercialization so that a successful exit can be obtained within 5–6 years. Furthermore, venture capital involvement can bring with it the ability and attention to the skills associated with commercialization. These issues lead to the following proposition: Proposition 12: Ventures receiving venture capital funding will become profitable faster and move towards successful exits sooner than non-venture capitalbacked ventures. Development of new industries Given that venture capitalists often invest in the commercialization of technological innovation, they are often credited with being central to the development of entirely new industries. Bygrave and Timmons (1992) and others have discussed their involvement in the development of the biotechnology, hard disk drives, relational databases, workstations and minicomputers, to name a few. Von Burg and Kenney (2000) have explicitly studied the role of venture capitalists in the development of the local area networking (LAN) industry. In sum, the default assumption seems to be that venture capitalists are intimately involved with the development of entirely new industries. Without venture capital involvement, these industries would not have developed. In their in-depth study of the development of LAN networks, von Burg and Kenney (2000) carefully chronicled venture capital involvement in the early stages of this industry. At one point very early in the development of this industry, a venture capitalist actually became involved in helping to write a business plan (venture capital involvement at this level is the exception and is probably even less likely today than it was 25 years ago). However, they had a very diﬃcult time finding other venture capitalists to collaborate in the investment, a requirement of most venture capitalists. Most venture capitalists ‘could not envision the economic space and could not believe that a startup could construct such a market’ (p. 1142). It was noted that virtually every venture capitalist in the world was contacted with little success. While the von Burg and Kenney article notes that several venture capitalists ultimately did invest in the venture, it was rejected by the vast majority of venture capitalists.

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On average it seems that the venture capitalists are extremely reluctant to get involved in funding new ventures that are not a part of an industry that is perceived to be developing. While venture capitalists are often characterized as investors who pursue risky opportunities, such opportunities seem to be true to the extent that the risk can be managed and minimized. When there are no industry benchmarks, no established ventures in a specific industry and there is no clear market, most venture capitalists seem to be very reluctant to pursue such opportunities. An exception has been the online grocery business where venture capital invested hundreds of millions of dollars in the late 1990s and very early 2000s. Here venture capitalists invested in an industry that was clearly ahead of its time. Given the tight networks that venture capitalists are typically involved with, they will tend to be persuaded by fellow venture capitalist decisions and a ‘who is investing where’ mentality. This herding influence and the syndicated investment approach is constructive for minimizing risk (Gompers and Lerner, 2000), but it does not contribute to the pursuit of ‘new industry’ type investments. This conclusion leads to the following propositions: Proposition 13: Venture capitalists tend not to make investments in ventures that are in unproven industries. The risk associated with new ventures is one of the critical factors that outside investors consider. A solid entrepreneurial team is one of the most important factors in obtaining venture capital funding because an experienced team is believed to be able to mitigate at least some of the risk that a venture is likely to encounter (for example Komisar, 2000; Timmons and Spinelli, 2004). Drawing from the von Burg and Kenney study, it seems that only when a venture capitalist has had a unique experience with a linking technology or has a special relationship with the entrepreneurs involved will they ever consider investing in a start-up in a new industry. Proposition 14: When venture capitalists do invest in new industries, it will likely be mediated by the strength of the entrepreneurial team and their experience with previous start-ups in related technologies. Counter to the assumption that venture capitalists regularly help develop new industries is the possibility that venture capitalist investments are sometimes counterproductive. The venture capital community is widely regarded as tightly knit with investments commonly occurring in syndicates (Lerner, 1994). Furthermore, venture capital investments typically occur in cycles based on the financial markets (number of successful IPOs and capital inflow to venture capitalists) as well as by which industries are in an aggressive growth phase. Given venture capitalists’ interest in investing in ‘hot’ deals and the herding behavior (Gompers and Lerner, 2000) that can so easily occur given the tighter circles that venture capital tend to run in, I suspect that venture capitalists often overinvest in some industries and this over-investment comes after it has become evident that a given industry is indeed emerging. For example, there were multiple venture capital investments in the computer disk drive industry prior to a shakeout in the market occurring, and many venture capital investments came up short. It seems that once an industry starts to emerge and it appears to be a major growth area, venture capitalists tend to

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over-invest in a specific market with capital rather than pull oﬀ and look to fund the next industry in the nascent stage. Proposition 15: Venture capitalists make investments in industries after it becomes evident that it is a growth area. Proposition 16: Venture capitalists invest in new industries only after a top venture capitalist has decided first to invest. Proposition 17: Venture capital investments made in new industries will be negatively related to venture capital firm performance. Concluding remarks Venture capitalists have a widespread reputation of funding risky ventures generally stemming from technology. While venture capitalists are often credited with starting new industries, this rarely seems to be the case. On average, it seems much more accurate to say that venture capitalists help to finance newer industries that are on the rise and showing promise but are rarely involved in funding ventures that actually give birth to an industry. It tends to be only after it becomes evident that a given technology is viable and that it holds great promise in the marketplace that venture capitalists tend to get involved. It appears that one of the greatest places that venture capitalists can add value to the ventures that they back and to the development of newer innovations, is by funding ventures that are ready to exploit their innovations and helping to move the venture into these new territories. It is not easy for any organization to transition from one phase into another or to become ambidextrous. Furthermore, economic development in today’s world frequently involves having a global awareness, if not presence. Most entrepreneurs and founding teams in themselves are unlikely to have the vision and capabilities to appropriately expand firms beyond the exploration phase. Venture capitalists can provide the impetus for such transitions. Measuring venture performance To this point, this chapter has discussed venture capital involvement in the ventures that they fund along with the broader impact that venture capitalists have on venture development and innovation. Furthermore, arguments and propositions have been developed regarding the potential performance eﬀects that these various dimensions are likely to have on venture firms. The intent has been to constructively push forward an agenda for future research. However, one of the major challenges of research regarding venture capital involvement is data collection, and particularly the measuring of firm performance. Measuring firm performance in a way that accurately represents the development and life of the firm is a substantial challenge as reflected by various discussions in the strategy literature (see Barney, 2001, for a review). The measurement of performance in entrepreneurial firms is compounded by several additional issues. First, performance indicators vary substantially across the industries of start-up firms. For example, ventures in the bio-technology industry rarely show any sales until the firm is 5–10 years old, often after it has gone public or is acquired. Second, private firms are typically very reluctant to disclose objective financial information that publicly

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traded firms are required to do. Unless private ventures are required by law (as is the case in Canada), it is highly unlikely that private entrepreneurial ventures will disclose accurate financial indicators of firm performance. Third, there is substantial variation in the way accounting data are recorded (while this is also true for publicly traded firms, it is even more so for newer entrepreneurial ventures). Accounting for all these diﬀerences in the way these data are recorded and then used for empirical research represents a substantial challenge. Given these issues, collecting meaningful data for venture capital-backed firms represents a substantial challenge for future research (Chandler and Hanks, 1993). The purpose of this section is to address some of the alternatives and challenges of measuring the performance of venture capital involvement and the investments that they make. Diﬀerent types of performance indicators will be discussed along with their potential for future use. The various performance measures along with their advantages and challenges are summarized in Table 8.1. This section does not deal with IPOs and publicly traded firms where performance data is much more widely available. Rather, addressing the strengths and limitations of performance data of publicly traded firms reaches beyond the scope of this chapter. Accounting measures of performance In thinking of performance, one typically first thinks of common financial measures involving growth in sales and revenue. A variety of financial measures and ratios have been developed with return on sales, return on equity and return on income being of the most common. Given that there are biases that come with each accounting measure, more than one indicator of performance is often encouraged so as to correct for firms that operate with relatively low levels of capital or whose sales are not likely to reflect the true growth and value of the firm for years to come. The typical limitations and shortcomings of these accounting measures become particularly problematic in entrepreneurial ventures. For example, many innovative ventures do not experience their first sales until years of research and testing are completed. Similarly, some ventures tend to be very capitalintensive while others are not creating substantial disparity in measures reflecting financial equity. Given these issues, it is not surprising that I was unable to locate any studies of venture capital firms or the ventures that they back (pre-IPO) using accounting measures of performance. Subjective measures of performance It seems that the most common type of performance measure used in venture capital studies involves subjective measures where entrepreneurs or venture capitalists (or both) respond to questions with Likert-type scales to indicate their own evaluations of the venture and the venture capitalist–entrepreneur relationship. The advantage of these types of measures is that they can at least start to capture some of the depth and richness of the relationship. Furthermore, self-report measures of performance should allow for better comparison of ventures across industries. Of course, as noted in Table 8.1, problems and biases exist with such measures and I suspect that it is very challenging to get research with such measures published in top-tier journals without at least some data collaboration from additional sources. In their study of subjective measures of performance, Chandler and Hanks (1993) found that (1) venture growth and (2) business volume measures have the best in terms of relevance, availability, reliability, and validity. Furthermore, they were found to be superior to measures

231

Venture Outcomes

• • • • • • • • • •

• • • • • • •

Hard to control for all the intervening factors to influence a venture over time. Specific outcome types (IPOs and mergers) are not equal. For example, there are good and bad acquisitions.

• • • • • •

Busenitz, Fiet and Moesel (2004) Manigart, Baeyens and Van Hyfte (2002) Dimov and Shepherd (2005)

Tyebjee and Bruno (1984) Amit, Brander and Zott (1998) Sapienza (1992) Wang and Ang (2004) DeClercq and Sapienza (2006)

Steier and Greenwood (1995) von Burg and Kenney (2000) Ruhnka, Feldman and Dean (1992)

Examples

Generalizability issues. • Addressing multiple • performance measures • simultaneously. • Communicating the • complexities of • performance in a meaningful manner to the research community. Hindsight bias. • Performance is usually • measured cross• sectionally. • Hard to obtain venture • capital and entrepreneurs’ • perspectives simultaneously. • Performance is still cross-sectional.

Challenges

• • • • • • • • • Can capture relationship • depth and some • intangibles. • Exposes the richness of • multiple dynamics. • Rigorous measurement of • specific constructs. • Accommodates large • number of statistical • analysis. A positive venture • outcome is the ultimate • goal. • Tracks definable events • over time. • Longitudinal in nature. • • • •

Can capture relationship depth and intangibles. Exposes the richness of multiple dynamics. Addresses the multi-dimensional nature of performance.

Advantages

• • • • • • • • • • Since venture capitalists • investments demand • exits to satisfy their own • investors, a change in • organizational ownership/ • form is very typical. • The four most common outcomes include: outof-business, still-private, acquired, and IPO.

Entrepreneur and/or • Large scale surveys. Venture Capital • Development of Evaluations • performance scales. (large numbers)

Entrepreneur and/or • Case studies. Venture Capital • In-depth interviews. Evaluations (small numbers)

Characteristics

Performance measurements in venture capital-backed ventures

Performance Measures

Table 8.1

232

Venture Capital Fund Returns

Accounting Measures of Financial Performance

Financial returns produced by venture capital-backed ventures: Return on sales, return on investment, return on equity, etc.

• Examines the combined • returns for specific • venture capital funds.

• • • • • •

Characteristics

(continued)

Performance Measures

Table 8.1

• • • • • • • • •

Provides feedback on the outcomes of ventures across multiple investments. Helps identify the ‘top’ venture capital firms / those ventures that are consistently making better decisions.

• Common performance • language. • Can look at the venture • capitalist–entrepreneur • relationship over time.

Advantages • • • • • • • • • • • • • • • • • • • • • • • • •

The seasonality of the IPO market alters the exit types over time. The meaning of financial returns. Accuracy of reports are self-report and can be misleading. Financial snap shots can be misleading. Data tends to be very hard to get from these mostly private venture capital firms. Performance in the industry tends to be very cyclical. Data tends to be very hard to get from these mostly private venture capital firms. Such data does not distinguish between lead and co-investors’ approaches.

Challenges

There are several studies that use private data from Venture Economics (e.g. Kaplan and Schoar, 2005), but this data seems to have very limited accessibility.

• Gompers and Lerner • (1999)

• • • • • •• • •

Examples

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that captured respondents’ satisfaction with performance and performance relative to competitors’ scales. Measures of growth that have broad appeal and meaning include growth in market share, cash flow and sales. Measures often used to measure business volume include earnings, sales, and net worth. A study addressing the determinants of venture performance used these measures of performance (Wang and Ang, 2004). Others such as DeClercq and Sapienza (2006) have adjusted and developed their own subjective measures of performance. In spite of the limitations of subjective measures, ongoing research using such measures seems to provide a legitimate window into the performance of privately held ventures. Venture outcomes as measures of performance A unique opportunity that comes with the study of venture capital-backed ventures is the pending change in firm status. Venture capitalists virtually always invest with a successful exit strategy clearly in mind and a 4–7-year time horizon (venture capitalists are typically committed to returning to their limited partners their principal and earnings within 8–10 years). With ventures that are successful, the exits typically take on the form of an IPO or an acquisition. Ventures that are not successful typically end up in bankruptcy and closure or they squeeze out a meager existence from which the venture capitalists at some point divest themselves (typically referred to as ‘living dead’). By example, Busenitz et al. (2004) used IPO, acquisition, living dead, and out-of-business as four distinct categories as their performance variable. More recently, Dimov and Shepherd (2005) contrasted IPO firms with those that went bankrupt as their dependent variable. This performance measure shows particular promise because venture capitalists invest with an exit in mind and a limited time horizon. While these outcomes provide four relatively clear and observable changes in organizational status, they are not without some caveats. The IPO market is clearly cyclical, with sometimes only the best of the best going public like in the early to mid-2000s. At other times, as in the late 1990s, some relatively poor performing ventures were able to go public. The IPO cycles undoubtedly impact the variance of the value that is placed on the acquisitions. Furthermore, variance in the value of an acquisition can be quite mixed since occasionally such an exit can be used to liquidate a venture. In an overall sense, venture outcomes hold much promise for future venture capital-based research. Furthermore, there are ways to potentially improve on acquisition outcomes being sharper and more representative of positive or negative exits. Concluding remarks In sum, performance measures for venture capital-backed ventures are critical for future research to make progress in advancing our understanding of this critical area. While performance measures are virtually always a challenge in business research, they represent some unique challenges in entrepreneurship and venture capital research. There is clearly no one right answer to this dilemma, although venture outcomes, as discussed above, represent a particularly encouraging approach. Furthermore, future research should seek to use multiple measures of performance wherever possible. Note 1. Venture capitalists invest in what is widely known as stages: seed, start-up, first round, second round, mezzanine, and so on. While venture capitalists do invest in all the rounds with some even specializing in

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early-stage or later-stage funding, venture capitalists on average are increasing the financial size of their rounds of funding and generally moving towards later rounds. This chapter assumes the average position while considering the diﬀerences in the various stages (for example Manigart et al., 2006).

References Amit, R., J. Brander and C. Zott (1998), ‘Why do venture capital firms exist? Theory and Canadian evidence’, Journal of Business Venturing, 13, 441–66. Amit, R., L. Glosten and E. Muller (1990), ‘Entrepreneurial ability, venture investments, and risk sharing’, Management Science, 36(10), 1232–45. Amit, R., L. Glosten and E. Muller (1993), ‘Challenges to theory development in entrepreneurship research’, Journal of Management Studies, 30(5), 815–34. Balkin, D.B., G.D. Markman and L.R. Gomez-Mejia (2000), ‘Is CEO pay in high-technology firms related to innovation?’, Academy of Management Journal, 43, 1118–29. Barkema, H.G. and L.R. Gomez-Mejia (1998), ‘Managerial compensation and firm performance: a general research framework’, Academy of Management Journal, 41, 135–45. Barney, J. (2001), Gaining and Sustaining Competitive Advantage, 2nd edn, Upper Saddle River, NJ: PrenticeHall. Barney, J.B., L. Busenitz, J. Fiet and D. Moesel (1989), ‘The structure of venture capital governance: an organizational economic analysis of relations between venture capital firms and new ventures’, Best Papers Proceedings of the Annual Meetings of the Academy of Management, Washington, DC. Barney, J.B., L. Busenitz, J. Fiet and D. Moesel (1996), ‘New venture teams’ assessment of learning assistance from venture capitalist firms’, Journal of Business Venturing, 11(4), 257–72. Beatty, R.P. and E. Zajac (1994), ‘Managerial incentives, monitoring, and risk bearing: a study of executive compensation, ownership, and board structure in initial public oﬀerings’, Administrative Science Quarterly, 39, 313–35. Bohren, O. (1998), ‘The agent’s ethics in the principal–agent model’, Journal of Business Ethics, 17, 745–55. Brown, S. and K. Eisenhardt (1998), Competing on the Edge: Strategy as Structure Chaos, Boston: Harvard Business School Press. Bruton, G., V. Fried and R.D. Hisrich (2000), ‘CEO dismissal in venture capital-backed firms: further evidence from an agency perspective’, Entrepreneurship: Theory & Practice, 24(4), 69–77. Busenitz, L., J.O. Fiet and D.D. Moesel (2004), ‘Reconsidering the venture capitalists’ “value added” proposition: an interorganizational learning perspective’, Journal of Business Venturing, 19, 787–807. Bygrave, W.D. and J.A. Timmons (1992), Venture Capital at the Crossroads, Boston: Harvard Business School Press. Chandler, G.N. and S. Hanks (1993), ‘Measuring the performance of emerging businesses: a validation study’, Journal of Business Venturing, 8, 391–408. Daily, C.M., J.L. Johnson, A.E. Ellstrand and D.R. Dalton (1998), ‘Compensation committee composition as a determinant of CEO compensation’, Academy of Management Journal, 41, 209–20. Daily, C., P. McDougall, J. Covin and D. Dalton (2002), ‘Governance and strategic leadership in entrepreneurial firms’, Journal of Management, 28(3), 387–412. De Clercq, D. and H. Sapienza (2006), ‘Eﬀects of relational capital and commitment on venture capitalists’ perception of portfolio company performance’, Journal of Business Venturing, 21, 326–47. Dimov, D.P. and D. Shepherd (2005), ‘Human capital theory and venture capital firms: exploring home runs and strike outs’, Journal of Business Venturing, 20, 1–21. Dolvin, S. (2005), ‘Venture capital certification of IPOs’, Venture Capital, 7(2), 131–48. Eisenhardt, K. (1989), ‘Agency theory: an assessment and review’, Academy of Management Review, 14(1), 57–74. Fama, E.F. and M.C. Jensen (1983), ‘Separation of ownership and control’, Journal of Law and Economics, 26, 301–25. Filatochev, I.F. and K. Bishop (2002), ‘Board composition, share ownership, and “underpricing” of UK IPO firms’, Strategic Management Journal, 23, 941–55. Fried, V.H. and R.D. Hisrich (1995), ‘The venture capitalist: a relationship investor’, California Management Review, 37, 101–13. Gomez-Mejia, L.R., D.B. Balkin and T.M. Welbourne (1990), ‘Influence on venture capitalists on high tech management’, The Journal of High Technology Management Research, 1, 103–18. Gompers, P.A. and J. Lerner (1996), ‘The use of covenants: an empirical analysis of venture capital partnership agreements’, Journal of Law and Economics, 39, 463–98. Gompers, P.A. and J. Lerner (1999), ‘An analysis of compensation in the US Venture Capital Partnership’, Journal of Financial Economics, 51, 3–44. Gompers, P.A. and J. Lerner (2000), The Venture Capital Cycle, Cambridge, MA: MIT Press.

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Gorman, M. and W. Sahlman (1989), ‘What do venture capitalists do?’, Journal of Business Venturing, 4, 231–48. Gray, S.R. and A. Cannella (1997), ‘The role of risk in executive compensation’, Journal of Management, 23, 517–40. He, Z-L. and P-K. Wong (2004), ‘Exploration vs. exploration: an empirical test of the ambidexterity hypothesis’, Organizational Science, 15, 481–94. Hellmann, T. and M. Puri (2000), ‘The interaction between product market and financing strategy: the role of venture capital’, The Review of Financial Studies, 13(4), 959–84. Jensen, M.C. and W.F. Meckling (1976), ‘Theory of the firm: managerial behavior, agency costs, and ownership structure’, Journal of Financial Economics, 3, 305–60. Jensen, M.C. and K.J. Murphy (1990), ‘Performance pay and top management incentives’, Journal of Political Economy, 98, 225–64. Jungwirth, C. and P. Moog (2004), ‘Selection and support strategies in venture capital financing: high-tech or low-tech, hands-oﬀ or hands-on?’ Venture Capital, 6(2–3), 105–23. Kaplan, S.N. and A. Schoar (2005), ‘Private equity performance: returns, persistence and capital flows’, Journal of Finance, 60, 1791–823. Kidwell, R.E. and N. Bennett (1993), ‘Employee propensity to withhold eﬀort: a conceptual model to intersect three avenues of research’, Academy of Management Review, 18, 429–56. Komisar, R. (2000), The Monk and the Riddle, Boston: Harvard Business School Press. Kortum, S. and J. Lerner (2000), ‘Assessing the contribution of venture capital to innovation’, Rand Journal of Economics, 32, 674–92. Lerner, J. (1994), ‘The syndication of venture capital investments’, Financial Management, 23 (Autumn), 16–27. Lerner, J. (1995), ‘Venture capitalists and the oversight of private firms’, Journal of Finance, 50(1), 301–18. MacMillan, I.C., D.M. Kulow and R. Khoylian (1989), ‘Venture capitalists’ involvement in their investments: extent and performance’, Journal of Business Venturing, 4, 27–47. Manigart, S., K. Baeyens and W. Van Hyfte (2002), ‘The survival of venture capital backed companies’, Venture Capital, 4(2), 103–24. Manigart, S., A. Lockett, M. Meuleman, M. Wright, H. Landström, H. Bruining, P. Desbrieres and U. Hommel (2006), ‘Venture capitalists’ decision to syndicate’, Entrepreneurship: Theory & Practice, 36(2), 131–53. March, J. (1991), ‘Exploration and exploitation in organizational learning, Organizational Science, 2, 71–87. Megginson, W. and K. Weiss (1991), ‘Venture capitalist certification in initial public oﬀerings’, Journal of Finance, 46(3), 879–903. Rosenstein, J., A. Bruno, W. Bygrave and N.T. Taylor (1993), ‘The CEO, venture capitalists, and the board’, Journal of Business Venturing, 8, 99–113. Ruhnka, J.C., H.D. Feldman and T.J. Dean (1992), ‘The “living dead” phenomenon in venture capital investments’, Journal of Business Venturing, 7, 137–55. Sahlman, W.A. (1990), ‘The structure and governance of venture-capital organizations’, Journal of Financial Economics, 27 (September), 473–521. Sapienza, H. (1992), ‘When do venture capitalists add value?’, Journal of Business Venturing, 7, 9–27. Sapienza, H., S. Manigart and W. Vermeir (1996), ‘Venture capitalist governance and value added in four countries’, Journal of Business Venturing, 11, 439–69. Steier, L. and R. Greenwood (1995), ‘Venture capitalist relationships in the venture structuring and postinvestment stages of new firm creation’, Journal of Management Studies, 32, 337–57. Timmons, J. and W. Bygrave (1986), ‘Venture capital’s role in financing innovation for economic growth’, Journal of Business Venturing, 1, 161–76. Timmons, J.A. and S. Spinelli (2004), New Venture Creation, New York: Irwin. Tyebjee, T.T. and A.V. Bruno (1984), ‘A model of venture capitalist investment activity’, Management Science, 30(9), 1051–66. von Burg, U. and M. Kenney (2000), ‘Venture capital and the birth of the local area networking industry’, Research Policy, 29, 1135–55. Wang, C.K. and B.L. Ang (2004), ‘Determinants of venture performance in Singapore’, Journal of Small Business Management, 42, 347–63. Williamson, O.E. (1983), ‘Credible commitments: using hostages to support exchange’, American Economic Review, 73, 519–40. Williamson, O.E. (1985), The Economic Institutions of Capitalisms, New York: The Free Press. Williamson, O.E. (1991), ‘Strategizing, economizing, and economic organization’, Strategic Management Journal, 12, 75–94.

9

The performance of venture capital investments Benoit F. Leleux

Introduction Venture capital is an interesting industry in which at least 75 per cent of the players you talk to are top quartile performers . . .

This tongue-in-cheek reference by a leading institutional investor (who preferred to remain anonymous) points not only to many venture capitalists’ tendency for self promotion but also to a more fundamental issue the industry has struggled with since its inception, namely the best metrics to use to report its financial performance. The issue has proven a very diﬃcult one to tackle by the academic and the professional communities alike, due to a unique combination of factors such as: (1) the basic diﬃculties in valuing venture capital investments (mostly minority stakes in restricted stocks of early stage, technology-rich companies), which test the limits of standard valuation techniques; (2) IRR-boosting cash flow management techniques, such as the progressive drawdown of the fund commitments; and (3) the very private nature of the industry, where reported numbers are often aggregations of self-reported rates of returns. In this chapter, we oﬀer to review the documented drivers of venture capital performance and the issues related to financial metrics in the venture capital industry, oﬀering a critical perspective on the limitations inherent in the system. The ultimate objective is to develop a grounded understanding of the performance dilemmas in the venture capital industry, more than it is to ‘explain’ variations in performance. While no comprehensive study exists to ‘explain’ fund performance, a growing body of evidence points to key drivers, both endogenous and exogenous. Performance in venture capital: a four-level approach The literature on the drivers of venture capital fund performance has been relatively scarce, partly due to the diﬃculty to access the fund-level data, which is normally only provided to limited partners in the funds and, partially, to national venture capital associations. On the other hand, a rich literature has developed to examine the performance of venture capital-backed companies, as well as the determinants of successful venture capital investing, including the structural conditions in which it would thrive and the benefits as seen from the entrepreneurial perspective. We use four complementary approaches to address the performance issue. First, at a micro (deal) level, we review the literature on key drivers of venture capital performance. This literature focuses mostly on how venture capitalists add value to entrepreneurial ventures. Second, we take a fund-level perspective and investigate the evidence regarding performance there. Third, we take a macro perspective (industry level) and review the evidence as to actual aggregated industry performance. Finally, we review generic issues with performance measurement in the venture capital context. 236

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The key messages in the critical review fall into three categories. First of all, the nature of the industry, and in particular the types of deals done, puts severe constraints on the very ability to measure value creation and hence performance over time. These factors are ingrained in the mesh of the industry, and thus to be taken as invariable. Second, structures have emerged to deal with the nature of the deals, themselves contributing to the variability of the returns. Finally, while the limitations inherent in performance reporting in this context are material, they do not prevent an eﬃcient functioning of the industry. An expected contribution of this chapter is to highlight the conditions precedent to industry practices and hopefully to provide a solid basis for the necessary interpretation of the numbers provided by the industry. This re-balancing of expectations is a pre-requisite for a healthy, sustainable venture capital industry. Value drivers in venture capital deals The largest part of the venture capital literature actually investigates key drivers of performance in venture capital-backed deals. We separate the presentation into three categories: (1) venture capital-controlled investment factors; (2) environmental factors; and (3) decision making processes. Venture capital-controlled investment factors Deal flows, screening and syndication Rigorous company and investment selection processes, including proprietary deal flows, deal flow quality and quantity, screening and syndication abilities are said to impact the performance of funds positively. Birkshaw and Hill (2003) support the view that syndication may allow investors to make decisions regarding investments based on multiple judgements by other parties, thereby (potentially) enhancing the accuracy of screening through the incorporation of greater experience and impartiality into the process. Corporate venture units may be able to more greatly diversify their risk by utilizing co-investment tactics for a defined amount of financial investment. Active participation in a community of investors may allow corporate venture units to avoid problems of adverse selection and to attain access to an enhanced deal flow. Involvement in a community of investors may provide a corporate venture unit with the opportunity to search more distant knowledge domains with reduced transaction costs, thereby accessing a greater volume of novel investment opportunities. Hochberg et al. (2004) show that venture capitalists tend to syndicate their investments with other venture capitalists rather than investing alone. Once they have invested in a company, venture capitalists draw on their networks of service providers – head hunters, patent lawyers, investment bankers and so on – to help the company succeed. The two main drivers of venture capital performance are the ability to source high quality deals and to nurture the investments. Syndications support both critical activities. Syndication networks facilitate the sharing of information, contacts and resources amongst venture capitalists. Strong relationships with other venture capitalists are likely to improve the chances of securing follow on venture capital funding for portfolio companies, and may indirectly provide access to other venture capitalists’ relationships with service providers such as head hunters and prestigious investment banks. Controlling for other known determinants of venture capital fund performance such as fund size as well as the competitive funding environment and the investment opportunities

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facing the venture capitalist, the authors find that venture capitalists that are better networked at the time a fund is raised subsequently enjoy significantly better fund performance, as measured by the rate of successful portfolio exits over the next ten years. Perhaps the leading alternative explanation for the performance enhancing role of venture capitalist networking is simply experience. It seems plausible that the better networked venture capitalists are, also the older and more experienced venture capitalists. Venture capital funds whose parent firms enjoy more influential network positions have significantly better performance as well. Similarly, the portfolio companies of better networked venture capital firms are significantly more likely to survive to subsequent rounds of financing and to eventual exit. Interestingly, once network eﬀects are controlled for in the models of fund and portfolio company performance, the importance of venture capitalist prior experience is reduced, and in some specifications, eliminated. Given the authors’ documented large returns to being well networked, enhancing a network position should be an important strategic consideration for an incumbent venture capitalist, while presenting a barrier to entry for new venture capitalists. Engel (2004) stresses the value of syndication as a successful strategy to overcome problems of information asymmetries. A public promotion of syndication can be helpful for supporting the learning process of venture capitalists, for increasing the quality of the value chain process and hence for pushing up the capital inflow by investors. Gompers and Lerner (2001), for their part, argue that by syndicating investments, venture capital firms can invest in more projects and largely diversify away firm-specific risk. Involving other venture firms also provides a second or third opinion on the investment opportunity, which limits the danger that bad deals will get funded. Control mechanisms Venture capitalists have developed over time a sophisticated toolbox of structural and contractual arrangements to help manage diﬃcult features of their transactions, such as high levels of uncertainty about future outcomes and large information asymmetries between the parties involved. Contingent control rights, which include continuous monitoring processes (such as positions on the Board, reporting requirements, and so on), the ability to replace the entrepreneur, powerful stock option compensations, investor liquidation rights, and the use of convertible securities have all been presented as critical drivers of performance in individual deals. Hege et al. (2003) focus on the significant performance gap between US and European venture capitalists, both in terms of types of exits and of rates of return realized. The authors partly attribute the gap to diﬀerences in the contractual terms of the relationship, like the frequency and eﬀectiveness of the use of instruments asserting an active role of venture capitalists in the value creation process. Venture capitalists in the US assert vigorously contingent control rights, through systematic use of financial instruments that convey residual control rights in case of poor performance, such as convertible securities, and they activate these controls more frequently, as measured by the replacement of entrepreneurs. Also, US venture capitalists exhibit sharper screening skills than their European counterparts. A better average quality of selected projects in the US is said to be consistent with the finding that a larger fraction of the total investments occur there in the initial round. Finally, there is some evidence for a more eﬀective management of financing relationship and participation of diﬀerent groups of investors in the US. Interestingly, the results also suggest that relationship financing,

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which is more pronounced for European companies, does not have any significant impact on performance. Kaplan and Strömberg (2003) focus on the agency problems inherent in contract design. The external risk results suggest that risk-sharing concerns are unimportant relative to other concerns, such as monitoring. Venture capitalists expect to take actions with their investments and those actions are related to the contracts. Venture capital management intervention is related to venture capital board control while venture capital support or advice is shown to be more related to venture capital equity ownership. Gompers and Lerner (2001) investigate the tools used by venture firms to address the information issues. These are said to include intense scrutiny before and after the provision of capital. The monitoring and information tools used include meting out financing in discrete stages over time, syndicating investments with other venture capital firms, taking seats on a firm’s board of directors, and compensation arrangements including stock options. Lerner (1995) similarly found evidence that board service is driven by a need to provide monitoring, showing that geographic proximity is an important determinant of venture board membership. Another mechanism utilized to influence managers and critical employees is to have them receive a substantial fraction of their compensation in the form of equity or options. General partner experience The industry knowledge and experience of the General Partners (GP), including access to and degree of implicit and tacit knowledge as well as the degree of specialization has been shown to impact the performance of funds. Gompers (1994) shows that unseasoned venture capital firms (those that have been in existence five years or less) are under tremendous pressure to perform during the initial stages of their first fund. These inexperienced venture capitalists have an incentive to ‘grandstand’, or to bring firms from their first fund to the public market sooner than would otherwise be optimal. On average, young venture capitalists lose almost $1 million on each initial public oﬀering because they bring the companies to market too early. Kaplan and Schoar (2005) show that venture capital returns persist strongly across funds raised by individual private equity partnerships. Performance increases (in the cross section) with fund size and with the GPs’ experience. The relation with fund size is concave, suggesting decreasing returns to scale. Similarly, a GP’s track record is positively related to the GP’s ability to attract capital into new funds. This is also supported by Gottschalg et al. (2004) who show that the main drivers of underperformance are funds that are small, European and run by inexperienced GPs. Engel (2004) similarly finds that large, older venture capital companies with access to implicit, tacit knowledge have a higher quality of the value chain process. Persistence of performance, timing and investment durations Kaplan and Schoar (2005) document substantial persistence in leverage buy-out (LBO) and venture capital fund performance. General partners whose funds outperform the industry in one fund are likely to outperform the industry in the next, and vice versa. Persistence is found not only between two consecutive funds, but also between the current fund and the second previous fund. These findings are markedly diﬀerent from the results for mutual funds, where persistence has been diﬃcult to detect, and when detected, tends to be driven by persistent underperformance rather than over-performance. Fund flows are positively

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related to past performance, however the relationship is concave in private equity. Similarly, new partnerships are more likely to be started in periods after the industry has performed especially well. But funds and partnerships that are raised in boom times are less likely to raise follow-on funds, suggesting that these funds perform poorly. A larger fraction of fund flows during these times, therefore, appears to go to funds that have lower performance, rather than top funds. Not only do more partnerships decide to start up after a period in which the industry performed well, but also, first time funds tend to raise bigger amounts of capital when the private equity industry performed well. Funds raised in boom years are more likely to perform poorly and therefore are unable to raise a follow-on fund. In sum, it appears that the marginal dollar invested in boom times goes towards financing funds which are less likely to be able to raise a subsequent fund. In periods of increased entry of funds into the industry overall, the authors observe a larger negative eﬀect on the young funds, than on the older, more established funds. Reputation of fund and general partners Nahata (2004) shows that venture capitalist reputation has a positive impact on the profitability of harvesting venture investments – as venture capitalists are able to attract higher tier underwriters, and companies backed by reputable venture capitalists are able to time IPOs near stock market peaks. High quality aﬃliation also has a strong and positive eﬀect on young companies’ valuations at the time of IPO. Kaplan and Schoar (2005) base their analyses on the premise that the underlying heterogeneity in general partners’ skills and competences should lead to heterogeneity in performance and to more persistence if new entrants cannot compete eﬀectively with existing funds. Several forces make it diﬃcult to compete with incumbents. First, many practitioners assert that unlike mutual fund and hedge fund investors, private equity investors have proprietary access to particular transactions, that is ‘proprietary deal flow’. In other words, better GPs may find better investments. Second, private equity investors typically provide management or advisory inputs along with capital. If high quality general partners are scarce, diﬀerences in returns between funds could persist. Third, there is some evidence that better venture capitalists get better deal terms (for example lower valuations) when negotiating with start-ups. Value added services Value added services provided to the investee companies, such as advisory services (including position on the Board, assistance with recruiting and compensating management, development/revision of business plan/strategies) and the utilization of syndication networks may improve the returns on investments. Kaplan and Strömberg (2000) point out that the venture capitalists expect to be active in areas such as developing the business plan, assisting with acquisitions, facilitating strategic relationships with other companies, or designing employee compensation. However, while venture capitalists play a monitoring and advisory role, they do not intend to become too involved in the company. Hege et al. (2003) find evidence supporting the view that venture capital firms in Europe are more deal makers and less active monitors, lagging in their capacity to select projects and add value to innovative firms. In Chapter 7, De Clercq and Manigart revisit the evidence on the value added of venture capitalists.

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Multistage investment The ability of venture capitalists to come back to fund successive stages of a venture is presented as another means used to leverage performance. Gompers and Lerner (2001) show that staged capital infusions may be the most potent control mechanism a venture capitalist can employ. Staged capital infusion keeps the owner/manager on a tight leash and reduces potential losses from bad decisions. Kaplan and Strömberg (2000) show it is common for a venture capitalist to make a portion of its financing commitment contingent on subsequent portfolio company actions or performance. This reduces the amount of funds that the venture capitalist has put at risk for a given investment and gives greater ability to the venture capitalist to liquidate the venture by not providing funds if performance is unsatisfactory. Higher management risk and market risk leads to greater use of state contingent contracting and staged investment commitment. Environmental factors A number of structural and environmental factors have also been shown to impact the reported performance of venture capital firms’ performance (Wang and Ang, 2004). Availability and status of public markets for IPOs The availability and status of public markets for initial public oﬀerings strongly influences the reported performance of the industry. Gilson and Black (1999) show that an active stock market is important for a strong venture capital industry because of the potential for venture capital exit through IPOs. Jeng and Wells (2000) examine the factors that influence venture capital fundraising internationally. The strength of the IPO market is an important factor, however it does not seem to influence commitments to early stage funds as much as later stage ones. Both Gilson and Black (1999) and Jeng and Wells (2000) see access to strong IPO markets as the key source of US competitive advantage in venture capital, as well as Cochrane (2000) and Gompers and Lerner (1998). Jeng and Wells (2000) also show that an increased volume of IPOs has a positive eﬀect on both the demand and supply of venture capital funds. On the demand side, the existence of an exit mechanism gives entrepreneurs an additional incentive to start a company. On the supply side, the eﬀect is essentially the same. Large investors are more willing to supply funds to venture capital firms if they feel that they can later recoup their investment. Gompers and Lerner (2001) show that venture capitalists take firms public at market peaks, relying on private financings when valuations are lower. Seasoned venture capitalists appear more proficient at timing IPOs. The superior timing ability of established venture capitalists may be in part due to the fact that they have more flexibility as to when to take companies public. Less established groups may be influenced in this decision by other considerations – for instance young venture capital firms have the incentives to grandstand. Nahata (2004) points out that successful exits are critical to ensuring attractive returns for investors and in turn to their raising additional capital. The choice of exit vehicle is governed by both firm-specific and VC-specific factors. Better performing portfolio companies not only lead to more successful exits (IPOs or acquisitions) but even among those two exit scenarios, relatively better performers are more likely to be taken public than sold to an acquirer. This is in line with the finding by Gompers and Lerner (2001) that IPOs tend to yield higher return.

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Overall economic cycle The investment opportunities available in the context of the competitive environment significantly determine venture capital performance. Gompers and Lerner (2001) suggest that the valuation of individual deals is aﬀected by overall macroeconomic conditions and the degree of competition in the venture capital industry. When a surge of money enters the venture capital industry, but there are only a certain number of worthy projects to finance, the result can be a substantial decline in the returns on investment in the industry. This results in ‘too much money chasing too few deals’. Inflows of venture capital tend to raise valuations. In the past, overinvestment by venture capitalists led to too many projects at too high valuations resulting in low returns. Increases in demand can, in the short run, only be met by existing funds which accelerate their investment flows and earn excess returns. Increases in supply lead to tougher competition for deal flow, and private equity fund managers respond by cutting their investment spending. Supply increases possibly indicate overheating accompanied by poorer performance. Ljungqvist and Richardson (2003) show that the competitive environment facing fund managers plays an important role in how they manage their investments. During periods in which investment opportunities are good, existing funds invest their capital and exit their investments more quickly, taking advantage of the favourable business climate. This tends to lead to better returns on their investments. In contrast, when facing greater competition from other private equity funds, fund managers draw down their capital more slowly and hold their investments for longer periods of time. Returns on investment undertaken when competition was tougher are ultimately significantly lower. Gottschalg et al. (2004) support the view that there was a substantial amount of money chasing too few deals in Europe and that part of the observed European underperformance is explained by this aspect. Fund performance is very sensitive to both business cycles and stock market cycles. Regulatory environment The regulatory environment faced by the venture capital industry, in particular capital gains tax rates, the evolution of interest rates (long and short term), labour market rigidities and information reporting requirements, can all impact on performance. Gompers and Lerner (1998) investigate aggregate performance and capital flows. The authors find that macroeconomic factors like past industry performance and overall economic performance as well as changes in the capital gains tax or ERISA provisions (see Chapter 1 for a review of the development of venture capital in the US) are related to increased capital flows into private equity. Lower capital gains taxes seem to have a particularly strong eﬀect on the amount of venture capital supplied by these tax-exempt investors. The impact of the capital gains tax does not arise through its eﬀect on those supplying venture capital, but rather by spurring corporate employees to become entrepreneurs, leading to more demand for venture capital. Jeng and Wells (2000) also highlight the fact that if the market does not have good information on small start-up firms, then investors will demand a high risk premium, resulting in more expensive funding for these companies. This cost of asymmetric information can be reduced if the country in which the company operates has strict accounting standards. With good accounting regulation, venture capitalists need to spend less time gathering information to monitor their investments.

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Gompers and Lerner (2001) show that government policy can have a dramatic impact on the current and long-term viability of the venture capital sector. In many countries of continental Europe, entrepreneurs face numerous daunting regulatory restrictions, a paucity of venture funds focusing on investing in high growth firms, and illiquid markets where investors do not welcome IPOs by young firms without long histories of positive earnings. Despite wide recognition of venture funds as key players underlying a country’s entrepreneurial performances, there are huge diﬀerences across industrialized countries in the relative amounts invested in venture capital. Jeng and Wells (2000) show that labour market rigidities, the level of IPOs, government programmes for entrepreneurship and bankruptcy procedures explain a significant share of cross country variations in venture capital intensity. Leleux and Surlemont (2003) highlight the role played by direct state interventions in the venture capital market across Europe. Their evidence is consistent with state interventions coming in after the emergence of a venture capital industry and to a large extent validating the industry, leading to higher private capital flows into the venture capital industry. They could not support the traditional view that state interventions prime the market, nor could they find evidence that public interventions crowded out private capital. Romain and Van Pottelsberghe de la Potterie (2004) show that indicators of technological opportunity, such as the stock of knowledge and the number of triadic patents aﬀect positively and significantly the relative level of venture capital activity. Labour market rigidities reduce the impact of the GDP growth rate and of the stock of knowledge, whereas a minimum level of entrepreneurship is required in order to have a positive eﬀect of the available stock of knowledge on venture capital intensity. Availability of investors Jeng and Wells (2000) find that the level of investment by private pension funds in venture capital is a significant determinant of venture capital over time but not across countries. Using mutual funds as a benchmark, studies by Sirri and Tufano (1998) and Chevalier and Ellison (1999) indicate that funds that outperform the market experience increased capital inflows. This relationship tends to be convex; mutual funds with above-average performance increase their share of the overall mutual fund market, something shown for private equity by Kaplan and Schoar (2005). The latter show that capital flows into private equity funds are positively and significantly related to past performance. Fund size is positively and significantly related to the performance of the previous fund. Decision making processes by venture capitalists Hatton and Moorehead (1994) showed that the quality of the entrepreneur ultimately determines the funding decision. Venture capitalists expect the product to be capable of high profit margins and to provide exit strategies. Three criteria were shown as heavily weighted by venture capitalists: (1) the degree of market acceptance for the product; (2) the return potential; and (3) the need for subsequent investments. Leleux et al. (1996) use binary conjoint analysis to formally investigate for the first time the decision tree of venture capitalists across Europe. Using a comprehensive list of investment criteria, they point out four major ‘types’ of investor, the largest one focusing primarily on human factors.

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Venture capitalists have also been shown to be subject to a number of decision-making biases. Zacharakis and Shepherd (2001) prove experimental evidence of their possible overconfidence, dependent upon the amount of information, the type of information, and whether the venture capitalist strongly believes the venture will succeed or fail. Overconfidence describes the tendency to overestimate the likely occurrence of a set of events. Overconfident people make more extreme probability judgements than they should, and overconfident venture capitalists may overestimate the likelihood that a funded company will succeed. The authors show that venture capitalists are intuitive decision makers, and when people are familiar with a decision and the structure of the information surrounding that decision, they resort to automatic information processing. It seems that forcing them outside their comfort zone has a negative eﬀect on their confidence and has an even greater eﬀect (negative) on their accuracy. Venture capitalists rely on how well the current decision matches past successful or failed investments. The supported high level of overconfidence in success or failure predictions may encourage the venture capitalist to limit information search and fund a lower potential investment (or prematurely reject a stronger potential investment). Overconfident venture capitalists may not fully consider all relevant information, nor search for additional information to improve their decision. Moreover, the natural tendency for people to recall past successes rather than failures may mean that venture capitalists will make the same mistakes again. Venture capitalists evaluate hundreds of data points during venture screening and due diligence which can lead to information overload (Zacharakis and Meyer, 2000) – as venture capitalists are drawn to more salient information factors and may ignore other factors that are more pertinent to the decision. Shepherd and Zacharakis (2002) also document the fact that venture capitalists rarely use decision aids, where bootstrapping models have the potential to improve venture capitalists’ decision accuracy, improving consistency, reducing the bias caused by a nonrandom sample, and by optimally weighting information factors and reducing the decision maker’s cognitive load. Decision aids also allow venture capitalists to acquire expertise faster than do current educational and training methods. Decision aids can provide cognitive feedback, which is the return of some measure of the person’s cognitive processes used in the decision. Cognitive feedback helps people come to terms with their decision environment and has been found to be markedly superior to outcome feedback. Zacharakis and Shepherd revisit in Chapter 6 the latest evidence on venture capital decision making. A fund level perspective on venture capital risk – return performance Research specifically concerning the returns to private equity has focused on describing the basic risk/return profiles of investments in private equity partnerships and private equity investments in companies, as documented by Hand (2004). Stevenson et al. (1987), in a pioneering study, highlight the following conditions which lead to high rates of return on venture capital funds: (1) a multistage investment or commitment of funds on an incremental basis with evaluation of venture performance before commitment of additional funds; (2) an objective evaluation of venture performance with the clear distinguishing of winners from losers; (3) parlaying funds or having the confidence to commit further funds to ventures identified as winners; (4) a persistence of returns from one round to the next, which implies that valuable information is gained

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from previous rounds of investment in the same venture; and (5) long term holding of investment portfolios for a period suﬃcient for geometric averaging of compound returns to cause winners to take over or raise portfolio returns. Ljungqvist and Richardson (2003) report that the risk adjusted excess value of the typical private equity fund is in the order of 24 per cent relative to the present value of invested capital, probably because of the highly illiquid nature of the fund. Cochrane (2000) characterizes venture capital returns based on the economics of individual investments in portfolio companies. He finds that venture returns are very volatile, with later stage deals showing much less volatility than early stage deals. Gottschalg et al. (2004) support the opposite view on performance: PE funds in their sample (raised between 1980 and 1995) seem to under-perform public stock markets. PE performance is higher when investments are exited in periods of high valuation levels on public stock markets, as proxied by the overall earning to price ratio. The authors also show that PE funds are exposed to substantial ‘left tail’ risk, that is they deliver significantly higher losses during large market downturns but are not as sensitive to economic conditions in good times. Lerner et al. (2004) support the view that the returns realized from private equity investments diﬀer dramatically across investor groups. In particular, endowments’ annual returns are nearly 14 per cent greater than average. Funds selected by investment advisors and banks lag sharply. These results were robust to controlling for the type and year of the investment, as well as the use of diﬀerent specifications. Kaplan and Schoar (2005), on a sample of funds active over the period 1980–1997, show average fund returns net of fees roughly equal to those of the S&P 500. Weighted by committed capital, venture funds outperform the S&P 500 while buyout funds do not. The authors suggest that gross of fees, both types of private equity partnerships earn returns exceeding the S&P 500. While LBO fund returns net of fees are slightly less than those of the S&P 500, VC fund returns are lower than the S&P 500 on an equal weighted basis, but higher than the S&P 500 on a capital weighted basis. They also show that performance persists strongly across funds raised by individual partnerships and improves with partnership experience. The industry level evidence: is venture capital delivering? The European venture capital scene was seriously shaken on its foundations by the publication in early 2005 of the benchmark returns for the industry, presented below in Table 9.1 and Figure 9.1. For the first time in its relatively short history, the average 10-year investment horizon returns for early stage investments became negative on a per annum basis. For all venture capital classes, including development and balanced funds, the performance was an equally unimpressive 5.3 per cent for the period. The pooled cumulative returns since inception for funds created since 1980 showed practically a zero return. The latest figures reported by the National Venture Capital Association (NVCA) for the US showed an average 10-year investment horizon return of 45.8 per cent per annum and a 20-year investment horizon return of 19.8 per cent, as shown in Table 9.2. The broader venture capital class, including also vehicles focusing on development capital, showed respectively figures of 25.4 per cent and 15.6 per cent for the 10- and 20-year investment horizons. The diﬀerentials between the European and US performance figures in terms of early-stage deals were the largest reported in the last 20 years.

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Table 9.1 European investment horizon returns as of 31 December 2005 (in per cent per annum) Net Horizon Returns as of 31 December 2005 Stage

1-year IRR %

3-year IRR %

5-year IRR %

10-year IRR %

4.9 12.2 32.7 25.4 20.9 51.2 24.1

2.3 0.9 2.8 0.6 7.9 1.2 5.2

7.5 1.6 2.7 4.0 5.0 4.8 1.2

0.1 8.8 7.6 5.3 12.6 9.7 10.2

Early-Stage Development Balanced All Venture Buyouts Generalist All Private Equity

All Venture All Buyouts

30 20

+12.6% +5.3%

10 2004

2005

2003

2002

2001

1999 2000

1998

1996 1997

1995

1993 1994

1992

–10

1991

0 1990

10-Year Rolling IRR (%)

40

–20 –30 –40

Figure 9.1 European 5-year rolling window IRRs as of 31 December 2005 (in per cent per annum) These comparative numbers are intriguing. First, they seem to support the view that the industries in the US and Europe are at very diﬀerent stages of their development. European venture capital industry emerged in the early 1990s, and only faced its first downturn when the Internet bubble burst. In other words, it never really had a chance to learn. The poor results indicate a painful ‘teething’ problem by an emerging industry. Second, it appears that the lessons from the natural selection process that led to a strong performing US industry were either not transferable or not adopted by its European counterpart. Generic issues with industry performance measurement These industry statistics clearly warrant further investigations. Both the absolute performance level of European venture capital and relative to the US industry is intriguing. In this section, we focus on issues related to the measurement of performance in venture capital.

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Table 9.2 US investment horizon returns as of 31 December 2004 (in per cent per annum) Venture Economics’ US Private Equity Performance Index (PEPI) Fund Type

1 Yr

3 Yr

5 Yr

10 Yr

20 Yr

Early/Seed VC Balanced VC Later Stage VC All Venture Small Buyouts Med Buyouts Large Buyouts Mega Buyouts All Buyouts Mezzanine All Private Equity NASDAQ S&P 500

1.4 5.8 0.4 3.6 24.1 17.8 16.8 20.6 19.8 8.5 14.0 0.3 4.8

5.5 1.2 0.6 1.4 5.4 4.3 9.6 9.0 8.5 3.7 5.3 2.7 1.0

8.6 4.2 6.6 6.3 1.6 3.2 0.9 2.7 1.8 1.8 0.5 15.3 4.7

45.8 17.0 15.2 25.4 8.7 10.6 10.9 7.7 8.7 6.9 12.5 9.4 9.0

19.8 13 13.7 15.6 26.7 17.7 14.5 9.7 13.0 9.2 13.8 11.4 10.8

Notes: * The Private Equity Performance Index is based on the latest quarterly statistics from Thomson Venture Economics’ Private Equity Performance Database analysing the cash flows and returns for over 1750 US venture capital and private equity partnerships with a capitalization of $585 billion. Sources are financial documents and schedules from Limited Partners investors and General Partners. All returns are calculated by Thomson Venture Economics from the underlying financial cash flows. Returns are net to investors after management fees and carried interest. Buyout funds sizes are defined as the following: Small: 0–250 $Mil, Medium: 250–500 $Mil, Large: 500–1000 $Mil, Mega: 1 Bil Source: Thomson Venture Economics/National Venture Capital Association

Issue #1: Valuing early stage companies We define venture capitalists as risk capital, that is equity-like, investors in young, rapidly growing companies that have the potential to develop into significant economic contributors. Their willingness to take the risks associated with such investments is driven by their beliefs that they can generate superior returns, even after adjusting for the risks prevailing in these settings. By providing critical early capital and hands-on supervision and advice, aggressively managing their portfolio (divesting poorly performing assets and reinvesting in successful ones over time), and racing to the most profitable exits, they represent, in the words of Gompers and Lerner (2000), the ‘Money of Invention’. How much is created thus depends on the value increase from the time of the investment(s). The first issue to be tackled in measuring financial returns to venture capital activities is thus the valuation of early-stage, privately held companies. The valuation exercise is rarely conducted in the context of a ‘market’ in the economics sense, not even a very imperfect one. First of all, the number of potential participants on either side of the deal (buyers or sellers) is too small to justify the term of market. In many instances, a single buyer and a single seller will be involved. Second, eﬃcient markets suppose the existence of suﬃcient information for both parties to properly evaluate the entity to be traded. Unfortunately, the amount and quality of information available to estimate the true worth of a private entity is often very limited. The typical valuation context is then one

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of bargaining under incomplete and asymmetric information, a field of study that has received a great deal of attention from academics but has so far not been able to come up with more than general guidance on how to put a price on a firm. New valuation guidelines have been adopted recently by the industry, focusing on the concept of Fair Value (EVCA Valuation Standards, 2005), also known as Fair Market Value or cash value in the US (PEIGG Valuation Guidelines, 2004). EVCA defines Fair Value as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. The estimation of Fair Value does not assume either that the underlying business is saleable at the reporting date or that its current shareholders have an intention to sell their holdings in the near future. The objective is to estimate the exchange price at which hypothetical market participants would agree to transact. Fair Value is not the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distressed sale. Although transfers of shares in private businesses are often subject to restrictions, rights of pre-emption and other barriers, it should still be possible to estimate what amount a willing buyer would pay to take ownership of the investment. In estimating Fair Value for an investment, EVCA recommends a ‘methodology that is appropriate in light of the nature, facts and circumstances of the investment and its materiality in the context of the total investment portfolio and should use reasonable assumptions and estimates’. This definition stresses the subjective nature of private equity investment valuation. It is inherently based on forward-looking estimates and judgements about the underlying business itself, its market and the environment in which it operates, the state of the mergers and acquisitions market, stock market conditions and other factors. Due to the complex interaction of these factors and often the lack of directly comparable market transactions, judgement needs to be exercised. Ultimately, it is only at realization that the true performance of an investment is apparent. Issue #2: Extensive use of contingent valuation techniques Standard valuation methodologies, from discounted cash flows to earnings multiples and real option formulae, are only as good as the fundamental assumptions and data used to feed them, that is in general very poor. The high level of uncertainty that prevails in the world of venture capital is an intrinsic part of that world, and will not disappear. Hence the very slow adoption of the most sophisticated valuation techniques, which are for the most part seen as ‘technical overkill’. Early stage financings (venture capital, angels, and so on) have earned a very distinctive (and deserved) reputation as some of the more obscure, if not outright esoteric, dimensions of the field. Start-up firms are a study in paradox, known as much for the passion and drive of their wizarddriven teams, the revolutionary technologies they hatch and their blind pursuit of the opportunities they generate as for their bad habit of failing in droves, burning cash as if there were no tomorrow, and ultimately not delivering the promised bounties, or only after excruciating delays and suﬀerings. So, how does one go about analysing and providing financing to such ‘outliers’ in terms of financial risk? To a large extent, the inevitable valuation inaccuracies and diﬀerences of opinion are ‘hedged’ through sophisticated contracting schemes which, in eﬀect: (1) provide for ‘contingent repricing’ through time as the venture develops, reallocating cash flow and control rights when need be; and (2) provide eﬀective screening and incentive mechanisms, helping to ‘smoke

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out’ entrepreneurs with lesser quality projects or venture capitalists with low add-on values (Cossin, Leleux and Saliasi, 2003). While there is comfort in knowing that initial valuation errors will be corrected over time, how should venture capitalists report actual deal valuations for the purpose of financial performance measurement? A first conceptual approach would be to value independently the multiple options that make up standard investment contracts. But for the very same reasons that valuations are diﬃcult, derivative valuations are even more uncertain. A second approach, less elegant but more applicable, consists in ignoring the contractual contingencies and reporting only the point valuations (that is share prices) at the time of the deal. While this ignores most of the value-related covenants, the valuation error would only aﬀect the initial reporting of the deal value: upon exit, the true value creation will be recognized. Issue #3: IRR-boosting cash flow management techniques Measuring the financial performance of a venture capital fund requires taking into consideration the industry’s unique set of operating procedures which impact these reported performances. The latter include: (1) the progressive commitments, draw-downs and investments of funds from investors into ventures; (2) the selective re-investments and divestments from ventures; and (3) the exits and distributions to investors. All the parameters of the investment cycle are managed by the venture capitalists to optimize not only reported IRRs on the fund but also the investment multiple, the two key performance metrics most watched in the industry. Venture capitalists’ need to manage IRR translates into a progressive commitment and drawdowns of the investors’ funds. The ‘clock’, in terms of return on capital, only starts ticking when the venture capitalist has the use of investors’ money in hand, hence a great reluctance to take the commitments in cash upfront. Funds either draw down the funds on the basis of a fixed schedule (for example 12 equal quarterly instalments) or more often on the basis of cash calls on an as-needed basis, with a 30- to 90-day payment basis. Venture capitalists’ insistence on progressive capital commitment to a venture is not only a risk management and control tool but also a cash disbursement mechanism. Associated with direct monitoring of the ventures, the objective is to minimize the period of capital usage and maximize its value creation eﬃciency. At the end of the process, venture capitalists need to exit the investments and distribute the proceeds back to investors (Leleux, 2002). Exits happen in a number of ways: a private recapitalization, a merger with or sale to an acquirer, or in a public oﬀering (IPO). The exit strategy most frequently chosen in the US is a public oﬀering, otherwise known as an IPO, since an IPO will provide investors with the highest overall returns. Once the investment is exited, the venture capital firm must then decide when and how to distribute the returns to its investors. A venture capital firm can either sell the stock and distribute the cash proceeds to the investors or it can distribute the stock directly to the investors. Stock distributions are most commonly selected because they provide the greatest benefits to the fund’s limited partners. Due to Securities and Exchange Commission (SEC) restrictions, a venture capitalist cannot easily liquidate its entire position. In instances when it can sell stock, a large block sale by a venture capitalist would negatively impact the stock price. However, a venture capital firm can distribute the shares of a portfolio company to its limited partners, who can then sell these shares without restriction.

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If an investor still believes in the long-term prospects of the company, he can also hold the stock for sale at a later date. Another benefit of this strategy is that a tax liability is not created until the stock is actually sold. Clearly, the above evidence supports the claim that a venture capitalist chooses a stock distribution for the benefits it provides to investors. As with most debates, there is another perspective to the distribution strategies chosen by venture capitalists and that is one which is self-serving. In taking a portfolio company public, a young venture capital firm improves its fundraising prospects (Gompers, 1996). By distributing shares instead of cash, a venture capitalist can increase its compensation, satisfy its largest institutional clients, and increase its overall personal return on investment. Issue #4: Collecting and aggregating individual fund IRRs Venture capital funds belong to the generic ‘private equity’ or ‘alternative assets’ portfolio allocation class. By definition, that industry deals primarily with private equity situations, that is situations where information disclosures are going to be extremely limited. In practice, only limited partners in a fund would receive detailed information as to the actual performance of the fund they are invested in. Only large institutional investors, such as major university endowments or fund-of-fund managers would ever accumulate a suﬃciently large number of positions in funds to be able to generate meaningful comparisons internally. A number of trade groups, such as EVCA and NVCA, often with the help of specialist advisory boutiques, such as Venture Economics or Almeida Capital, are generating their own ‘industry’ performance numbers. In doing so, they face the same diﬃculties in accessing the basic fund performance information and have to rely on voluntary disclosure by member firms. For example, EVCA and PricewaterhouseCoopers tapped all national private equity and venture capital associations to identify all companies that participated in private equity activities during 2002 (for the 2002 Annual European Private Equity Survey, published as the 2003 EVCA Yearbook). A total of 1528 eligible companies were contacted and 73 per cent of the firms, or 1112, responded to the two-part, self-completion survey. While it would be diﬃcult to criticize the organizations for the non-respondents, it is fair to question whether self-disclosure leads to censoring of the performance distribution curve, for example if non-respondents were primarily funds with low performance during the year. Issue #5: Industry performance and correlation with other asset classes Performance and risk can only be evaluated in the context of the correlation of the venture capital asset class with respect to other major sectors. In particular, if venture capital exhibited a low level of correlation with respect to these assets, a high proportion of its risk can be diversified away in a well-balanced portfolio. Unfortunately, the evidence in this respect is not as encouraging as some would pretend. First of all, the performance of the venture capital industry is highly correlated to that of technology-rich stock markets, so that venture capital positions do not provide much diversification to a Nasdaq-rich portfolio. The best diversification is obtained with respect to portfolios of real estate or long-term fixed income instruments. Correlations to key equity indices are in general positive and relatively high (0.5 to 0.7), so that the benefits in including venture capital in the portfolio are actually relatively minimal.

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Conclusions In this chapter, we document the extent of contributions to understanding the issues in measuring performance in the venture capital industry. In particular, we highlight the unreliability of the performance measures in general and the diﬃculty to access fund level data. Despite these shortcomings, a rich literature has emerged to identify key drivers of performance at the fund level or at the level of the investee companies. References Birkshaw, J. and S. Hill (2003), ‘Corporate venturing performance: an investigation into the applicability of venture capital models’, Working Paper, London: London Business School. Chevalier, J. and G. Ellison (1999), ‘Are some mutual fund managers better than others? Cross-sectional patterns in behavior and performance’, Journal of Finance, 54(3), 875–99. Cochrane, J. (2000), ‘The risk and return of venture capital’, Working Paper, Anderson Graduate School of Management. Cossin, D., B. Leleux and E. Saliasi (2003), ‘The liquidation preference in venture capital investment contracts: a real option approach’, in J. McCahery and L. Renneboog (eds), Venture Capital Contracting and the Valuation of High Tech Firms, Oxford: Oxford University Press, pp. 318–36. Engel, D. (2004), ‘The performance of venture backed firms: the eﬀect of venture capital company characteristics’, Industry and Innovation, 11(3), 249–63. EVCA Valuation Standards (2005), www.evca.com. EVCA Yearbook (2003), www.evca.com. Gilson, R. and B. Black (1999), ‘Does venture capital require an active stock market?’, Journal of Applied Corporate Finance, 11(1), 36–48. Gompers, P. (1994), ‘The rise and fall of venture capital’, Business and Economic History, 23(2), 1–24. Gompers, P. (1996), ‘Grandstanding in the venture capital industry’, Journal of Financial Economics, 42(1), 133–56. Gompers, P. and J. Lerner (1998), ‘What drives venture capital fundraising?’, Working Paper, Harvard University. Gompers, P. and J. Lerner (2000), The Money of Invention: How Venture Capital Creates New Wealth, Boston, MA: Harvard Business School Press. Gompers, P. and J. Lerner (2001), ‘The venture capital revolution’, Journal of Economic Perspectives, 15(2), 145–68. Gottschalg, O., L. Phalippou and M. Zollo (2004), ‘Performance of private equity funds: another puzzle?’, Working Paper, INSEAD, France. Hand, J. (2004), ‘Determinants of the returns to venture capital investments’, unpublished Working Paper, Kenan-Flagler Business School. Hatton, L. and J. Moorehead (1994), ‘Determining venture capitalist criteria in evaluating new ventures’, Working Paper, California State University. Hege, U., F. Palomino and A. Schwienbacher (2003), ‘Determinants of venture capital performance: Europe and the United States’, Working Paper, RICALFE-European Commission DG Research. Hochberg, Y., A. Ljungqvist and Y. Lu (2004), ‘Who you know matters: venture capital networks and investment performance’, Working Paper, Stern School of Business. Jeng, L. and P. Wells (2000), ‘The determinants of venture capital funding: evidence across countries’, Journal of Corporate Finance, 6, 241–89. Kaplan, S. and A. Schoar (2005), ‘Private equity performance: returns, persistence, and capital flows’, Journal of Finance, 60(4), 1791–823. Kaplan, S. and P. Strömberg (2000), ‘How do venture capitalists choose investments?’, Working Paper, University of Chicago. Kaplan, S. and P. Strömberg (2003), ‘Financial contracting theory meets the real world: evidence from venture capital contracts’, Review of Economic Studies, 70(2), 281–316. Leleux, B. (2002), ‘Note on distribution strategies of venture capital firms’, IMD Working Paper Series GM-1120. Leleux, B. and B. Surlemont (2003), ‘Public versus private venture capital: seeding or crowding out? A pan European analysis’, Journal of Business Venturing, 18(1), 81–104. Leleux, B., D. Muzyka and S. Birley (1996), ‘Trade-oﬀs in the investment decisions of European venture capitalists’, Journal of Business Venturing, 11, 273–87. Lerner, J. (1995), ‘Venture capitalists and the oversight of privately-held firms’, Journal of Finance, 50, 301–18. Lerner, J., A. Schoar and W. Wong (2004), ‘Smart institutions, foolish choices?: the limited partner performance puzzle’, NBER and Harvard University Working Paper.

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Ljungqvist, A. and M. Richardson (2003), ‘The investment behaviour of private equity fund managers’, Working Paper, Stern School of Business. Nahata, R. (2004), ‘The determinants of venture capital exits: an empirical analysis of VC backed portfolio companies’, Working Paper, Vanderbilt University. PEIGG Valuation Guidelines (2004), Private Equity Industry Guidelines Group, www.peigg.org. Romain, A. and B. Van Pottelsberghe de la Potterie (2004), ‘The determinants of venture capital: additional evidence’, Working Paper, Solvay Business School. Shepherd, D. and A. Zacharakis (2002), ‘Venture capitalists’ expertise – a call for research into decision aids and cognitive feedback’, Journal of Business Venturing, 17, 1–20. Sirri, E. and P. Tufano (1998), ‘Costly search and mutual fund flow’, Journal of Finance, 53 (October), 1589–622. Stevenson, H., D. Muzyka and J. Timmons (1987), ‘Venture capital in transition: a Monte Carlo simulation of changes in investment patterns’, Journal of Business Venturing, 2(2), 103–21. Wang, C. and B. Ang (2004), ‘Determinants of venture performance in Singapore’, Journal of Small Business Management, 42(4), 347–63. Zacharakis, A. and D. Meyer (2000), ‘The potential of actual decision models: can they improve the venture capital investment decision?’, Journal of Business Venturing, 15(4), 323–46. Zacharakis, A. and D. Shepherd (2001), ‘The nature of information and overconfidence on venture capitalists decision making’, Journal of Business Venturing, 16, 311–32.

10 An overview of research on early stage venture capital: Current status and future directions Annaleena Parhankangas1

Introduction Entrepreneurship can be seen as an engine of innovation and growth, and a provider of economic and social welfare (Schumpeter, 1934; Birch, 1979; Birley, 1986; Kortum and Lerner, 2000). Entrepreneurs developing revolutionary new products require a substantial amount of capital during the formative stages of their companies’ life cycles. Even though most entrepreneurs prefer internal to external funding, few entrepreneurs have suﬃcient funds to finance early stage projects themselves. It is also at this stage of development, when collateral-based funding from banks, the second most preferred source of funding by entrepreneurs (Myers, 1984), is often inappropriate or even potentially lifethreatening to the new firm (Gompers, 1994; Murray, 1999). Therefore, the alternative provision of venture capital has become an attractive source of finance for potentially important companies operating on the frontier of emerging technologies and markets (Tyebjee and Bruno, 1984; Bygrave and Timmons, 1992; Murray, 1999). However, the management of early stage venture capital investments has proved to be challenging. Early stage investors are obliged to deal with multiple sources of uncertainty spanning the commercial, technical and managerial aspects of the new enterprise (Storey and Tether, 1998). Early stage investments typically involve new products targeted to nonexisting markets developed by management teams with little or no prior history, exposing investors to significant information asymmetries (Chan, 1983; Amit et al., 1990; Chan et al., 1990; Sahlman, 1990; Amit et al., 1998). In addition, it will usually take several years to transform an early stage company to a firm capable of being floated or sold to a trade buyer (Dimov and Murray, 2006). As a result, early stage venture capitalists are faced with the combination of long term commitment in a young venture and a considerable likelihood of failure. The venture capital industry has partly responded to these challenges by rejecting early stage financing activity as too uneconomic (Dimov and Murray, 2006). Some go as far as to state that eﬃcient markets do not exist for allocating risk capital to early-stage technology ventures and that most funding for technology development in the phase between invention and innovation comes from angel investors, corporations and federal governments, not venture capitalists (Branscomb and Auerswald, 2002). Given the significant challenges and opportunities associated with early stage venture capital, the volume of research on this topic is increasing, whether measured in terms of published research articles, publication outlets, or support provided by private donors or policy. The initial empirical research was mostly conducted during the 1980s, four decades after the first venture capital firm was established in the United States. The pioneers in early stage venture capital research focused on fundamental questions, such as ‘what do venture capitalists do’ and ‘how do they add value in their portfolio companies’. For instance, the seminal paper of Tyebjee and Bruno (1984) developed a model of venture 253

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capital activity involving five sequential steps: deal origination, deal screening, deal evaluation, deal structuring and post-investment activities. MacMillan et al. (1985; 1987) analyzed the criteria used by early stage venture capitalists to evaluate new venture proposals. Bygrave and Timmons (1986) and Gorman and Sahlman (1989) focused on the role of venture capitalists in promoting innovation and growth in early stage companies. Bygrave (1988) investigated the logic of syndication in the early stage venture capital industry. It is noteworthy that these questions still continue to attract the attention of new generations of researchers. The pioneers in early stage venture capital research focused primarily on the US market. However, the diﬀusion of US style venture capital practices to other nations was followed by a stream of international venture capital research describing the European and Asian context (Muzyka et al., 1996; Sapienza et al., 1996; Brouwer and Hendrix, 1998; Bruton and Ahlstrom, 2002; Kenney et al., 2002a; 2002b; Wright et al., 2005). These studies typically address the cross-country diﬀerences in early stage venture capital activities and the role of the early stage venture capital investments in revitalizing the entrepreneurial systems of Europe and Asia. Another significant trend in (early stage) venture capital research is the sharpening distinction between research on early stage and later venture capital activities, perhaps reflecting the recent tendency of venture capitalists to shift away from early stage investments to later stage deals (Tyebjee and Bruno, 1984; Bygrave and Timmons, 1992; Camp and Sexton, 1992; Gompers, 1994; Mason and Harrison, 1995; Sohl, 1999; Gompers and Lerner, 2001; Balboa and Marti, 2004). As the original definition of venture capital involves investments in young firms characterized with high risk and pay-oﬀ (CrispinLittle and Brereton, 1989; Bygrave and Timmons, 1992; Gompers et al., 1998; Sahlman, 1990; Wright and Robbie, 1998; Gompers and Lerner, 2001), investments in early stage firms may be regarded as classic venture capital. Later stage investments, in turn, are sometimes labeled as private equity (Lockett and Wright, 2001) or merchant capital (Bygrave and Timmons, 1992). It was not until later that the notion of early stage venture capital emerged as several authors demonstrated that the stage focus of a venture capitalist is one of the most important features along which venture capital firms could be distinguished (Robinson, 1987; Ruhnka and Young, 1987; Fried and Hisrich, 1991). As research on early stage venture capital continues to grow and proliferate, it is important to take a look back and evaluate the progress made and to identify gaps in the existing knowledge. This chapter is based on a review of 179 peer-reviewed articles and other relevant publications focusing on early stage venture capital financing.2 Even though a great eﬀort was taken to provide a reasonable overview of the existing knowledge, the size and scope of the research field makes it impossible to provide a detailed description of every article reviewed or an exhaustive listing of all studies published on the topic this far. Instead, the focus of the literature review is primarily on scholarly research. It is also important to note that the studies focusing on the co-evolution of venture capital, regions and industries (see for instance Manigart, 1994; Martin et al., 2002; Klagge and Martin, 2005) and the policy aspects of early stage venture capital are beyond the scope of this study, as these topics will be covered in other parts of this book. This chapter organizes the literature on early stage venture capital financing by first analyzing the special characteristics of the early stage ventures, investors and funds. Thereafter, I continue with the implications of these diﬀerences for managing venture capitalist

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255

INSTITUTIONAL SETTING Characteristics of early stage venture capital

Management of early stage investments

Characteristics of early stage investments • Market and agency risks • Information asymmetries Characteristics of early stage investors and funds

• Fund raising • Appraisal • Structuring • Monitoring and adding value • Exiting and performance

Figure 10.1

Synthesis and analysis of early stage venture capital research • Major themes and findings • Theories and methods • Future research

Outline for the chapter

investment activity (Tyebjee and Bruno, 1984) over the venture capital cycle (Gompers and Lerner, 2001) in diﬀerent institutional settings. Finally, this chapter is concluded with a synthesis and analysis of prior knowledge and suggestions for future research. The approach for presenting and analyzing prior studies is illustrated in Figure 10.1. Early stage venture capital industry: key characteristics and challenges In order to gain a better understanding of the challenges and opportunities faced by early stage investors, I will first identify those key characteristics that distinguish early stage ventures from later stage deals. Thereafter, I will discuss the major risks faced by early stage investors and recent trends in the global early stage investment activity. This subsection ends with a description of the key characteristics of early stage investors and funds. Classification of venture capital investments based on their development stage: early stage ventures vs. later stage deals Prior literature classifies venture capital investments based on the development stage of the portfolio company (Robinson, 1987; Bygrave and Timmons, 1992). Stanley Pratt, the publisher of Venture Capital Journal, distinguishes between ‘seed, start-up, first stage, second stage, third stage and bridge financing’ (Bygrave and Timmons, 1984; Ruhnka and Young, 1987). These investment stages have been found to diﬀer in terms of their key characteristics, developmental goals and major developmental risks (Ruhnka and Young, 1987; Flynn and Forman, 2001), as presented in Table 10.1. The seed, start-up capital and first stage financing are usually considered early stage venture capital (Pratt’s Guide to Venture Capital Sources, 1986; Ruhnka and Young, 1987; Crispin-Little and Brereton, 1989). Seed financing involves a small amount of capital provided to an inventor or an entrepreneur to prove a concept (Sohl, 1999; Branscomb and Auerswald, 2002), before there is a real product or company organized (NVCA, 2005). Ruhnka and Young (1987) found that characteristic for the seed stage is the existence of a mere idea or a concept, and the absence of the management team beyond the founder and one or more technicians. The critical goals for the seed stage include producing a product prototype and demonstrating technical feasibility, as well as conducting a preliminary market assessment. Contrary to public perception, seed stage companies are not likely candidates for venture capital investments, but are more likely to be backed by

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Table 10.1 Characteristics of the various investment stages (adapted from Sohl, 1999; Crispin-Little & Brereton, 1989; Ruhnka & Young, 1987) Seed Stage

Start-Up Stage

First Stage

Later Stages

Source of funding

Founder, Angels

Angels, VCs

Angels, VCs

VCs, Private Equity

Demand

0–$25K

$100K–$500K

$500K–$2000K

>$2000K

Venture • Idea or concept characteristics • only • No management, • founders/ • technicians only • Prototype not • developed/tested

• • • • • • • • • • •

Business plan and market analysis completed Prototype under evaluation/beta testing Management team incomplete Product ready to market, some initial sales

• • • • • • • • • •

Market receptive, some orders/sales Marketing push needed Full management team in place Ramp-up in manufacturing needed Prototype ready

• • • • • • • • • • • • •

Significant sales and orders Increasing sales/broaden market (Near) break-even or profitable Seasoned management completed/ revamped Established product

Major goals

• • • • • • • • • •

Complete beta testing/get product ready to the market Make initial sales, verify demand Establish manufacturing feasibility Build management organization

• • • • • • • • • • •

Achieve market penetration and sales goals Reach break-even or profitability Increase production capacity/reduce unit cost Build sales force/distribution systems

• • • • • • • • • • • • •

Increase sales, growth, market share targets Need to windowdress for IPO, buyout or merger Improve cash flow break-even, profitability Diversify products Begin major expansion of the company

Beta tests unsatisfactory Founders cannot attract/manage key management Potential market size/share not feasible Cash used up, inability to attract additional funding Inadequate marketing/sales volume Product not cost competitive Unanticipated delays in product development Competition develops first

• • • • • • • • • • • • • • • • • • • • •

Founders are poor managers/ inadequate management team Product not suﬃciently competitive in the market Manufacturing costs too high/ inadequate profit margin Market not as big as projected/slow market growth Marketing strategy wrong/inadequate distribution Excessive burn rate/inadequate financial controls

• • • • • • • • • • • • • • • •

Inadequate management/loss of key management Inadequate sales/market share Unanticipated competition IPO window shuts/ no exit vehicle Cannot achieve adequate profit margin Technological obsolescence

• • • • • • • • • • •

Develop and prove the concept Produce working prototype Market assessment Assemble management team and structure company Develop detailed business plan

• Major risks

• • • • • • • • • • • • •

Workable prototype cannot be produced Potential market not large enough Development delayed, funds run out Product cannot be produced at a competitive cost Founder cannot manage development

• • • • • • • • • • • • • • • • • • • • •

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informal investors (business angels), family and friends (Tyebjee and Bruno, 1984; Crispin-Little and Brereton, 1989; Sohl, 1999). Start-up financing provides funds for product development and initial marketing. In the start-up stage, the investigation of the feasibility of the business concept has generally progressed to the point of having a formal business plan together with some analysis of the market for the proposed product or service. Major benchmarks for this stage include establishing the technological, market and manufacturing feasibility of the business concept (Ruhnka and Young, 1987; Crispin-Little and Brereton, 1989). The first stage financing provides funds to initiate commercial manufacturing and sales. The first stage is characterized by having a full management team in place, a market receptive to the product, a need for a ramp-up of the production process, and the existence of a ready prototype for the market (Ruhnka and Young, 1987; Crispin-Little and Brereton, 1989; Sahlman, 1990; Sohl, 1999; Branscomb and Auerswald, 2002). Even though there exists less consensus on the typical characteristics of the ventures in later stages of their development (Ruhnka and Young, 1987), it is possible to distinguish more mature portfolio companies from early stage investments. As later stage investments targets have already established their market presence, their key developmental goals include achieving market share targets and reaching profitability in order to make it possible for venture capitalists to exit the investment successfully. In comparison to early stage ventures struggling with challenges related to product, market and organization development, the later stage investments face the threat of technological obsolescence and unanticipated competition caused by new entrants (Ruhnka and Young, 1987; CrispinLittle and Brereton, 1989; Branscomb and Auerswald, 2002). Major risks associated with early stage investments 3 Of all themes related to early stage venture capital research, perhaps most attention has been paid to the nature and extent of risks related to investments in nascent ventures. It is widely believed that early stage ventures imply higher overall risks and volatility of returns than more established portfolio companies (Brophy and Haessler, 1994). These risks are particularly serious for new technology-based firms (Bygrave, 1988; Mason and Harrison, 1995; Balboa and Marti, 2004), such as university spin-outs (Wright et al., 2006), due to the long lead time of product development and severe diﬃculties associated with the transfer of technology into the market place. The high level of risks inherent in early stage venture capital investments can be partly explained by the existence of information asymmetries between the venture capitalist and the entrepreneur (Chan, 1983; Amit et al., 1990; Chan et al., 1990; Sahlman, 1990; Amit et al., 1998). In early stage companies characterized with intangible assets and a heavy reliance on R&D (Gompers and Lerner, 2001), the venture capitalist has only a limited understanding of the quality of the project, and the competence and willingness of the entrepreneur to act in the interest of the other shareholders. Stated diﬀerently, early stage venture capitalists are exposed to high levels of ‘hidden information’ and ‘hidden action’ on the part of the entrepreneur (Akerlof, 1970; Holmström, 1978). As Amit et al. (1990) put it: an early stage technology investment often involves (Murray and Marriott, 1998) a technology that has not yet been proven; which is to be incorporated into novel products and/ or services which still remain solely in the mind of the entrepreneur; and will eventually be

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oﬀered to markets and customers whose existence remains purely hypothetical. On the top of these uncertainties, the new enterprise may uncommonly be managed by a technological entrepreneur or a founding team whose experience of commercial practices and disciplines is negligible, as are their personal assets by which the venture may be financed or the investment guaranteed.

The risks inherent in venture capital investments in general and in early stage investments in particular can be further divided to market and agency risks (Gorman and Sahlman, 1989; Ruhnka and Young, 1987; 1991; Barney et al., 1994; Fiet, 1995; Murray and Marriott, 1998; Gompers and Lerner, 2001). Market risk refers to risks due to unforeseen competitive conditions aﬀecting the size, growth and accessibility of the market, and upon factors aﬀecting the level of market demand. Because of high levels of market risks inherent in young ventures, the early stage investors’ overriding concerns include failures to capture a large enough market share or to ramp up the production process (Ruhnka and Young, 1987; 1991; Muzyka et al., 1996). Agency risk, in its turn, is a risk that is caused by separate and possibly divergent interests of agents and principals (Sahlman, 1990; Fiet, 1995). Agency risks may result in opportunism, shirking, conflicting objectives or incompetence (Parhankangas and Landström, 2004). For example, early stage entrepreneurs might invest in research projects that bring great personal returns but low monetary payoﬀs to shareholders (Gompers and Lerner, 2001). Agency risks may also result in delays in product development, or the failure of the founders to comply with the development objectives of their investors (Ruhnka and Young, 1987; 1991; Murray and Marriott, 1998; Gompers and Lerner, 2001). Recent trends in the frequency of early stage investments The market and agency risks inherent in nascent ventures are likely to make investors doubtful of their ability to appropriate returns from early stage investments (Branscomb and Auerswald, 2002). These doubts may be reflected in the decreasing interest in early stage investments all over the world. Figure 10.2 shows that the share of early stage investments of the total value of all deals has fallen from approximately 50 per cent in the 1960s to 15 per cent in 2005. The corresponding figure for European early stage investments was 12 per cent in 2004 (EVCA/Thomson Venture Economics, 2004). However, the situation looks less alarming, if the percentage of early stage deals of all investments is used as a proxy. As Figure 10.3 shows, 60 per cent of all deals in Europe are seed or early stage investments (Bottazzi et al., 2004). Characteristics of early stage venture capitalists and funds As early stage ventures diﬀer from later stage deals along several dimensions, it should come as no surprise that prior studies also report venture capital firms investing in early stage companies being fundamentally diﬀerent from their counterparts focusing on more mature portfolio companies. It has been proposed that early stage investments are typically made by venture capital firms: ●

located in the United States, especially on the West Coast (Crispin-Little and Brereton, 1989; Black and Gilson, 1998; Gompers et al., 1998; Schwienbacher, 2002);

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70% 60% 50% 40% 30% 20% 10% 0% 1960

1980

1990

2005

Source: Venture Economics

Figure 10.2 The share of early stage investments of the value of all global deals during the years 1960–2005 ● ● ●

located in countries with strong laws for contract repudiation and shareholder rights (Cumming, Fleming and Schwienbacher, 2006); hiring investors with a higher degree of education than venture capital firms focusing on later stage investments (Flynn and Forman, 2001; Bottazzi et al., 2004); being older and larger than venture capital firms focusing on later stage deals (Gompers et al., 1998; Dimov and Murray, 2006) and the dominance of older and larger firms may be explained by their greater expertise and ability to extract benefits from early stage investments. However, Bottazzi et al. (2004) and Schwienbacher (2002) report some contradictory evidence from the European and

Expansion 39%

Start-Up 42%

Seed 17% Source: Bottazzi et al., 2004

Figure 10.3

Venture deals by stage in Europe

Bridge 2%

260

● ●

Handbook of research on venture capital US context, suggesting that young venture capital firms are more likely to engage in seed financing; being more often independent than captive (Wright and Robbie, 1996; Kenney et al., 2002a; 2002b); and being less often involved in cross-border investments (Schwienbacher, 2002; Hall and Tu, 2003).

In a similar vein, funds focusing on early stage investments tend to have some distinct characteristics. Prior research has paid a significant amount of attention to the relationship between fund size and early stage investments, producing somewhat mixed results. Some studies suggest that as venture capital funds become larger, their interest and involvement in early-stage investments fades (Bygrave and Timmons, 1992; Elango et al., 1995). This aversion is closely related to the fact that early stage investments are typically very small and highly uncertain in terms of their outcome. For growing funds, such investments are often uneconomic given the diversion of scarce investment manager talent (Giﬀord, 1997). However, Dimov and Murray (2006) found a U-shaped relationship between fund size and the number of seed investments; even though the number of seed investments decreases as the amount of invested capital increases, seed investments nevertheless become a viable investment option after some minimum capital point has been reached. This finding is consistent with the idea that funds with a seed focus need to have a minimum scale of eﬃciency given their fixed cost structures (Murray and Marriott, 1998; Murray, 1999). Studies focusing on the management of the early stage venture capital investments As information asymmetries, market risks and agency risks are an integral part of young ventures, much of the prior literature highlights how venture capitalists may deal with these challenges over the venture capital cycle and in their relationship with the entrepreneur. In particular, special attention will be paid to fund raising, appraisal strategies, structuring the deal, monitoring and adding value, as well as exit strategies deployed by the early stage venture capitalists (see Figure 10.4). The availability and feasibility of these risk reduction strategies depend, to a large extent, on the institutional context of early stage investors. Therefore, this section ends with a review of management practices applied by early stage venture capitalists embedded in diﬀerent institutional contexts. Fund raising Funds to be invested in early stage ventures may be raised from pension funds, insurance companies, banks, government agencies, private individuals or corporate investors. Prior research reports that corporate and individual backed funds, academic institutions and, in some cases, pension funds, prefer investments in firms at an early development stage, whereas banks more often invest in later stage deals (Mayer et al., 2005; Schertler, 2005; Cumming, 2006a). Venture capital commitments to early stage firms have been highly variable over time (Gompers and Lerner, 2001) and across countries (for example, Black and Gilson, 1998; Jeng and Wells, 2000; Megginson, 2004; Mayer et al., 2005). Even though the United States dominates the early stage scene by the sheer volume of funds directed to nascent ventures, the share of early stage venture capital of GDP is even higher in many other industrialized nations (Figure 10.5).

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261

Fund raising

Appraisal

Structuring

Monitoring and adding value

Exit Figure 10.4

Managing early stage investments

0.12

Percent GDP

0.10 0.08 0.06 0.04 0.02

Greece Italy Spain China Austria Australia Japan Netherlands Germany UK Norway France Finland USA Switzerland Ireland S. Africa Singapore Canada Belgium N. Zealand Denmark Sweden Mean

0.00

Source: Reprinted with kind permission of Babson College and London Business School, Figure 10.5, ‘Early stage venture capital investment by country’, in M. Minniti, W. Bygrave and E. Autio (2005), Global Entrepreneurship Monitor 2005 Executive Report.

Figure 10.5

Early stage venture capital investment by country (Percent GDP, 2004)

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These drastic cross-national and temporal variations may partly explain the fact that several studies focus on the role played by various macro-economic and institutional factors (for example Söderblom and Wiklund, 2006) in either alleviating or aggravating risks associated with investments in young ventures. In a similar vein, investors’ experience, size and prior performance (for example Gompers et al., 1998; Marti and Balboa, 2000; Kaplan and Schoar, 2005) seem to facilitate commitments to venture capital funds. A more detailed review on early stage fund raising activities will be provided in the section dedicated to institutional environment and the management of venture capital activities. Appraisal of early stage deals Prior research has identified several stages of venture capitalists’ appraisal process, including deal generation, initial screening, second/detailed screening and deal approval (Bygrave and Timmons, 1992; Fried and Hisrich, 1994; Wright and Robbie, 1996). Traditionally, little time was spent on searching for deals, as most proposals received by early stage venture capitalists were referrals from third parties (Tyebjee and Bruno, 1984). However, increasing competition between the venture capitalists has created a need to allocate more time to the deal generation process (Sweeting, 1991; Shepherd et al., 2005). In a similar vein, early stage venture capitalists exposed to information asymmetries and adverse selection problems (Amit et al., 1990) spend a significant amount of time and eﬀort in evaluating and screening early stage investment opportunities (Carter and Van Auken, 1994; Kaplan and Strömberg, 2001). In deal generation and initial screening phases, early stage venture capitalists typically focus on rather general (non-financial) investment criteria, which enable them to conclude whether a proposal is viable for further consideration (Zacharakis and Meyer, 2000). Such general evaluation criteria include a wide variety of factors, such as: ● ● ● ● ● ●

completeness and track record of the management team; attractiveness of the business opportunity and industry; liquidity of the venture; possession of proprietary products and product uniqueness; innovation output; and similarity of the founding team in comparison to the investor (Tyebjee and Bruno, 1984; MacMillan et al., 1985; 1987; Sandberg et al., 1988; Rea, 1989; Fried and Hisrich, 1991; Elango et al., 1995; Muzyka et al., 1996; Zacharakis and Meyer, 1998; Shepherd et al., 2000; Kaplan and Strömberg, 2001; Engel and Keilbach, 2002; Franke et al., 2002).

Much of the prior research concludes that the entrepreneur and the entrepreneurial team are the most important decision criteria in distinguishing between successful and failed ventures (MacMillan et al., 1985; 1987). Therefore, it is widely believed that most venture capitalists prefer an opportunity that oﬀers a good management team and reasonable financial and product market characteristics even if it does not meet the overall fund and deal requirements (Muzyka et al., 1996). However, some more recent studies contradict this logic by suggesting that the most important selection criteria center on the market and product attributes (Hall and Hofer, 1993; Zacharakis and Meyer, 1995). Finally, it is important to note that prior research reports various interactions between the

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evaluation criteria presented above. For instance, the study by Zacharakis and Shepherd (2005) suggests that the more munificent the environment, the more importance the venture capitalist attaches to general experience in leadership. In addition, start-up experience may in some cases substitute leadership experience. Prior studies give us a reason to believe that the evaluation criteria applied by early stage venture capitalists diﬀer fundamentally from those employed by later stage investors. For instance, Birley et al. (1999) found that the leadership potential and operational skills of entrepreneurs dominate when making investments in early stage ventures. However, when evaluating buyouts, the leadership capability of the whole team increases in importance. In addition, several researchers suggest that early stage investors attach more importance to the possession of proprietary products, product uniqueness, high growth markets and the quality of the entrepreneurial team, whereas late stage investors are more interested in demonstrated market acceptance, profitability and cash flow as well as relatively short exit horizons (Fried and Hisrich, 1991; Bygrave and Timmons, 1992; Elango et al., 1995; Wright and Robbie, 1996). For early stage venture capitalists, the single most important source of information is the business plan, projecting the future of the company (MacMillan et al., 1985; 1987; Wright and Robbie, 1996). An adverse selection problem arises, as venture capitalists have to rely greatly on information provided by the entrepreneur. Therefore, venture capitalists exercise considerable eﬀorts in due diligence in order to verify the robustness of reported accounting information, especially profit and cash flow forecasts (Wright and Robbie, 1996; Manigart et al., 1997). The due diligence process often involves auditing the macro and legal environment, as well as financial, marketing, production, and management aspects of a firm (Harvey and Lusch, 1995). In company valuations, venture capitalists use various standard methods for valuing investments, such as variations of price earnings ratio multiples and capitalized maintainable earnings (EBIT) multiples. However, it has been found that venture capitalists focusing on early stage investments place significantly less emphasis on valuation methods based on past performance information (Wright and Robbie, 1996; Wright et al., 1997). When assessing the quality of human capital, past oriented interviews and work samples tend to increase the decision accuracy for early stage investors (Smart, 1999), even though this process is usually less timeconsuming for seed and start-up investments with smaller entrepreneurial teams with little or no track record (Cumming, Schmidt and Walz, 2006). The valuation processes of early stage investments are intrinsically diﬃcult (Tyebjee ansd Bruno, 1984; Branscomb and Auerswald, 2002). Paradoxically, prior literature has identified situations where these diﬃculties have led to a herd mentality (Lerner et al., 2005) creating an overflow of venture capital in particular sectors (Sahlman and Stevenson, 1987). It is more common, however, that venture capitalists impose higher minimum internal rates of return (IRR) and market size hurdles on new, technologybased firms to compensate for higher levels of risk (Elango et al., 1995; Fiet, 1995; Murray and Lott, 1995; Wright and Robbie, 1996; Manigart et al., 1997; Lockett et al., 2002). According to a British study, two-thirds of early stage investors look for rates of return of at least 46 per cent, whereas 75 per cent of later stage investors settle for an IRR of 35 per cent or below (Wright and Robbie, 1996). As a result, information asymmetries between investors and entrepreneurs are often cited as one of the major reasons for which positive net cash flow projects fail to get funded (Leland and Pyle, 1977; Amit et al., 1998).

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While relatively little attention is paid to the role of the entrepreneur in the early stages of the venture capital process, Timmons and Bygrave (1986) and Smith (1999) report that entrepreneurs evaluate venture capitalists in terms of their value-added, reputation, industry specialization, the amount of capital, experience, and physical location. It has been argued that the entrepreneurs are more likely to accept oﬀers from venture capitalists with a good reputation, often at a substantial discount of the venture’s value (Hsu, 2004). Finally, entrepreneurial teams may also assume an active role in signaling the value of their venture to prospective investors (for example, Amit et al., 1990; Busenitz et al., 2005). In some cases, third parties, such as technology transfer oﬃces, may assist new ventures in the signaling process by participating in screening and preparation of proposals for venture capitalists (Wright et al., 2006). Venture capitalists seem to be relatively skilled in picking the most successful new ventures in the industry (Timmons and Bygrave, 1986; Timmons, 1994; Amit et al., 1998). Their superior screening skills may partly explain the growing research interest in the cognitive processes of early stage venture capitalists embedded in highly uncertain and ambiguous environments conducive to cognitive biases and the use of heuristics in decision-making (Baron, 1998). As a starting point for this stream of literature is the notion of a venture capitalist as an intuitive decision-maker (Khan, 1987), who does not understand his or her decision process (Zacharakis and Meyer, 1998). Reliance on intuition may stem from information richness or ‘information overload’ surrounding new ventures, making it impossible for investors to increase the quality of decision making by collecting and processing more information (Zacharakis and Meyer, 2000; 1998). Prior studies have identified several heuristics characteristic to the venture capitalist’s decision making, such as representative and satisfying heuristics (Gompers et al., 1998; Zacharakis and Meyer, 2000). Even though these heuristics may speed up the decision making process and allow more time for value-adding activities, they may also lead to the underestimation of risks and a herding phenomenon (see Chapter 6 by Zacharakis and Shepherd). It has also been found that venture capitalists may suﬀer from overconfidence and attribution bias, causing them to overestimate the likelihood of success and to attribute failure to external, uncontrollable events, rather than to their own actions or incompetence (Zacharakis et al., 1999; Zacharakis and Shepherd, 2001; Shepherd et al., 2003). Within this cognitive research stream, there are also studies analyzing the attempts of seed and early stage investors to reduce ambiguity surrounding their investment decisions. For instance, Fiet (1995) focuses on the reliance of formal and informal networks in venture capital decision making. Moesel et al. (2001) and Moesel and Fiet (2001), in their turn, set out to explore how early stage venture capitalists use various sense-making techniques to perceive and interpret diﬀerent forms of order amidst the apparent chaos of the emerging industry segments. Finally, there is a growing stream of literature analyzing how venture capitalists may use various decision aids to improve their decision making quality (Khan, 1987; Zacharakis and Meyer, 2000; Shepherd and Zacharakis, 2002; Zacharakis and Shepherd, 2005). Structuring early stage investments and investment portfolios Prior literature has extensively scrutinized how venture capitalists structure individual venture capital investments and investment portfolios as a safeguard against moral hazard and information asymmetries inherent in early stage investments (Sahlman, 1990; Kaplan

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and Strömberg, 2001; Cumming, 2005b). Prior studies have identified four major mechanisms of risk reduction: 1) contractual covenants included in the venture capital contracts; 2) the use of preferred convertible stock; 3) staged capital infusion; and 4) compensation schemes aligning the interests of venture capitalists and entrepreneurs. First, venture capital contracts typically give investors cash-flow rights, voting rights, board rights, liquidation rights, as well as non-compete and vesting provisions (Sahlman, 1990). Prior studies suggest that these rights are more often granted to early stage investors, fraught with information asymmetries and hold-up problems (Carter and Van Auken, 1994; Kaplan and Strömberg, 2001; Cumming, Schmidt and Walz, 2006). Second, there is some empirical evidence indicating that convertible preferred equity may minimize the expected agency problems associated with start-up and expansion stage investments (for example, Sahlman, 1990; Gompers, 1997; Bascha and Waltz, 2001; Kaplan and Strömberg, 2001; Cumming 2002),4 whereas debt and common stock are more appropriate at the later stages of venture financing (Trester, 1998). Third, staged capital infusion gives investors the option to cut oﬀ badly performing ventures from new rounds of financing (Sahlman, 1990; Gompers, 1995; Gompers and Lerner, 2001), thus minimizing the losses carried by the early stage venture capitalist. Fourth, while both venture capitalists and entrepreneurs receive a substantial fraction of their compensation in the form of equity and options, they also have an additional incentive to maximize the value of the portfolio company. The venture capitalist may also employ additional controls on compensation, such as vesting of the stock option over a multi-year period, making it impossible for the entrepreneur to leave the firm and take his or her shares (Gompers and Lerner, 2001). It is interesting to note that similar compensation schemes contingent on performance, contractual covenants and high levels of monitoring are also applied to mitigate agency problems between venture capitalists and their fund providers (Sahlman, 1990; Robbie et al., 1997; Wright and Robbie, 1998). Venture capitalists may also manage risks on the portfolio level by focusing on particular industries or geographical areas, limiting the size of investments, or by investing in syndicates. For instance, there are studies indicating that venture capitalists prefer less industry diversity and a narrower geographical scope, when dealing with high risk (early stage) investments (Gupta and Sapienza, 1992; Norton and Tenenbaum, 1992). According to Robinson (1987), venture capitalists generally favor a larger number of smaller investments in early stage ventures in comparison to larger investments in more mature portfolio companies. Ruhnka and Young (1987), in their turn, suggest that venture capitalists may elicit risks by distributing their investments across various investment stages. Finally, several authors suggest that the risk sharing motivation for syndication is significantly more important for early stage venture capitalists than for venture capital firms investing in later stages only (Bygrave, 1988; Lerner 1994; Gompers and Lerner, 2001; Lockett and Wright 2001; Lockett et al., 2002; Kut et al., 2005; Cumming, 2006a; Cumming, Schmidt and Walz, 2006). Monitoring and adding value in early stage investments It is argued that venture capital investors may address the problems of asymmetric information not only by intensively scrutinizing firms before their investment decision and structuring their investment portfolios with great care, but also by monitoring their portfolio companies afterwards (Lerner, 1999). As evidence of a more hands-on role of early

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stage investors, several scholars found that they spend more time with their portfolio companies than later stage investors (Barney et al., 1989; Gorman and Sahlman, 1989; Sapienza and Gupta, 1994). In a similar vein, early stage investors are reported to be more eager to require corrective actions, such as changes in management, if the new venture fails to live up to the expectations (Carter and Van Auken, 1994; Hellman and Puri, 2002). However, some contradicting evidence exists suggesting that portfolio companies receive more venture capitalists’ attention as they mature (Gomez-Mejia et al., 1990). In addition, some studies propose that the diﬀerences in the level of venture capital involvement are not stage-related (MacMillan et al., 1988; Fried and Hisrich, 1991; Sapienza, 1992), but depend on a host of other factors, such as the size of the venture capital firm, its level of experience, the size of the investment, the power of the board of directors or the characteristics of the portfolio company (Flynn, 1991; Fiet et al., 1997; Flynn and Forman, 2001). For instance, Sweeting and Wong (1997) demonstrate that venture capitalists adopting a hands-oﬀ approach tend to focus on companies that are well-managed and led by experienced teams with proven track records. In addition to intensive monitoring, early stage venture capitalists may attempt to increase the value of their investment by providing several ‘value-added services’ to their portfolio companies. Several scholars conclude that venture capitalists investing in earlier stages take a more active managerial role in a young firm (Rosenstein et al., 1993; Carter and Van Auken, 1994; Sapienza and Gupta, 1994; Sapienza et al., 1994; Elango et al., 1995; Sapienza et al., 1996). The value-adding activities provided by venture capitalists involve evaluating and recruiting managers after the investment decision, negotiating employment contracts, contacting potential vendors, evaluating product market opportunities, or contacting potential customers (Timmons and Bygrave, 1986; MacMillan et al., 1988; Gorman and Sahlman, 1989; Fried and Hisrich, 1991; Elango et al., 1995; Kaplan and Strömberg, 2001; Hellman and Puri, 2002). Flynn (1991) goes as far as to state that early stage venture capitalists take a leadership role in administrative and strategic responsibilities of a new firm. It seems that the level of early stage venture capitalists’ involvement in value-adding activities is determined by various human capital and fund characteristics: prior consulting, industry and entrepreneurial experience of the venture capitalist contribute to a higher level of value-adding activities. Prior studies also report that investment managers of diversified portfolios and captive funds spend less time with their portfolio companies (Sapienza et al., 1996; Lockett et al., 2002; Megginson, 2004; Knockaert et al., 2006). The active involvement of the venture capitalist in the operations of a new venture seems to matter from a financial point of view (Barney et al., 1994; Flynn and Forman, 2001; Cumming et al., 2005). It has been suggested that the involvement of venture capitalists may help the professionalization of young firms and speed up the commercialization of innovations (Timmons and Bygrave, 1986; Cyr et al., 2000; Engel and Keilbach, 2002; Hellman and Puri, 2002). Venture capital financing may enhance the portfolio company’s credibility in the eyes of third parties, such as suppliers, customers and other investors, whose contributions will be crucial for the company’s success (Megginson and Weiss, 1991; Steier and Greenwood, 1995; Black and Gilson, 1998). Flynn (1995) provides preliminary evidence that the degree of analysis, assistance in the articulation of strategy, and pressure to view issues from a longer term perspective by the venture capitalist are positively associated with the overall performance of a new venture.

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Prior studies also emphasize the importance of the relationship quality between the venture capitalist and the entrepreneur (for example, Fried and Hisrich, 1995). Sapienza and Koorsgaard (1996) highlight the importance of entrepreneurs’ timely feedback of information in building trustful relationships with the investor and securing future funding. Higashide and Birley (2002) argue that conflict as disagreement can be beneficial for the venture performance, whereas conflict as personal friction is negatively associated with success. In a similar vein, Busenitz et al. (2004) report a positive association between new venture performance and procedurally just interventions by venture capitalists. Exit strategies and performance of early stage investments There exists some evidence suggesting that early stage venture capitalists view either trade sales or initial public oﬀerings (Carter and Van Auken, 1994; Murray, 1994; Amit et al., 1998; Black and Gilson, 1998; Das et al., 2003) as their preferred route to exit. Surprisingly enough, very few early stage venture capitalists regard later stage investors as an attractive exit option (Murray, 1994). In their study focusing on the duration of venture capital investments, Cumming and MacIntosh (2001) found that earlier stage deals are likely to be held for a shorter period of time than later stage investments, suggesting significant culling of early stage deals. Several scholars report higher returns to later stage investments in comparison to early stage deals (Murray and Marriott, 1998; Murray, 1999; Cumming, 2002; Manigart et al., 2002; Hege et al., 2003; Cumming and Waltz, 2004). However, early stage investors in the United States tend to outperform their colleagues focusing on later stage deals and investors in other parts of the world. These diﬀerences in performance may reflect the superior ability of the US investors to manage early stage investments (Sapienza et al., 1996) or, alternatively, structural issues related to the minimum viable scale for a technology-based venture capital fund (Murray and Marriott, 1998; Murray, 1999). The performance of the US and European venture capital funds by stage of investment is depicted in Table 10.2. A wealth of studies focuses on the determinants of returns to venture capital investments (for example, Cumming, 2002; Gottschalg et al., 2003; Ljungqvist and Richardson, 2003; Kaplan and Schoar, 2005). However, it is important to note that these studies focus Table 10.2 European and US private equity funds’ pooled internal rates of return (IRR%) by stage of investment in 2003

Stage Early stage Balanced Buyout

Europe 1-Year IRR

Europe 3-Year IRR

Europe 5-Year IRR

Europe 10-Year IRR

US 1-Year IRR

US 3-Year IRR

US 5-Year IRR

US 10Year IRR

1.0 0.5 22.8

8.8 5.7 2.6

5.5 0.9 5.7

0.6 10.3 12.5

38.9 14.7 12.2

7.7 0 2.8

1.5 0.4 1.0

44.7 18.2 8.6

Note: The sample includes funds created in 1980–2003. Source: EVCA/Thomson Venture Economics

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on venture capital funds in general, not on early stage funds in particular. These studies report that: ●

●

●

●

● ● ●

●

specialization exerts a positive impact on returns, possibly due to learning curve eﬀects enjoyed by venture capitalists accumulating superior knowledge in a specific industry sector (Gupta and Sapienza, 1992; De Clerq and Dimov, 2003); successful venture capitalist firms outperform their peers over time, suggesting ‘persistence phenomena’ or the development of core competences that cannot be easily imitated (Gottschalg et al., 2003; Ljungqvist and Richardson, 2003; Cumming et al., 2005; Diller and Kaserer, 2005; Kaplan and Schoar, 2005); the relationship between experience and performance is ambiguous. For instance, Manigart et al. (2002) and Diller and Kaserer (2005) report a positive relationship, Fleming (2004) reports no relationship and De Clerq and Dimov (2003) an adverse relationship between experience and performance; larger funds outperform smaller funds, but only up to a point, suggesting an inverted U-shaped relationship between fund size and performance (Gottschalg et al., 2003; Hochberg et al., 2004; Laine and Torstila, 2004; Kaplan and Schoar, 2005); fast fund growth is negatively associated with performance (Kaplan and Schoar, 2005); the number of portfolio companies per investment manager and performance exhibit an inverted U-shaped curve (Jääskeläinen et al., 2002; Schmidt, 2004); performance is positively associated with the number of endowments and negatively associated with the number of banks investing in the fund (Lerner et al., 2005); and narrow geographical focus is associated with lower performance (Manigart et al., 2002).

It is hardly surprising that various management practices applied over the venture capital cycle have the potential to contribute to the performance of venture capital funds. For instance, the ability to generate a continuous stream of high quality investment opportunities (Ljungqvist and Richardson, 2003; Megginson, 2004) and sharp screening and selection skills (Hege et al., 2003; Schmidt, 2004; Diller and Kaserer, 2005) are reported to lead to superior performance. In a similar vein, a number of factors related to deal structuring, such as the type of contracts (Kaplan et al., 2003), staged financing (Gompers and Lerner, 1999; Hege et al., 2003), convertible securities (Hege et al., 2003; Cumming and Walz, 2004), venture capitalists’ ownership stake (Amit et al., 1998; Cumming, 2002), syndication (Jääskeläinen et al., 2002; De Clerq and Dimov, 2003; Cumming and Waltz, 2004) and acting as a lead investor (Sahlman, 1990; Manigart et al., 2002; Gottschalg et al., 2003), have performance implications. Prior research also emphasizes venture capitalists’ ability to add value in their portfolio companies (Barney et al., 1994; Flynn, 1995; Flynn and Forman, 2001; Diller and Kaserer, 2005) from a financial point of view. In terms of exit strategies, it has been stated that going public is the most profitable exit route for venture capitalists (Black and Gilson, 1998).

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Institutional context and the management of early stage investments Cross-national diﬀerences in the management of early stage investments have received a fair amount of attention in venture capital literature. Prior studies report that such diﬀerences may exist in the way in which the venture capital firms are organized, as well as in fund raising, deal generation, deal screening, investment structure and post-investment activities. On the whole, these institutional diﬀerences may play a major role in determining the ability of early stage investors to shield themselves from risks and profit from their investments. For instance, Megginson (2004) shows that venture capital firms in the United States usually take the form of independent limited partnerships and obtain their funding from institutions, such as pension funds. This structure and larger average fund size oﬀer substantial contracting benefits for investors operating under information asymmetries and uncertainty (Murray and Marriott, 1998; McCahery and Vermeulen, 2004; Söderblom and Wiklund, 2006). Europeans, in their turn, organize their venture capital firms as investment companies or subsidiaries of larger financial groups (Wright et al., 2005). Factors promoting fund raising activities include GDP growth and the growth rate of R&D (Gompers et al., 1998; Jeng and Wells, 2000; Romain and Pottelsberghe, 2004), favorable tax, regulatory and legal environments (La Porta et al., 1997; Gompers et al., 1998; Marti and Balboa, 2000; Da Rin et al., 2005, forthcoming), and government programs facilitating investments in young ventures (Lerner, 2002; Leleux and Surlemont, 2003; Cumming, 2006b, forthcoming). Commitments to early stage ventures are negatively aﬀected by labor market rigidities (Black and Gilson, 1998; Jeng and Wells, 2000; Romain and van Pottelsberghe, 2004), high capital tax gains (Gompers et al., 1998), and, in some cases, the presence of government programs crowding out private venture capital investors (Armour and Cumming, 2004). There is some disagreement among the researchers regarding the role of deep and liquid stock markets. While some researchers argue that venture capital fund raising is boosted by well-functioning public markets that allow new firms to issue shares (Black and Gilson, 1998; Armour and Cumming, 2004; Da Rin et al., 2005, forthcoming), others argue that this positive eﬀect exists only for later stage investments and not for early stage deals (Jeng and Wells, 2000). As the aforementioned determinants of fund raising have mostly been studied in the context of venture capital in general,5 future research should confirm these results for early stage venture capital in particular. It is worth mentioning that the studies focusing on the determinants of funds raised by early stage venture capitalists largely ignore cultural and social factors (Wright et al., 2005). A notable exception is the study by Nye and Wassermann (1999) showing that diﬀering levels of cultural learning contribute to diﬀerent rates of growth of venture capital industries in India and Israel. In a similar vein, cultural factors may play a significant role in either promoting or hindering entrepreneurship, thus aﬀecting the supply of high quality investment opportunities available for early stage venture capitalists (Acs, 1992; Baygan and Freuedenberg, 2000; Hayton et al., 2002; Kenney et al., 2002b). Relative to deal generation, deal screening and valuation, several researchers conclude that venture capitalists in the United States apply a more comprehensive set of criteria for evaluating risks associated with new ventures than their colleagues in other parts of the world (Ray, 1991; Ray and Turpin, 1993; Knight, 1994; Hege et al., 2003). Also the relative importance of evaluation criteria may vary across nations. Americans tend to value

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potential for significant market growth, whereas venture capitalists in transition economies rely on foreign business education or exposure to Western business practices as an important signal of managerial ability. Asian venture capitalists, in their turn, seek personality compatibility when assessing management teams (Ray, 1991; Knight, 1994; Bliss, 1999). In addition, prior studies suggest that venture capitalists in developed markets use external specialists for investment appraisal and apply sophisticated valuation procedures based on standard corporate finance theory. Investors in emerging venture capital industries, in their turn, rely on their own expertise and cash flow methods for valuation and put greater emphasis on information related to product, market and proposed exit (Ray, 1991; Ray and Turpin, 1993; Wright and Robbie, 1996; Karsai et al., 1997; Manigart et al., 2000; Lockett et al., 2002; Wright et al., 2004). Variations in corporate and tax law environments may have implications for the financing structure of venture capital investments (Wright et al., 2005). For example, convertible instruments are more widely used in common law countries than in civil law countries (Cumming, 2002; Cumming and Fleming, 2002; Hege et al., 2003; Kaplan et al., 2003; Cumming, 2005a; Lerner and Schoar, 2005). Kaplan et al. (2003) report that venture capital contracts vary across legal regimes in terms of the allocation of cash flow, board, liquidation and other control rights. However, more experienced venture capitalists all over the world seem to implement US-style contracts regardless of the legal regime. Finally, the motivations for and the use of syndication strategies tend to diﬀer depending on the institutional context (Manigart et al., 2006). Although investors’ monitoring behavior shares many similarities across nations (Ray, 1991; Pruthi et al., 2003; Bruton et al., 2005), there exist some diﬀerences relative to the nature of post-investment relationship between the entrepreneur and the venture capitalist. The active managerial role adopted by the venture capitalist tends to be particularly visible in the US high-tech industries, where many senior partners have become legendary for their skills in finding, nurturing and bringing to market high-tech companies (Megginson, 2004). In line with this reasoning, Sapienza et al. (1996) found that venture capitalists in more developed venture capital markets (the United States and the United Kingdom), are more involved in their portfolio companies and add more value than their colleagues in less developed venture capital markets (France). Hege et al. (2003) and Schwienbacher (2002), in their turn, report that US venture capital firms, in comparison with European firms, are more likely to take corrective actions in their portfolio companies. Unlike Westerners, Asians view capitalist firms and their portfolio as a single collective entity, which reduces the need to manage and control the agency risks (Bruton et al., 2003). This greater relationship orientation stemming from a more collectivistic culture is also reflected in the value-added services provided by venture capitalists while American venture capitalists are more involved in serving as a sounding board to the venture and in financially oriented services, Asian venture capitalists emphasize the eﬀorts to build relationships both inside and outside of the firm. Prior research also reports cross-national variations in preferred exit strategies and the timing of exit (Cumming and MacIntosh, 2003; Cumming, Schmidt and Walz, 2006). For instance, IPOs are reported to be a more common exit vehicle in countries where legal investor protections are strong, whereas buybacks gain importance in countries with a weaker legal framework protecting the interests of investors. The eﬀect of various environmental and institutional factors on fund performance is

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mostly indirect in nature (Söderblom and Wiklund, 2006). However, there is some evidence that overall business cycles, industry cycles and stock market cycles (Gottschalg et al., 2003; Avnimelech et al., 2004; Diller and Kaserer, 2005; Kaplan and Schoar, 2005) directly influence the returns to early stage funds. A factor that also seems to have a major impact on fund performance is the allocation and level of funds. Several researchers show that an increase in the allocation of money exerts a significant negative impact on fund performance (Gompers and Lerner, 2000; Ljungqvist and Richardson, 2003; Hochberg et al., 2004; Da Rin et al., 2005, forthcoming; Diller and Kaserer, 2005). Finally, legal protections available for investors have been reported to contribute to the superior performance of venture capital funds (Armour and Cumming, 2004; Kaplan et al., 2003; Cumming and Walz, 2004; Lerner and Schoar, 2005). To sum up the discussion above, investors in successful early stage venture capital markets (in terms of the volume of and return on investments) tend to be more active in alleviating risks associated with early stage venture capital investments. This more extensive reliance on risk reduction strategies may be explained by the superior skills of investors operating in mature markets and institutional environments with favorable legislations, government policies and tax regimes. It is noteworthy, however, that the very nature of risk, or at least the perception of it, may diﬀer depending on the institutional environment. Therefore, the solutions originating mostly from the Anglo-Saxon context may not be readily applicable in nations with drastically diﬀerent normative, cognitive and regulatory institutions. Conclusions and discussion The purpose of this chapter was to review decades of research on early stage venture capital, basically focusing on two major research themes. The first one describes the diﬀerences between investments in early stage ventures and later stage deals. The second dominant theme identifies several management practices available for early stage venture capitalists exposed to high levels of information asymmetries and related risks. I will first summarize the key findings emerging from these two research streams. Thereafter, I will continue with some theoretical and methodological considerations, as well as suggestions for future research. Summary of key findings Based on the studies discussed above, it is possible to argue that early stage investment targets, investors and funds diﬀer from those involved in later stage venture capital activities. Perhaps most importantly, early stage ventures struggle with challenges associated with new product and market development, building up a competent management team and managing growth, making them more susceptible to market and agency risks than more mature investment targets. The venture capital firms focusing on early stage investments tend to be shielding themselves from these risks by relying on their experience and size. In a similar vein, there seems to be a minimum scale of eﬃciency, after which early stage investments become a viable option for venture capital funds. Early stage venture capital has also been found to flourish in institutional environments enjoying favorable tax, regulatory and legal environments, providing investors with incentives and protection from various market and agency risks. Prior literature suggests that early stage venture capitalists actively seek to reduce the

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risks and uncertainties at every stage of the venture capital cycle. First, prior studies list several criteria along which early stage venture capitalists and entrepreneurs may assess each other’s potential. The most recent literature pays increasing attention to the cognitive processes of venture capitalists in highly uncertain decision contexts. Second, early stage investors may alleviate information asymmetries and risks through contractual covenants included in the venture capital contracts, the use of preferred convertible stock and staged capital infusion, as well as compensation schemes aligning the interests of venture capitalists and entrepreneurs. Venture capitalists may also attempt to control the risks by focusing on particular industries or geographical areas, limiting the size of the investments, or investing in syndicates. Third, early stage venture capitalists typically devote a substantial amount of time to monitoring and value-adding activities in the post-investment phase. Finally, relative to the exits and fund performance, early stage investors are reported to severely under-perform in later stage deals. In a similar vein, American early stage funds enjoy significantly higher returns than their counterparts in Europe. The factors determining the performance of early stage venture capital investments include the characteristics of venture capital firms and funds, the management of the investment process, as well as various macro-economic and institutional factors. Theoretical and methodological considerations Research on early stage venture capital has been conducted by scholars representing many diﬀerent disciplines, most notably finance and economics, entrepreneurship and cognitive psychology. First, finance scholars (for example, Chan, 1983; Amit et al., 1990; 1998; Lerner, 1994; Giﬀord, 1997; Gompers, 1995; 1997; Elitzur and Gavious, 2003; Hsu, 2004) have primarily relied on asymmetric information, signaling and agency theories when trying to explain the nature of the relationship between venture capitalists and early stage ventures. Given this theoretical orientation, the focus tends to be on the dark side of the venture capitalist–entrepreneurship interaction and how venture capitalists may alleviate problems associated with moral hazard and asymmetric information all over the world (for example, Cumming and Fleming, 2002; Hege et al., 2003; Kaplan et al., 2003; Lerner and Schoar, 2005). Second, entrepreneurship scholars have traditionally taken a rather atheoretical approach (for example, Camp and Sexton, 1992; Carter and Van Auken, 1994; Elango et al., 1995; Brouwer and Hendrix, 1998; Balboa and Marti, 2004) or borrowed from ‘Stages of Development Theories’ of new ventures (Ruhnka and Young, 1987; Flynn and Forman, 2001), when describing the global trends in early stage venture capital investments or identifying characteristics distinguishing early stage ventures from later stage deals. However, more recently, entrepreneurship scholars have turned to strategy and sociology literature – drawing mostly on the resource-based theory, procedural justice theory and institutional theory, when analyzing the intricacies of the social relationships in early stage venture capital investments (Fiet et al., 1997; Karsai et al., 1997; Bruton and Ahlstrom, 2002; Bruton et al., 2002; Busenitz et al., 2004; Manigart et al., 2002; Bruton et al., 2005). Unlike the studies conducted by finance scholars, this research stream tends to emphasize more the sunny side of early stage venture capital investments as engines of growth and innovation and the crucial role of venture capitalists as providers of valueadded services to nascent ventures.

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It is important to note that both finance and entrepreneurship scholars emphasize issues embedded in the venture capitalist–entrepreneur relationship and the external environment surrounding nascent ventures. An emerging stream in early stage venture capital research has taken a more introspective view by focusing on the role of cognitive and sensemaking processes of venture capitalists (for example Zacharakis and Meyer, 1998; Moesel and Fiet, 2001; Moesel et al., 2001; Zacharakis and Shepherd, 2001). This shift in focus is hardly unexpected, as cognitive processes are likely to play a crucial role in the reduction of uncertainty and chaos surrounding new ventures. In terms of research methods used, there is relatively little variation in early stage venture capital research. A vast majority of studies reviewed adopt a quantitative approach relying on information derived from surveys or data base data. Only a fraction of papers represents either a purely theoretical or qualitative approach. However, it seems likely that as our need for a more in-depth understanding of early stage venture capital grows, other research methods, such as experiments and ethnographies, will increase in importance in the future. Moving forward: Suggestions for future research After decades of research, our knowledge on early stage venture capital remains limited. For instance, although several scholars have acknowledged the recent declining trend in investments in early stage ventures, we still know very little about the reasons underlying this development. Therefore, future studies should set out to identify changes in the incentive systems and governance structures within the venture capital industry, potentially explaining the relative decline in investments in young ventures. Approaching this question would also necessitate a shift toward more longitudinal research methods than hitherto applied in early stage venture capital research. Second, several studies suggest that the financial needs of early stage ventures might be best addressed by a combination of public funding schemes and informal venture capital (Branscomb and Auerswald, 2002). An interesting area for future research would thus be addressing the complementarities between public funding and early stage venture capitalists (Lerner, 2002) or the synergies between business angel funding and early stage venture capital (Harrison and Mason, 2000). Third, there seem to be significant regional diﬀerences in the operations and performance of early stage venture capitalists. On the one hand, prior literature gives us a reason to believe that the Anglo-Saxon nations in general and the United States in particular have managed to create an institutional environment conducive to early stage venture capital, and therefore, could act as role models for other nations. On the other hand, it is also possible to argue that nations with institutional environments drastically diﬀerent from that of the United States should develop their own versions of early stage venture capital. An interesting avenue for future research would thus involve exploring how this modified version of venture capital should look, operate and help investors deal with risks inherent in early stage investments. Fourth, the greatest challenges associated with early stage venture capital investments are cognitive in nature. These challenges relate to the perceptions of risks and sensemaking processes of venture capitalists facing chaotic environments surrounding new ventures. As Fried and Hisrich (1994) put it, successful venture capitalists are, above all, eﬃcient information processors and producers. This gives us a reason to believe that

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research on early stage venture capital will continue to benefit from borrowing from research on human cognition and information processing mechanisms. Notes 1. The author would like to thank Hans Landström, Mike Wright, and the participants of the Workshop on Venture Capital Policy in Lund for their invaluable comments on the earlier version of this chapter. 2. I used ABI Inform/Proquest, JSTOR, Google Scholar and SSRN electronic databases to identify suitable references. In addition, I reviewed the reference sections of all articles to find more relevant references. The main focus of the literature search was on papers focusing explicitly on early stage venture capital and on articles comparing early stage venture capital to investments in later stage deals. 3. Strictly speaking, there is a distinction between uncertainty and risk: risk is an uncertainty for which probability can be calculated (with past statistics, for example) or at least estimated (doing projection scenarios). However, for uncertainty, it is impossible to assign such a (well grounded) probability (www.wikipedia.org). In this chapter, these two terms are often used as synonyms, reflecting their usage in prior studies. 4. However, Norton and Tenenbaum (1993) and Cumming (2005a; 2006a) found that the use of preferred stock is not more frequent in early stage ventures. 5. The studies reviewed herein focus on the performance of venture capital funds, excluding buyouts. However, these studies do not focus solely on seed, start-up and first stage investments.

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Muzyka, D., S. Birley and B. Leleux (1996), ‘Trade-oﬀs in the investment decisions of European venture capitalists’, Journal of Business Venturing, 11, 273–87. Myers, S.C. (1984), ‘The capital structure puzzle’, Journal of Finance, 39(3), 575–92. Norton, E. and B.H. Tenenbaum (1992), ‘The eﬀects of venture capitalists’ characteristics on the structure of the venture capital deal’, Journal of Small Business Management, 31(4), 32–41. Norton, E. and B.H. Tenenbaum (1993), ‘Specialization versus diversification as a venture capital investment strategy’, Journal of Business Venturing, 8(5), 431–43. NVCA (2005), www.nvca.com/def.html, accessed 4 November, 2005. Nye, D. and N. Wassermann (1999), ‘Patterns of VC evolution: comparing the Israeli and Indian venture capital industries’, Journal of Private Equity, 3(1), 109–28. Parhankangas, A. and H. Landström (2004), ‘Responses to psychological contract violations in the entrepreneur–Venture capitalist relationship: an exploratory study’, Venture Capital, 6(4), 217–42. Pratt’s Guide to Venture Capital Sources (1986), (edited by Jane K. Morris), 10th edn, Wellesley Hills, Massachussetts: Capital Publishing Corporation. Pruthi, S., M. Wright and A. Lockett (2003), ‘Do foreign and domestic venture capital firms diﬀer in their monitoring of investees?’, Asia Pacific Journal of Management, 20(2), 175–204. Ray, D. (1991), ‘Venture capital and entrepreneurial developments in Singapore’, International Small Business Journal, 10(1), 11–26. Ray, D. and D. Turpin (1993), ‘Venture capital in Japan’, International Small Business Journal, 11(4), 39–56. Rea, R.H. (1989), ‘Factors aﬀecting success and failure of seed/start-up negotiations’, Journal of Business Venturing, 4(2), 149–59. Robbie, K., M. Wright and B. Chiplin (1997), ‘The monitoring of venture capital firms’, Entrepreneurship: Theory & Practice, 21(4), 9–28. Robinson, R.B. (1987), ‘Emerging strategies in the venture capital industry’, Journal of Business Venturing, 2(1), 53–77. Romain, A. and B. van Pottelsberghe (2004), ‘The determinants of venture capital: a panel analysis of 16 OECD countries’, Working Paper WEP-CEB 04/015, Université Libre de Bruxelles. Rosenstein, J., A.V. Bruno, W. Bygrave and N.T. Taylor (1993), ‘The CEO, venture capitalists and the board’, Journal of Business Venturing, 8, 99–113. Ruhnka, J.C. and J.E. Young (1987), ‘A venture capital model of the development process for new ventures’, Journal of Business Venturing, 2, 167–84. Ruhnka, J.C. and J.E. Young (1991), ‘Some hypotheses about risk in venture capital investing’, Journal of Business Venturing, 6, 115–33. Sahlman, W.A. (1990), ‘The structure and governance of venture-capital organizations’, Journal of Financial Economics, 27(2), 473–521. Sahlman, W.A. and H. Stevenson (1987), ‘Capital market myopia’, Journal of Business Venturing, 1, 7–30. Sandberg, W.R., D.M. Schweiger and C.W. Hofer (1988), ‘The use of verbal protocols in determining venture capitalists’ decision processes’, Entrepreneurship: Theory & Practice, Winter, pp. 8–20. Sapienza, H.J. (1992), ‘When do venture capitalists add value?’, Journal of Venture Business Venturing, 7, 9–29. Sapienza, H.J. and A.K. Gupta (1994), ‘Impact of agency risks and task uncertainty on venture capitalist–CEO interaction’, Academy of Management Journal, 37(6), 1618–1632. Sapienza, H.J. and A.M. Korsgaard (1996), ‘Procedural justice in entrepreneur–investor relations’, Academy of Management Journal, 39(3), 544–74. Sapienza, H.J., A. Amason and S. Manigart (1994), ‘The level and nature of venture capitalist involvement in their portfolio companies: a study of three European countries’, Managerial Finance, 20, 3–18. Sapienza, H.J., S. Manigart and W. Vermeir (1996), ‘Venture capital governance and value added four countries’, Journal of Business Venturing, 11, 439–69. Schertler, A. (2005), ‘European venture capital markets: fund providers and investment characteristics’, Applied Financial Economics, 15(6), 367–80. Schmidt, D. (2004), ‘Private equity-, stock- and mixed asset-portfolios: a bootstrap approach to determine performance characteristics, diversification benefits and optimal portfolio allocations’, Working Paper, Cepres Center of Private Equity Research, University of Frankfurt. Schumpeter, J.A. (1934), The Theory of Economic Development, Cambridge, MA: Harvard Press. Schwienbacher, A. (2002), ‘An empirical analysis of venture capital exits in Europe and in the United States’, Working Paper, University of California at Berkeley and University of Namur. Shepherd, D.A. and A.L. Zacharakis (2002), ‘Venture capitalists’ expertise: a call for research into decision aids and cognitive feedback’, Journal of Business Venturing, 17, 1–20. Shepherd, D.A., M.J. Armstrong and M. Lévesque (2005), ‘Allocation of attention within venture capital firms’, European Journal of Operational Research, 16, 545–64. Shepherd, D.A., R. Ettenson and A. Crouch (2000), ‘New venture strategy and profitability: a venture capitalist’s assessment’, Journal of Business Venturing, 15, 449–67.

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Shepherd, D.A., A.L. Zacharakis and R. Baron (2003), ‘VCs’ decision processes: evidence suggesting more experience may not always be better’, Journal of Business Venturing, 18, 381–401. Smart, G.H. (1999), ‘Management assessment methods in venture capital: an empirical analysis of human capital valuation’, Venture Capital, 1(1), 59–82. Smith, D.G. (1999), ‘How early stage entrepreneurs evaluate venture capitalists’, Frontiers of Entrepreneurship Research, Wellesley, MA: Babson College. Söderblom, A. and J. Wiklund (2006), ‘Factors determining the performance of early stage high-technology venture capital funds: a review of the academic literature’, Working Paper, Small Business Service, UK. Sohl, J.E. (1999), ‘The early stage equity market in the United States’, Venture Capital, 1, 102–20. Steier, L. and R. Greenwood (1995), ‘Venture capitalist relationships in the deal structuring and post-investment stages of new firm creation’, Journal of Management Studies, 32(3), 337–57. Storey, D.S. and B. Tether (1998), ‘New technology-based firms in the European Union: an introduction’, Research Policy, 26, 933–46. Sweeting, R.C. (1991), ‘UK venture capital funds and the funding of new technology-based businesses: process and relationships’, Journal of Management Studies, 28(6), 601–22. Sweeting, R.C. and C.F. Wong (1997), ‘A UK “hands-oﬀ” venture capital firm and the handling of postinvestment investor–investee relationships’, Journal of Management Studies, 34(1), 84–111. Timmons, J.A. (1994), New Venture Creation: Entrepreneurship for the 21st Century, Homewood, IL: Irwin. Timmons, J.A. and W.D. Bygrave (1986), ‘Venture capital’s role in financing innovation for economic growth’, Journal of Business Venturing, 1(2), 161–77. Trester, J.J. (1998), ‘Venture capital contracting under asymmetric information’, Journal of Banking & Finance, 22, 675–99. Tyebjee, T.T. and A.V. Bruno (1984), ‘A model of venture capitalist investment activity’, Management Science, 30(9), 1051–66. Wright, M. and K. Robbie (1996), ‘Venture capitalists, unquoted equity investment appraisal and the role of accounting information’, Accounting and Business Research, 26(2), 153–68. Wright, M. and K. Robbie (1998), ‘Venture capital and private equity: a review and synthesis’, Journal of Business Finance and Accounting, 25(5/6), 521–70. Wright, M., S. Pruthi and A. Lockett (2005), ‘International venture capital research: from cross-country comparisons to crossing borders’, International Journal of Management Reviews, 7(3), 135–65. Wright, M., K. Robbie and C. Ennew (1997), ‘Venture capitalists and serial entrepreneurs’, Journal of Business Venturing, 12, 227–49. Wright, M., A. Lockett, B. Clarysse and M. Binks (2006), ‘University spin-out companies and venture capital’, Research Policy, 35, 481–501. Wright, M., A. Lockett, S. Pruthi, S. Manigart, H.J. Sapienza, P. Desbrières and U. Hommel (2004), ‘Venture capital investors, institutional context, valuation and information: US, Europe, and Asia’, Journal of International Entrepreneurship, 2, 305–26. Zacharakis, A. and G. Meyer (1995), ‘The venture capitalist decision: understanding process versus outcome’, Frontiers of Entrepreneurship Research 1995, Wellesley, MA: Babson College, pp. 465–78. Zacharikis, A.L. and G.D. Meyer (1998), ‘A lack of insight: do venture capitalists really understand their own decision process?’, Journal of Business Venturing, 13, 57–76. Zacharakis A.L. and G.D. Meyer (2000), ‘The potential of actuarial decision models: can they improve the venture capital investment decision?’, Journal of Business Venturing, 15, 323–46. Zacharakis A.L. and D.A. Shepherd (2001), ‘The nature of information and overconfidence on venture capitalists’ decision making’, Journal of Business Venturing, 16(4), 311–32. Zacharakis, A.L. and D.A. Shepherd (2005), ‘A non-additive decision-aid for venture capitalists’ investment decisions’, European Journal of Operational Research, 162, 673–89. Zacharakis, A., G. Meyer and J. DeCastro (1999), ‘Diﬀering perceptions of new venture failure: a matched exploratory study of venture capitalists and entrepreneurs’, Journal of Small Business Management, 37(3), 1–14.

11 Private equity and management buy-outs Mike Wright

Introduction Management buy-outs and related transactions involve simultaneous changes in the ownership, financial structure and incentive systems of firms. Although buy-outs can be traced back to the eighteenth and nineteenth centuries, the modern phenomenon began to appear in the late 1970s in the US and diﬀused to the UK in the early 1980s (Wright et al., 1991). Buy-outs represent an important part of private equity markets internationally, yet present major challenges that may diﬀer from investing in early stage entrepreneurial ventures (see Chapter 10). In terms of their importance to private equity markets, buy-outs have accounted for major shares of both the volume and value of transactions since the 1980s (Wright et al., 2000a). In many European private equity markets they account for the majority of funds committed annually (EVCA, 2004). Buy-outs have played an important role in the transition from Communism in Central and Eastern Europe from the beginning of the 1990s (Wright et al., 2002a). Buy-outs oﬀered a mechanism to eﬀect transition that would enhance the ownership and control of enterprises where there were strong insider interests and often an absence of external buyers. For similar reasons, further privatization and restructuring activity has seen the spread of buy-outs to Africa (Wright et al., 2000c). Buy-outs are now spreading in significant numbers to Asia in both developed markets that need to restructure, such as Japan and Korea, as well as emerging and transition economies such as China (Wright et al., 2003a). By enabling corporations to restructure, buy-outs have become an important part of the overall mergers and acquisitions market, for example, accounting for the majority of transactions in the UK (CMBOR, 2005). The incentive and monitoring mechanisms they introduce may help to enhance firm performance. These mechanisms, coupled with the lower risk from investing in established firms, have contributed to private equity firms’ buy-out portfolios outperforming other venture capital investment stages (EVCA, 2004; BVCA, 2004). In terms of challenges, buy-outs raise a number of important issues across the private equity investment life-cycle that may diﬀer from those relating to early stage investments. Buy-outs involve more established businesses that reduce some of the problems associated with early stage ventures such as the identification of a new market and the valuation of businesses with little or no cash-flow. However, buy-outs raise challenges that relate, for example, to the identification of ways to generate capital gains in mature businesses, to whether managers of existing businesses can make the transition to ownermanagers and become entrepreneurial, to achieving the appropriate balance of debt and equity financing in structuring transactions, and to the identification of suitable means to obtain capital gains from businesses that may be diﬃcult to exit through an IPO. This chapter examines the issues relating to private equity and management buy-outs. The buy-out literature can be characterized as having two main streams, a finance stream 281

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and an entrepreneurship stream. In the US, buy-outs have traditionally been viewed as a corporate finance phenomenon (Jensen, 1989; 1993). The major focus of much research is on financial aspects relating to buy-outs at the bought out firm level. This research has examined in detail the antecedents of buy-outs and their performance eﬀects. In Europe, buy-outs have tended to be viewed as an entrepreneurial phenomenon with the private equity market having a long-standing involvement (Wright and Coyne, 1985). This chapter seeks to integrate these streams and generate themes for further research. There is relatively little work, however, that considers the whole of the private equity investment life-cycle. Similarly, little work has examined the role of private equity financiers and the managers and entrepreneurs in the bought out companies. The structure of the chapter is as follows. The first section provides an overview of the development of buy-outs, starting with a consideration of definitions of buy-outs. This is followed by a brief elaboration of a framework for analysing the factors leading to the development of a private equity-based buy-out market and a review of the development of the main private equity-backed buy-out markets. The second principal section analyses private equity and buy-outs using a life-cycle perspective. Specifically, this section considers buy-out deal generation and antecedents; screening and negotiation; valuation; structuring; monitoring and adding value; and exit and longevity. Both theoretical perspectives and empirical evidence are considered. Finally, some conclusions are presented and areas for further research outlined. The development of private equity and buy-outs This section begins by defining diﬀerent forms of buy-out. It goes on to outline the factors influencing the development of a private equity-based buy-out market and then summarizes the trends in the international growth of buy-out markets. Definitions of buy-outs In general, buy-outs involve the creation of a new independent entity in which ownership is concentrated in the hands of management and private equity firms, if present, with substantial funding also provided by banks. Private equity firms become active investors through taking board seats and specifying contractual restrictions on the behaviour of management which include detailed reporting requirements. Lenders also typically specify and closely monitor detailed loan covenants (Citron et al., 1997). As shown in Table 11.1, buy-outs may take a number of forms. In a leveraged buy-out (LBO), typically a publicly-quoted corporation or a large division of a group is acquired by a specialist LBO association. In the US, the resulting private company is typically controlled by a small board of directors representing the LBO association, with the CEO usually the only insider on the board (Jensen, 1989; 1993). As the name suggests, these deals are generally highly leveraged, with the LBO association acquiring a significant equity stake. The same institutions may be involved as debt and equity subscribers – under a so-called ‘strip financing’ arrangement – or, alternatively, specialist institutions may be involved with debt instruments ranging from secured loans to junk bonds (Jensen, 1989). By contrast, a management buy-out (MBO) usually involves the acquisition of a divested division or subsidiary or of a private family-owned firm by a new company in which the existing management takes a substantial proportion of the equity. In place of the LBO association, MBOs usually require the support of a private equity firm. The

Private equity and management buy-outs Table 11.1

283

Definitions of buy-outs

Management Buy-out (MBO) Management Buy-in (MBI) Management Employee Buy-out (MEBO) Leveraged Buy-out (LBO) Investor-led Buy-out (IBO) Leveraged Build-up (LBU) Buy-in Management Buy-out (BIMBO)

Existing Management Main Non-Venture Capital Owners Outside Individuals Main Non-Venture Capital Owners Existing Management and Employees Significant Owners Outside LBO Association Main Owners; high debt Venture Capital Firm Initiates Transaction; Management Some Equity Initial Buy-out Used as a Platform to Develop Larger Group By Acquisitions Hybrid Buy-in/Buy-out

former parent may retain an equity stake, perhaps to support a continuing trading relationship. In smaller transactions management are likely to obtain a majority of the voting equity (CMBOR, 2005). MBOs typically involve a small group of senior managers as equity-holders but depending on circumstances equity-holding may be extended to other management and employees, creating a management–employee buy-out (MEBO). MEBOs may occur, for example, where it is important to tie in the specific human capital of the employees or where a firm is widely spread geographically, making direct management diﬃcult, or on privatization where there is a need to encourage trade unions to support the transfer of ownership (for example, in bus services and transportation). A management buy-in (MBI) (Robbie et al., 1992) is simply an MBO in which the leading members of the management team are outsiders. Although superficially similar to MBOs, MBIs carry greater risks as incoming management do not have the benefits of the insiders’ knowledge of the operation of the business. Venture capitalists have sought to address this problem by putting together hybrid buy-in/management buy-outs (socalled BIMBOs) to obtain the benefits of the entrepreneurial expertise of the outside managers and the intimate internal knowledge of the incumbent management. Investor-led buy-outs (IBOs) involve the acquisition of a whole company or a division of a larger group in a transaction led by a private equity firm and are also referred to as bought deals or financial purchases. The private equity firm will typically either retain existing management to run the company or bring in new management to do so, or employ some combination of internal and external management. Incumbent management may or may not receive a direct equity stake or may receive stock options. IBOs developed in the late 1990s when private equity firms were searching for attractive deals in an increasingly competitive market and where corporate vendors or large divisions were seeking to sell them through auctions rather than giving preference to incumbent managers. Leveraged build-ups (LBUs) involve the development of a corporate group based on an initial buy-out or buy-in which serves as a platform investment to which are added a series of acquisitions. LBUs developed as private equity firms sought new means of generating returns from buy-out type investments. The initial platform deal may need to be of a suﬃciently large size for it to attract the management with the skills and experience to grow a large business through acquisition. LBUs may be attractive in fragmented

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industries with strong demand prospects. The potential problems with LBUs relate to the identification, purchase and subsequent integration of suitable acquisition candidates. Factors influencing the development of a private equity-based buy-out market Wright et al. (1992) develop a framework to examine the factors influencing the diﬀerential development of management buy-out markets. They identify three main factors that need to be present for a buy-out market to develop: ●

●

●

The generation of deal opportunities is likely to be heavily influenced by both the supply of deal flow from diﬀerent vendor sources and the demand for private equity in terms of the willingness of managers to take risks and their willingness to buy enterprises. The infrastructure to complete transactions includes sources of funding both in respect of private equity and the availability of senior and mezzanine debt. It also covers the nature of legal and taxation regimes, including corporate reporting regimes, and the existence of advisors who can both identify and negotiate buy-outs. The existence of suitable exit routes comprises the availability of stock markets, mergers and acquisitions markets and the scope for recapitalizations through secondary buy-outs.

Using this model, Table 11.2 provides an illustrative comparative synthesis of the factors influencing the development of private equity-based buy-out markets in UK, Germany, Central and Eastern Europe (CEE) and Japan which represent diﬀerent institutional contexts. A detailed comparison of the factors influencing the development of all markets is beyond the scope of this chapter (for further discussion see Wright et al., 1992; 2003a; 2004; 2005). Panels A and B in Table 11.2 relate to the generation of deal opportunities. Panel A illustrates the important diﬀerences between these countries in terms of the supply of buyout opportunities. For example, in the UK the strongest supply of opportunities was the restructuring of diversified groups, with going private transactions becoming more important latterly. In contrast, in Germany the need to deal with succession problems in family-owned firms was relatively more important. In CEE, the transition from communism initially created opportunities to privatize state-owned assets. In Japan, the need to restructure the keiretsus provides major scope for divestment buy-outs. Panel B examines the demand side and in particular emphasizes diﬀerences in attitudes to entrepreneurial risk and the willingness of management to undertake a buy-out. The most notable distinction is that in the UK these factors were considerably more positive than in the other countries, but some change in attitudes there is noted. Panel C relates to the infrastructure to complete deals. Again, the UK has more developed private equity and debt markets, better intermediary networks and more favourable legal and taxation frameworks than in continental Europe. It is notable that in the other countries, changes are underway to make this infrastructure more favourable. These changes reflect the pressures from the potential supply of deals to enable industrial restructuring to take place noted in Panel A. Finally, Panel D relates to the existence of suitable exit routes and their importance for private equity firms to realize their gains in buy-out investments. There are notable

Private equity and management buy-outs

285

Table 11.2 Comparison of factors aﬀecting MBO market development in Western Europe, CEE and Japan Panel A: Supply of opportunities Supply of opportunities • • • • • • •

Need to deal with family succession problems Need to restructure diversified groups

UK

Germany

CEE

Japan

Moderate need

High need

Low need

Moderate

Becoming established from mid-1990s

Increasingly established in early 2000s

Substantial and increasing from 2000

Former GDR apart, relatively little

Bulk of privatizations completed

Established patterns throughout period • Need to privatize Well established • state-owned programme • companies from 1980s; now complete

• • •

Scope for ‘going- Large stock private’ market; few transactions initial deals now significant • Development Highly developed • stage of M&A • markets

Relatively small number of quoted companies Becoming active

Low, slowly gaining momentum under the Koizumi Administration Many candidates; Moderate but specific growing since opportunities 2003 must grow Relatively active Active in light of need for restructuring

Panel B: Demand for private equity Demand for private equity • • • • •

Attitude to entrepreneurial risk Willingness of managers to buy

UK

Germany

CEE

Japan

Was very positive from early 1980s High

Traditionally low, changing slowly Starting to develop

Positive and growing

Traditionally very low; very slow change Increasing in light of frustrations in larger groups & perceived greater rewards available

High, but lacking financial means

Panel C: Infrastructure to complete deals Infrastructure to complete deals

UK

Germany

CEE

Japan

• •

Grew rapidly from early

Traditionally small & not

Small but developing

Significant recent entry of

Private Equity and Venture

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Table 11.2 (continued) Panel C: Infrastructure to complete deals (continued) Infrastructure to complete deals

•

UK

Germany

Capital market

1980s

Supply of debt

High

MBO orientated Tradition of high leverage

• Intermediaries • network • Favourability of • legal framework

Highly developed Favourable

• •

Favourable

Favourability of taxation regime

Fragmented Moderately favourable

Reforms in progress

CEE

Japan funds for MBOs

Low but growing

Highly developed Favourable

Moving to favourable with EU reforms

Banks undergoing major restructuring but buy-outs seen as attractive option Quite developed Recent positive changes in buyout specific aspects; eﬀorts to increase flexibility Reforms in progress

Panel D: Realization of gains Realization of gains

UK

Germany

CEE

Japan

•

Stock markets

New issues sparse; secondary tier market closed

Growing domestic capital pool and appetite

Recent development aiding buy-out exit

•

Trade sales

Receptive to private equity cos. From mid-1980s; now more diﬃcult Highly active

M&A market developing Possible route

Highly active

Active

Possible exit route

Beginning to appear

• Secondary • buy-outs/ • restructuring Source: CMBOR

Increasing interest

Private equity and management buy-outs

287

diﬀerences in the role of stock markets in facilitating IPOs. However, even developed stock markets provide limited opportunities to exit buy-out investments, unless they are larger, fast growing businesses. Accordingly, acquisitions markets assume an important role to enable businesses to be sold to other corporations. As many corporations begin to complete their restructuring and as markets become more concentrated and global, there is less scope for the trade sale exit route, especially for smaller deals. This shift has seen the emergence of the secondary buy-out or buy-in where an initial deal is sold to another private equity firm enabling the first to achieve an exit. This option is important in the more developed UK market but as the other markets become more mature and need to seek exits, the ability to achieve a secondary buy-out may be useful in an environment of relatively weak stock and corporate acquisition markets. Trends in the development of private equity-based buy-out markets In this section, the development of private equity-based buy-out markets in diﬀerent countries is discussed. Buy-outs in the US Although buy-outs were present in the US during the 1960s and 1970s, the major period of growth was in the 1980s with the taking private of listed corporations a prominent feature (Figures 11.1 and 11.2). The US economy of the 1980s was characterized by extensive (hostile) corporate takeovers and restructuring. Jensen (1991) argues that during this period, LBOs and MBOs functioned as the necessary catalyst for change in ineﬃcient conglomerate firms. The US market developed with the greater use of senior and mezzanine debt than in Europe and a concentration on mature sectors with low investment needs. The existence of a quoted market for high yield debt enabled very large transactions to be completed and allowed LBO specialists and

200 Value $bn

180 160 140 120 100 80 60 40 20 0 1988 Figure 11.1

1990

1992

1994

Value of LBOs in the US

1996

1998

2000

2002

2004

288

Handbook of research on venture capital 900 number

800 700 600 500 400 300 200 100 0 1988 Figure 11.2

1990

1992

1994

1996

1998

2000

2002

2004

Number of LBOs in the US

management teams to compete with corporate acquirers (Kaufman and Englender, 1993; Baker and Smith, 1998). The culmination of the 1980s LBO wave was associated with many bankruptcies and fierce public and political resistance (anti-takeover legislation) such that activity slowed abruptly (Kaplan and Stein, 1993). From 1997 onwards, there was a modest rise in both public to private (PTPs) and divestment buy-outs in the US, with a sharp increase taking place in 2003 to 2005 in both value and volume. The concept became more associated with seeking growth opportunities than with cost reduction and asset stripping as previously (Kester and Luehrman, 1995). Correspondingly, private equity firms have also emerged as more important financiers in the US buy-out market. Since 2000, PTPs were initially motivated by the decline of the stock markets which seems to make the sale of public equity too costly as a source of funds. The implementation of the Sarbanes-Oxley Act which tightened disclosure requirements for listed corporation following corporate governance concerns in the wake of the Enron scandal is said to increase the costs of a listing substantially. The level of buy-outs of private companies is very low in the US compared to most other countries. Buy-outs in the UK Wright et al. (2000a) identify four phases in the development of the UK buy-out market. The first phase involved initial market development in the early 1980s. In the context of deep recession, many deals involved failed firms or firms restructuring to avoid failure. Relaxation of the prohibition on firms providing financial assistance to purchase their own shares in 1981 reduced the barriers for lenders to obtain security for the funds they advanced. The second phase involved rapid market growth from the mid-1980s to the end of the decade. Buy-outs were increasingly the result of considered refocusing strategies and a first peak was reached in 1989. Deal numbers rose throughout the 1980s up to 1990. The advent of specialist private equity and mezzanine funds together with entry by US banks from the mid-1980s helped fund

Private equity and management buy-outs

289

this development. The shift to buy-out funds reflected a need for specialized managers who can provide professional monitoring and advice. In addition, funds enabled larger deal sizes to be completed than were typically feasible with straight captive funding by parent banks or insurance companies. Further, the raising of funds by former captives (to create semi-captives) provides a mechanism to tie executive remuneration more closely to returns from investment, which may not be possible within an overall bank/insurance company corporate remuneration structure. The third phase involved the collapse of large deals and resurgence of deals involving distressed firms in the recession of the early 1990s. The ending of the recession in 1994 saw the emergence of a fourth phase involving rapid growth in market value, which reached a new peak in 2000. Greater focus on larger transactions by market players saw deal numbers fall. Beyond the period covered by Wright et al. (2000a), the years after 2000 marked a major reassessment of the market in the wake of the collapse of the dot.com boom and its wider repercussions. In contrast to the US, divestments from larger groups have been more important sources of buy-out in the UK. Toms and Wright (2005) attribute this diﬀerence to a number of factors relating to financing availability and taxation diﬀerences. In the UK, both buy-outs involving divestment and those involving family-owned firms have become less important in recent years. Correspondingly, secondary buy-outs and public to private buy-outs in particular became more important from the mid-1990s. The lack of liquidity and the need for expansion capital as a consequence of the cut-oﬀ of institutional equity finance, is argued to have pressured small listed companies to respond to advances by private equity firms. However, this is only part of the explanation as increasingly larger corporations are being targeted (CMBOR, 2005). Continental Europe The continental European buy-out market was generally slower to develop but some countries saw more active buy-out markets much earlier than others, such as the Netherlands and Sweden (Tables 11.3a and 11.3b) (Wright et al., 1991). The French market began to develop from the mid-1980s as concerns about succession in family businesses led to the introduction of fiscal incentives to undertake buy-outs. Market growth was also fuelled by a change to a more positive entrepreneurial culture towards buy-outs. The French private equity industry grew rapidly from the mid-1980s, with lawyers particularly playing an important role in the diﬀusion of the buy-out concept. Development of the Second Marché and the Nouveau Marché enhanced the scope for the realization of buy-out investments although partial sales have provided a frequent realization route for investors. Buy-out activity could be identified in Germany in the early 1980s, but it was only from the early 1990s that the market began to show significant growth leading to a peak in 2000 before market value halved the following year. In contrast to the UK and France, the willingness of German managers to undertake buyouts has traditionally been low but is changing as the growth of corporate restructuring has significantly reduced managerial security of tenure. The infrastructure to complete German deals was for a long time less than favourable – few intermediaries, an underdeveloped private equity market and high rates of taxation. Many of these restrictions did not begin to ease until the mid-1990s, such as relaxation of the capital gains tax regime relating to share disposals. Stock markets in Germany have traditionally been less developed than in the other two countries.

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Table 11.3a

Number of buy-outs/buy-ins

Country Name

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

4 2 7 21 95 79 7 12 59 6 8 14 14 45

6 11 14 25 115 73 9 23 56 7 5 13 16 53

7 10 16 33 137 97 9 25 61 6 3 23 21 65

5 19 13 16 155 79 15 33 74 4 6 39 23 51

4 16 18 19 147 51 9 42 65 8 6 30 33 56

13 18 18 15 128 66 12 29 78 7 5 28 24 54

7 25 11 23 126 90 16 17 59 9 1 37 48 50

17 24 18 29 123 102 19 38 60 12 6 42 25 35

12 20 12 28 142 104 14 43 74 16 5 51 23 30

14 36 16 27 150 110 9 43 68 11 3 33 39 28

Total (CE) UK

373 598

426 646

513 707

532 688

504 653

495 614

519 638

550 628

574 699

587 686

Total (inc UK)

971

1072

1220

1220

1157

1109

1157

1178

1273

1273

2002

2003

2004

Austria Belgium Denmark Finland France Germany Ireland Italy Netherlands Norway Portugal Spain Sweden Switzerland

Source: CMBOR/Barclays Private Equity/Deloitte

Table 11.3b

Value of buy-outs/buy-ins (€m)

Country Name

1995

1996

1997

1998

1999

2000

2001

Austria Belgium Denmark Finland France Germany Ireland Italy Netherlands Norway Portugal Spain Sweden Switzerland

56 14 54 189 1424 1208 172 271 857 18 344 241 685 712

68 147 388 723 2189 1704 116 1115 988 316 154 227 700 1276

128 414 263 455 5250 3523 97 3115 1059 181 64 374 1551 2426

95 823 269 559 6198 5313 258 695 3435 23 84 861 928 1347

680 2595 2165 1085 8375 4660 1475 2714 2901 226 206 1713 2926 1013

734 337 1313 675 6448 15076 259 2550 1739 1004 83 944 3164 1772

47 150 303 88 1744 517 1448 2266 498 1391 848 335 1047 460 1039 977 6405 15550 8768 11878 7500 8121 11578 17912 5021 4918 779 935 737 3428 7770 2472 4428 1793 4958 6936 1371 142 301 427 2 26 54 8 1530 2069 970 2791 3000 1116 2223 1813 715 2764 864 1327

Total (CE) UK

6245 10111 9012 12602

18900 20888 32734 17109 23265 26750

36098 34045 42445 41903 50165 38339 31334 24823 23518 30074

15257 22713

36009 44153 59484

74437 65379 67268 65421 80239

Total (inc UK)

Source: CMBOR/Barclays Private Equity/Deloitte

Private equity and management buy-outs Table 11.4a

291

Continental European buy-outs/buy-ins by source: number of deals

Type

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Family & Private Foreign parent Local parent Privatization Public buy-in Public to Private Receivership Secondary Buy-out Unknown

87 56 149 16 0 2 16 5 42

96 63 153 8 2 8 22 7 67

125 73 203 8 3 8 14 10 69

167 74 162 9 3 5 10 22 80

126 69 168 4 1 31 11 29 65

117 69 176 4 8 20 8 30 63

92 96 210 3 2 14 11 30 61

88 102 198 3 2 13 43 29 72

114 99 188 4 2 18 21 61 67

136 85 218 1 2 10 14 68 53

Total

373

426

513

532

504

495

519

550

574

587

2003

2004

Source: CMBOR/Barclays Private Equity/Deloitte

Table 11.4b Type

Continental European buy-outs/buy-ins by source: value (€m) 1995

1998

1999

6867 3616 6741 1259 204 477 85 654 984

5686 2508 3496 4314 4025 6695 5059 5584 4676 3925 4253 3965 13456 14945 16176 18575 18236 16340 387 1092 97 2441 989 4 32 904 173 237 571 1070 5248 6204 7502 6676 3788 7928 85 79 58 1688 945 105 1934 3709 1376 4066 8413 13054 849 1073 491 523 683 1004

6244 10110 18900 20887

32736 36098 34045 42445 41903 50165

Family & Private 1473 Foreign parent 1144 Local parent 2784 Privatization 226 Public buy-in 0 Public to Private 47 Receivership 159 Secondary Buy-out 71 Unknown 340 Total

1996 2870 940 4430 238 10 259 203 360 800

1997 5503 2865 5898 2289 121 286 93 1264 581

2000

2001

2002

Source: CMBOR/Barclays Private Equity/Deloitte

The overall European trend in buy-out vendor sources is shown in Tables 11.4a and 11.4b. In France, deal opportunities initially arose from a need to sell businesses by the owners of family firms facing succession problems. Succession and portfolio reorganization issues in the large number of family-controlled listed companies in France also contributed to a marked growth in buy-outs from this source. Divestments from corporations have now become a major part of the French private equity market associated with growing competitive pressures on French industry and increasing focus on corporate governance and shareholder value. Reluctance by founders of small and medium sized firms in countries like Germany, Spain and Italy both to let go and to sell to private equity firms has restricted market growth. Buy-outs from family firms have become relatively less important as divestments have become more important alongside secondary buy-outs. The European market for PTP transactions is still small, in part because Continental European countries have fewer

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listed companies. Culture may also be important, with managers in some countries wishing to avoid the burden of a listing in the first place while in others managers may be too proud of their listing to even rationally consider going private (CMBOR, 2002). Buy-outs worldwide The buy-out concept has also spread to Japan as the country faced major problems of corporate reorganization in the light of macro-economic problems. The country saw occasional buy-outs during the early 1990s but 1998 marked the real birth of the market. The market continued to grow from 2000, and by 2003 67 deals were completed with the total value increasing almost five-fold over the previous year to 520 billion yen (€4200 million). Divestments by Japanese corporations have consistently provided the largest source of buy-outs to date. An important development from late 2000 was the appearance of buy-outs of whole listed companies. Buy-outs of failed firms also contribute an important element of the market being facilitated by the establishment of the Civil Rehabilitation Law in 2000, which provided a more flexible in-court corporate rescue scheme to help deal with the problem of distressed firms resulting from the country’s macro-economic diﬃculties. Buy-outs of privately-owned (family) firms have also increased in relative importance. Despite these growth trends, the maturity of diﬀerent buy-out markets varies quite markedly. An indicator of relative market maturity is the ratio of the value of buy-out transactions to a country’s GDP across Europe (Figure 11.3). The UK is by far the largest single buy-out market as a proportion of GDP, while the French and German markets fare less well compared to their overall buy-out market size. Most notably, Spain and Italy as relatively large economies are seen to have very undeveloped buy-out markets. Summary This section has shown the heterogeneity of the buy-out concept and demonstrated its applicability to diﬀerent firm and country contexts. The heterogeneity of market development shown in Figure 11.1 strongly reflects the impact of the diﬀerences in the factors influencing the development of buy-out markets outlined earlier in the section. The pattern of individual market development over time suggests that changes in these factors do help to stimulate market growth. Those countries with low buy-out market value to GDP ratios may need to consider how some of these factors can be relaxed to facilitate the development of buy-out markets to address needs for restructuring corporations and eﬀecting ownership transition in family firms. The buy-out life-cycle To examine the issues relating to private equity and management buy-outs, we adopt a life-cycle perspective of the buy-out process (Wright and Robbie, 1998). Essentially, the life-cycle perspective involves the deal generation; screening and negotiation; valuation; structuring; monitoring and adding value; and exiting and longevity. We discuss each of these stages in the life-cycle in turn. The discussion encompasses examination of buy-outs of listed firms that are taken private and buy-outs of privately-owned firms. Buy-out deal generation and antecedents Buy-out deal opportunities which developed in the 1980s were linked to agency cost problems and a failure of firms’ internal control mechanisms (Jensen, 1993). In particular, the

Private equity and management buy-outs

293

UK Netherlands Germany Belgium France Finland Sweden Ireland Switzerland Spain Norway Italy Denmark Austria Portugal 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 2004

2003

2002

Source: CMBOR/Barclays Private Equity/Deloitte and OECD Statistics

Figure 11.3

Buy-outs as a percentage of GDP

multi-divisional firm was argued to be failing to deliver shareholder benefits (Thompson and Wright, 1988). Although the multi-divisional firm was hypothesized to reduce managerial discretion, many firms nominally structured in this way in practice lacked the control and incentive mechanisms that were conceptually necessary to generate performance improvements (Hill, 1985). Moreover, the comparative advantage of the internal capital market, a central feature of resource allocation in multi-divisional firms, was argued to have declined with improvements in the eﬃciency of external markets (Bhide, 1992).

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Jensen (1989) argued that these problems were particularly acute in mature businesses which generated free cash flows since these firms would tend to engage in unprofitable diversification rather than disgorge the cash in abnormally large dividends. This diversification may be beneficial to managers remunerated on the basis of firm size but not for shareholders. Similarly, a multi-product firm with satisfactory overall cash flow and weak governance may experience considerable inertia in taking decisions to reorganize its activities in line with changing market conditions (Jensen, 1993). These situations generated the conditions for buy-outs to improve eﬃciencies. First, reconcentration of equity in the hands of insiders and/or with private equity firms with a close association with the new firm provides the incentive to seek profitable opportunities. Second, private equity firms become active monitors, unlike passive shareholders in a listed corporation, and have the specific skills to undertake this monitoring. Third, the large-scale substitution of debt, quasi-debt and quasi-equity, for ordinary equity in the financing of the buy-out carries a commitment to meet servicing costs which reduces managerial discretion and places pressure on management to perform. Fourth, management’s equity stake may also be based on performance outcomes, according to a performancecontingent contract or ratchet mechanism (Thompson et al., 1992). Finally, where there is a trading relationship with a former parent, a divestment buy-out may have an increased incentive to perform where it is heavily dependent on its former parent and where the former parent retains an equity interest (cross-holding) (Wright, 1986). The failure of internal control systems may also be seen in more innovative firms. In large, integrated diverse organizations, bureaucratic measures may be adopted to try to ensure performance but these measures may restrict experimentation and constrain innovative activity (Francis and Smith, 1995). Managers in the pre-buy-out situation thus face investment restrictions from headquarters, particularly where their firms are peripheral to the main product line of the parent company (Wright et al., 2001). These problems may be eased after the buy-out. Instead of obeying orders from headquarters that block innovation and investment in order to optimize the goals of the diversified parent company, the buy-out creates discretionary power for the new management team to decide what is best for the business, how to organize and lead the company, and how to set up a business plan that is most profitable for themselves and the firm (Wright et al., 2000b; 2001). Several further arguments have been advanced to explain buy-outs, particularly those involving the taking private of listed corporations. First is the tax hypothesis. As the vast majority of PTP transactions take place with a substantial increase in leverage, the increase in interest deductions constitutes an important source of expected wealth gains. Interest tax deductibility on the new loans constitutes a major tax shield increasing the pre-recapitalization value. Second is the transaction cost hypothesis associated with the direct costs of maintaining a stock exchange listing (DeAngelo et al., 1984). The transaction costs hypothesis suggests that the wealth gains from going private are largely the result of the elimination of the direct and indirect costs associated with maintaining a stock exchange listing. Third is the defence against hostile takeover hypothesis which suggests that the premiums in PTPs reflect the fact that the management team may intend to buy out the other shareholders in order to insulate itself against an unsolicited takeover. Lowenstein (1985) reports that some corporations have gone private via an MBO as a defensive measure against a hostile takeover threat.

Private equity and management buy-outs

295

Fourth is the undervaluation hypothesis which states that when the pre-transaction firm’s stock is underperforming, the management or an LBO specialist are able to pay higher premiums in a PTP transaction as they are expected to create additional shareholder value once the firm is private. There may be asymmetric information between management and outsiders about the maximum value that can be realized with the assets in place. Management with superior private information may perceive that the share price is undervalued in relation to the true potential of the firm. This problem may be exacerbated where listed corporations find it problematical to use the equity market to fund expansion, as it may be diﬃcult to attract the interest of institutional shareholders and fund managers. The lack of interest in such shares creates illiquidity and implies that they are likely to remain lowly valued which provides an impetus to go private. Lowenstein (1985) argues that management may employ specific accounting techniques to depress the pre-announcement share price, such as manipulating dividends and deliberately depressing earnings. Fifth is the wealth transfer from other stakeholders hypothesis. A firm going private can transfer wealth from bondholders to stockholders by issuing debt of higher or equal seniority. In PTPs, the third mechanism in particular can lead to substantial bondholder wealth expropriation. Sixth, potential financial distress costs may deter firms from going private and hence the expected benefits associated with this form of organizational structure may not be realized (Opler and Titman, 1993). Much of the evidence relating to deal generation concerns the antecedents to the taking private of listed firms in the US. US studies of the role of free cash flow in the decision to go private have produced mixed results. Lehn and Poulsen (1989) and Singh (1990) report that firms going private have greater free cash flow than firms remaining public, but lower sales growth. However, Kieschnick (1998) reworked Lehn and Poulsen’s sample using a weighted logistic regression and found free cash flow and sales growth to be insignificant. In addition, Opler and Titman (1993) find that leveraged buy-outs are more likely to exhibit only the combined characteristics of low Tobin’s Q and high cash flow than firms remaining public. Further, Halpern et al. (1999) also find no evidence to support the free cash flow hypothesis. This US evidence, therefore, suggests that going private is not being driven by the need to return free cash to the shareholders. Kaplan (1989b) estimates the tax benefits of US PTPs to be between 21 per cent and 72 per cent of the premium paid to shareholders to take the company private for the first half of the 1980s. Singh (1990) reports that US MBOs were significantly more under takeover pressure prior to the MBO than a sample of matched firms. DeAngelo (1986) finds no evidence of systematic manipulation of pre-buy-out accounting data by incumbent management. Wu (1997) does show evidence consistent with the view that managers manipulate earnings downwards prior to the MBO proposal. Asquith and Wizman (1990), Cook et al. (1992) and Warga and Welch (1993) show that bondholders with covenants oﬀering low protection against corporate restructuring lose some percentage of their investment. UK evidence indicates that firms that go private through a buy-out are more likely than those that remain listed to have higher CEO ownership, higher institutional ownership and more duality of CEO and chairman (Weir et al., 2005a). These firms did not have excess free cash flows or face a greater threat of hostile acquisition but they did have lower growth opportunities. In a related study, Weir et al. (2005b) find that managers’ perception that the market undervalued the company was significantly associated with going

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private. Renneboog et al. (2007) find for a sample of UK PTPs completed between 1997 and 2003 that the main sources of the shareholder wealth gains are undervaluation of the pre-transaction target firm, increased interest tax shields and incentive realignment. In contrast, they find that an expected reduction of free cash flows does not determine the premiums nor are PTPs a defensive reaction against a takeover. The buy-out concept may also apply to private family-owned firms. There is increasing recognition that there may not be suitable family members willing or able to take on the ownership and management of the business (Wright et al., 1992; Bachkaniwala et al., 2001). In mature private family firms, growth opportunities may have been exhausted and founders somewhat detached from the running of the business as they begin to pursue other interests. Second tier management may possess greater information about the running of the business and possess the managerial skills to introduce needed professional management but not be in a position to take appropriate decisions (Howorth et al., 2004). A management buy-out may be a means of eﬀecting succession and be acceptable to the founder as the best way to preserve their psychic income through maintaining the company’s independent identity and culture, as well as continuing to be involved in the business. However, dominant founders may not have developed strong second tier management who could become owner-managers. If this is the case, a management buy-in may be needed (Robbie and Wright, 1996). Screening and negotiating buy-outs In appraising potential investments, private equity firms are faced with an adverse selection problem (Amit et al., 1993). In contrast to early stage owner-managed ventures, private equity firms considering funding management buy-out proposals need to take their decisions on the basis of observed managerial performance in post, expectations about whether improving managerial incentives will improve performance and management’s willingness to take on the risk of a buy-out in order to secure the fruits of their human capital. Management buy-ins typically focus on enterprises which require turnaround and restructuring, but as the buy-in entrepreneur comes from outside there are problems of asymmetric information, both in relation to their true skills and because it has not been possible to observe the manager in post. These problems create uncertainty for the private equity financier about whether the deal in which they are investing is what they thought it was, which may be diﬃcult to address before they commit their funds. In a management buy-out, private equity firms may be guided by incumbent management’s deep knowledge of the business (Birley et al., 1999). Management may not necessarily have clear incentives to reveal truthful information since they may either wish to underplay problems in their anxiety to make the deal appear viable or overplay problems in order to reduce the transaction price. However, detailed probing may enable the private equity firm to uncover major diﬃculties and approach an accurate assessment of the true state of aﬀairs. By investing in insiders, private equity firms may be able to reduce uncertainties more than is the case for management buy-ins. Management buy-in entrepreneurs may be able to reduce some of the problems of asymmetric information where they have detailed knowledge about the industry sector but even here, information availability for private firms may be limited (Robbie and Wright, 1995). In such cases they may be able to use personal networks to carry out informal verification about the state of the target enterprise. These problems may arise in both buy-outs of listed corporations and those involving private firms.

Private equity and management buy-outs

297

One way to improve the chances of success in negotiating a buy-out of a listed corporation is to seek irrevocable commitments from significant shareholders to accept the bidder’s bid before the oﬀer is made public. Gaining these commitments means that the bidder is sending a signal to other non-committed shareholders that the deal is a good one. The announcement of substantial irrevocable commitments may also make other potential bidders less likely to enter the contest with an alternative bid. The initial commitment ensures that, without any higher alternative bid, the agreement to sell the share becomes binding. Private equity bidders for listed companies may use irrevocable commitments in an attempt to ensure the success of a PTP proposal and reduce the costs associated with failure, as well as avoiding a bidding contest that would potentially reduce their returns from the investment. Weir et al. (2007) find that those proposing a management buy-out (MBO) are more likely to gain the backing of other shareholders the greater the bid premium and the more reputable the private equity backer. Informational asymmetries between vendors and purchasers may impact buy-outs involving private family firm succession. Flows of information may impact both succession planning and buy-out negotiation process. A number of negotiation issues are raised, which centre around information asymmetries between founders and managers, as well as the extent to which negotiations are dominated by one or other party or whether they are collaborative (Howorth et al., 2004). Scholes et al. (2005) find lower information asymmetry problems if family firm vendors and the existing management team are equally involved in succession planning. However, they found that negotiations were less likely to involve a mutually agreed price where the succession process was driven by the vendor. Valuation Private equity investors need to value potential deals in order to consider whether they are likely to achieve their target rates of return. Private equity firms typically use a combination of price/earnings multiples and discounted (free) cash flow multiples (Manigart et al., 1997). Other things being equal, the higher the premium that purchasers pay, the more that needs to be done post-deal to achieve target rates of return. At the same time, vendors, seeing that the private equity and management purchasers are undertaking a buy-out as they believe they can enhance performance, may seek to capture some of these future gains by seeking a higher price before being persuaded to sell their shares. For listed corporations, the value vendors place on a business is reflected in the share price response to the announcement of an attempt to take a firm private. A series of US studies (DeAngelo et al., 1984; Kaplan, 1989a; Lehn and Poulsen, 1989; Marais et al., 1989) finds a large abnormal gain for the target’s shareholders when a going private LBO deal is announced. Kaplan (1989a) reports a median abnormal gain of 42 per cent for 76 US buy-outs in the period 1980–86. Similar stock market studies of voluntary divestments as LBOs by diversified companies (for example Hite and Vetsuypens, 1989; Markides, 1992) reveal small but significant positive announcement eﬀects. This US evidence is also reflected in the UK. Renneboog et al. (2007) examine the valuation of buy-outs of listed corporations in the UK during 1997–2003 and find that the share price reaction to the PTP announcement is about 30 per cent. There is the possibility of systematically lower premiums where insiders involved in the buy-out take action to reduce the apparent valuation in order to buy out at a price that is advantageous to themselves. This could be passive, where managers simply exploit asset

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prices which appear (to them) to be too low or it could be the result of some deliberate misrepresentation or concealment by them. Evidence on the former has been obtained from abnormal stock market returns for announced and then withdrawn LBOs (DeAngelo et al., 1984; Marais et al., 1989). Smith (1990) argues that abandoned, hiddeninformation buy-outs should show the same subsequent performance gains as completed ones and hence the same market response, assuming the buy-out is solely motivated by insider information. She finds no such evidence and hence concludes against the hidden information view. However, the stock market response appears to depend substantially on whether or not a subsequent bid occurs (Lee, 1992), whilst existing owners’ returns are greater when competitive bids are received (Easterwood et al., 1994). Insiders may manage earnings prior to a management bid in order to reduce the profits base for valuing the business. The evidence is somewhat contradictory: DeAngelo (1986) reports none whilst Perry and Williams (1994) find evidence of consistent falls in the last complete financial year prior to an announcement. Kaplan and Stein (1993) analyse the structure of MBO pricing across the whole of the 1980s. They suggest that deal prices rose with the level of leverage leading to over-heating and a sharp rise in the failure rate at the end of the decade. Thus if there were initial transfers from the pre-MBO owners, this trend was reversed across the period. Structuring The structuring of buy-out deals involves both the combination of financial instruments required to eﬀect the purchase and the contractual mechanisms introduced by private equity firms which give them various cash flow and control rights. The latter may be either attached directly to particular financial instruments or be included in the corporate charter, shareholders’ agreement, or articles of association. In the US, Cotter and Peck (2001) show that active monitoring by a buy-out specialist substitutes for tighter debt terms in monitoring and motivating managers of LBOs. Buyout specialists that control a majority of the post-LBO equity tend to use less debt in transactions. Buy-out specialists that closely monitor managers through stronger representation on the board also tend to use less debt. In the UK, where evidence is most comprehensive, the majority of buy-outs are backed by private equity firms and hence are likely to use equity and quasi-equity instruments. The probability of receiving equity backing increases with size (CMBOR, 2005). While in the late 1990s, about a half of buy-outs with a transaction value of less than £10m received private equity backing, this proportion had fallen to about one fifth a decade later. At the largest end of the market, it is relatively rare for deals with a transaction value above £100m to be wholly debt funded (Tables 11.5a and 11.5b). In contrast to early stage venture capital deals, buy-outs tend to make use of a wider range of financial instruments comprising equity, quasi-equity (for example redeemable and convertible shares), quasi-debt (various layers of privately and publicly placed mezzanine or subordinated debt), senior debt (various layers of secured debt with diﬀerent maturities and return characteristics) and asset-based financing such as leasing (Wright et al., 1991). The relative importance of these financial instruments is shown in Tables 11.6a and 11.6b which provide mean deal structuring data for all UK buy-outs completed in each year. Although continental Europe has a bank-based system (Black and Gilson, 1998), US buy-outs typically involve greater levels of debt. In the US, banks appear to be more

Private equity and management buy-outs Table 11.5a

299

Share of UK buy-outs that are private equity backed 1997

Deal Size Range Less than £10m £10m – £25m £25m – £50m £50m – £75m £75m – £100m Over £100m

2000

VC Backed

Total Deals

277 65 32 22 10 15

548 74 38 22 11 16

% VC VC Backed Backed 50.5 87.8 84.2 100.0 90.9 93.8

134 69 22 20 7 40

Total Deals 424 89 27 26 7 45

2002 % VC VC Total % VC Backed Backed Deals Backed 31.6 77.5 81.5 76.9 100.0 88.9

113 44 22 14 5 24

493 67 28 16 6 27

22.9 65.7 78.6 87.5 83.3 88.9

Source: CMBOR/Barclays Private Equity/Deloitte

Table 11.5b

Share of UK buy-outs that are private equity backed 2003

Deal Size Range

2004

2005

VC Total % VC VC Total % VC VC Total % VC Backed Deals Backed Backed Deals Backed Backed Deals Backed

Less than £10m £10m – £25m £25m – £50m £50m – £75m £75m – £100m Over £100m

108 43 31 18 5 20

569 54 39 23 5 21

19.0 79.6 79.5 78.3 100.0 95.2

105 51 37 20 7 43

506 72 45 24 7 47

20.8 70.8 82.2 83.3 100.0 91.5

115 46 38 14 11 48

497 63 47 16 11 51

23.1 73.0 80.9 87.5 100.0 94.1

Source: CMBOR/Barclays Private Equity/Deloitte

Table 11.6a

UK buy-out/buy-in deal structures, less than £10m financing

Type of Finance (Average %)

1993

2000

2001

2002

2003

2004

Equity Mezzanine Debt Loan Note Other Finance Total financing (£m) Vendor contribution Management contribution Proportion of equity held by management

41.0 3.4 36.2 7.4 14.1 265 10.8 16.0 68.7

54.4 4.6 35.0 3.6 3.0 331 2.7 6.3 63.7

41.1 1.8 46.6 2.8 7.5 402 4.1 5.0 61.8

30.4 1.7 48.9 10.5 8.5 290 6.6 7.6 78.4

43.1 0.6 47.8 3.0 5.6 223 2.8 3.5 66.8

41.1 1.0 44.8 7.1 6.0 228 7.2 8.6 61.8

Source: CMBOR/Barclays Private Equity/Deloitte

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Table 11.6b

UK buy-out/buy-in deal structures, £10m or more financing

Type of Finance (Average %) Equity Mezzanine Debt Loan Note Other Finance Total financing (£m) Vendor contribution Management contribution Proportion of equity held by management

1993

2000

2001

2002

2003

2004

33.2 4.5 47.5 8.6 8.2 1905 5.1 2.4 27.6

43.3 4.7 46.4 1.7 3.8 13339 2.3 5.3 32.1

37.2 5.0 46.6 4.0 7.3 13614 4.3 2.1 36.8

37.6 4.6 50.2 3.2 4.4 9934 3.4 2.0 35.7

41.6 3.6 49.3 2.8 2.7 10922 1.2 3.1 27.7

39.9 5.2 50.7 1.9 2.3 11463 2.9 2.7 33.0

Source: CMBOR/Barclays Private Equity/Deloitte

willing to lend on the basis of stable cash flow and the ability to sell assets in liquid corporate asset markets at going concern value. In the bank-based systems of continental Europe, asset markets are much less liquid, and collateral value may be more likely to be based on estimated distress value. In continental Europe, the mezzanine finance providers, which can help increase the debt available in buyouts, are relatively less well-developed and unbundling deals involving the sell-oﬀ of surplus assets post-buy-out are quite unusual compared to the US (CMBOR, 2005). As Kaplan and Strömberg (2001) find for venture capitalists, Sahlman (1990) and Robbie and Wright (1990) indicate that private equity investors in buy-outs also use various contractual mechanisms to encourage entrepreneurs both to perform and to reveal accurate information. These mechanisms include staging of the commitment of investment funds, convertible financial instruments (‘equity ratchets’) which may give financiers control under certain conditions, basing compensation on value created, preserving mechanisms to force agents to distribute capital and profits, and powers written into Articles of Association which require approval for certain actions (for example acquisitions, certain types of investment and divestment, and so on) to be sought from the investor(s) (Robbie and Wright, 1990). In addition to such structural mechanisms, the process of the relationship with the investee company is also an important aspect of the corporate governance framework. Monitoring and adding value In this section we consider the mechanisms and processes of monitoring and adding value, the eﬀects of monitoring and investor involvement, and aspects relating to restructuring failure. Mechanisms and process Active private equity investor monitoring in buy-outs and buyins has some similarities with that undertaken by venture capital firms in early stage ventures. Sahlman (1990) in comparing LBO Associations with venture capitalists notes that executives in the former may typically assume control of the board of directors but are generally less likely than venture capitalists to assume operational control. UK evidence in

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301

buy-outs and buy-ins shows that board representation is the most popular method of monitoring investee companies, with there also being a requirement for the regular provision of accounts to the private equity investor (Robbie et al., 1992). However, reflecting the greater asymmetric information issues in buy-ins, private equity firms exercise a greater degree of control than for buy-outs (Robbie et al., 1992). Equity ratchets are also found to be more frequently used in buy-ins, reflecting the greater uncertainty about their future performance. With respect to the process of monitoring, evidence from buy-outs and buy-ins emphasizes the extent of keeping the private equity firm informed of developments through regular contact. Hatherly et al. (1994) show that on balance the relationship between financial institutions and management buy-outs involves partnership and mutual interest with devices to control agency problems generally being used in a flexible manner. However, in smaller buy-ins in particular, private equity firms do not appear to be particularly active in responding to signals about adverse performance or in developing relationships with entrepreneurs (Robbie and Wright, 1995). In larger buy-ins there is evidence of extensive and repeated active monitoring (Wright et al., 1994). This diﬀerence illustrates the comparative cost–eﬀort–reward trade-oﬀs involved in the active monitoring of large and small investments. Bruining and Wright (2002) provide exploratory case study evidence suggesting how private equity firms can enhance the entrepreneurial orientation through integrating the contributions of specialist top management decision-making, influencing the leadership style of CEOs, keeping value added strategy on track and assisting in new ventures, and in broadening market focus. Bruining et al. (2004) also provide detailed case analysis of how private equity firms can contribute to the development of management control systems that facilitate strategic change in diﬀerent types of buy-outs. Eﬀects of monitoring and involvement Research on US LBOs during the 1980s indicates substantial mean improvements in profitability and cash flow measures over the interval between one year prior to the transaction and two or three years subsequent to it (Kaplan, 1989a; Muscarella and Vetsuypens, 1990; Smith, 1990; Opler, 1992; Kaplan and Stein, 1993; Smart and Waldfogel, 1994). Similarly, UK evidence indicates the vast majority of buy-outs show clear improvements in profitability and working capital management (Wright et al., 1992). Wright et al. (1996a) concluded that firms experiencing an MBO generated significantly higher increases in return on assets than comparable firms that did not experience an MBO over a period from two to five years after buy-out. In the French market, Desbrieres and Schatt (2002) find that firms that were acquired outperform comparable firms in the same industry both before and after the buy-out. However, in contrast to findings relating to US and UK LBOs, the performance of French MBO firms declines after the transaction is consummated, but this downturn seems to be less detrimental to former subsidiaries of groups than to former family businesses, the latter forming a more important part of the French market. Buy-outs are a means for refocusing the strategic activities of the firm (Seth and Easterwood, 1993; Phan and Hill, 1995). Both Wright et al. (1992) and Zahra (1995) find that buy-outs are followed by significant increases in new product development and other aspects of corporate entrepreneurship. Buy-outs also improve productivity. Lichtenberg and Siegel (1990) found that total factor productivity for plants involved in LBOs rose from 2 per cent above its industry

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control pre-LBO, to 8.3 per cent above over the first three years of post-LBO operation. For the UK, Wright et al. (1996a), Amess (2003) and Harris et al. (2005) show that management buy-outs are associated with improvements in total factor productivity. Harris et al. (2005) show, in contrast to US evidence, that MBO establishments were approximately 2 per cent less productive than comparable plants pre-LBO but experienced a substantial increase in productivity of approximately 90 per cent post-LBO. US evidence strongly supports the view that capital investment falls immediately following the LBO as a result of the increased leverage (Kaplan, 1989a; Smith, 1990). The evidence on UK MBOs is rather diﬀerent. Wright et al. (1992) report that asset sales are oﬀset by new capital investment, particularly in plant and equipment. The eﬀect of buy-outs on R&D is less clear, although on balance there seems to be a reduction (Smith, 1990; Lichtenberg and Siegel, 1990; Long and Ravenscraft, 1993). However, as many LBOs are in low R&D industries, the overall eﬀect may be unsubstantial. There is some evidence that in buy-outs that do have R&D needs, this expenditure is used more eﬀectively (Zahra, 1995). There is mixed evidence on the eﬀects of buy-out on employment. Kaplan (1989a), Smith (1990), and Opler (1992) – but not Muscarella and Vetsuypens (1990) – report small increases in total firm employment following LBOs. Kaplan (1989a) and Smith (1990), however, report that buy-outs do not expand their employment in line with industry averages. Lichtenberg and Siegel (1990) report an 8.5 per cent fall in non-production workers, over a three-year period, with production employment unchanged. Early UK evidence suggested that job losses occur most substantially at the time of the change in ownership (Wright et al., 1992). Amess and Wright (2007) show in a panel of 1350 UK buy-outs covering the period 1999–2004 that employment growth is 0.51 of a percentage point higher for MBOs after the change in ownership and 0.81 of a percentage point lower for MBIs. These findings are consistent with the notion that MBOs lead to the exploitation of growth opportunities, resulting in higher employment growth. The same patterns do not emerge from MBIs, typically because the latter transactions involve enterprises that require considerable restructuring. The wealth of existing bondholders will be adversely aﬀected if new debt, issued at the time of the restructuring, impacts adversely on the perceived riskiness of the original debt. Marais et al. (1989) fail to detect any such wealth transfer but Asquith and Wizman (1990) report a small average loss of market value but those original bonds with protective covenants showed a positive eﬀect. As buy-outs typically substitute debt for equity they tend to reduce corporate tax liabilities but this tax saving generally accounts for only a small fraction of the value gain in buy-outs (Schipper and Smith, 1988; Kaplan, 1989b). Some indications of the eﬀects of monitoring mechanisms introduced in buy-outs are given by comparing alternative organizational forms. For example, leveraged recapitalizations, which simply substitute debt for equity in quoted companies, have been shown to raise shareholder value (Denis and Denis, 1993) but they do not appear to have the same performance impact as LBOs, which also involve managerial ownership and institutional involvement (Denis, 1994). Similarly, defensive Employee Share Ownership Plans (ESOPs), in which leveraged employee share purchases are used to forestall takeovers, do not appear to perform as well as LBOs (Chen and Kensinger, 1988). Thompson et al. (1992) found that the management team shareholding size had by far the larger impact

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on relative performance in UK MBOs. Similarly, Phan and Hill (1995) found that managerial equity stakes had a much stronger eﬀect on performance than debt levels for periods of three and five years following the buy-out. Nikoskelainen and Wright (2007) examine the role of corporate governance in enhancing the real returns to exited buy-outs and find an average (median) return of 22.2 per cent (5.3 per cent) net of market index returns based on a sample of 321 exited buy-outs in the UK between 1995 and 2004. Their analysis shows that a balance of interrelated firmlevel corporate governance mechanisms (including gearing, syndication and management ownership) is critical for value-increase in buy-outs, and the importance of these mechanisms for enhancing returns is context-dependent in relation to the size of the transaction, among other things. Cumming and Walz (2004) assess the returns to buy-outs from the investor’s perspective based on a sample of 39 countries around the world. For the subset of the buy-out data from the US and the UK which spans the 1984–2001 period, they find an average (median) return to LBOs to be 26.1 per cent (31.4 per cent) and an average return to MBOs/MBIs to be 21.5 per cent (18.5 per cent) net of market index returns. This study also shows that the average returns to earlier stage venture capital investments are significantly greater than the average returns to buy-outs, whereas the median returns to buyouts are greater than the median returns to earlier stage venture capital investments. Cumming and Walz (2004) find that returns are high for syndicated investments but lower for co-investments, which suggests the capital from a follow-on fund is used to bail out the bad investments from earlier funds. Knigge et al. (2006) show that, in contrast to venture capital funds, the performance of buy-out funds is largely driven by the experience of the fund managers regardless of market timing. Restructuring and failure High leverage in the structuring of buy-outs may mean that financial distress is signalled sooner than if an enterprise were funded substantially by equity (Jensen, 1991). A firm which defaults on interest and loan payments may still retain greater value and stand a better chance of being reorganized, than one which is finally forced to waive a dividend. Kaplan and Stein (1993) in a study of larger US buy-outs and Wright et al. (1994) for the UK provide strong evidence that higher amounts of debt were associated with an increased probability of failure or needing to be restructured. Many of these firms may be restructured and sold as going concerns (Citron et al., 2003). However, a problem of enforcing restructuring is that it may be diﬃcult to agree with other parties what form it should take, especially in smaller investments where management are usually important majority shareholders. If institutions are a controlling shareholder, as is usually the case in larger buy-outs and buy-ins, making changes is theoretically straightforward. However, in cases with large syndicates of financiers, restructuring may be delayed or may take a particular direction because of diﬀerences in the attitudes of syndicate members (Wright and Lockett, 2003). An important issue in dealing with investees that are in distress concerns whether or not to replace the CEO. Larger management buy-ins may be able to bear extensive restructuring, and it may be economical for institutions to invest the eﬀort to undertake it, whereas the possibilities may be very limited for smaller cases. In small buy-outs and buy-ins, management may own the vast majority of the equity and a very small group of managers may carry out the major functions, thus making it diﬃcult to remove underperforming

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management or to enforce a trade sale until a pressure point arises which cannot be relieved by other funding sources. In larger buy-outs and buy-ins, no single manager may be indispensable and it may thus be easier for institutions to exert pressure to remove under-performing senior managers. Exit and longevity There is some debate about whether buy-outs are a long or short term form of organization (Jensen, 1989; Rappaport, 1990). Evidence suggests that the longevity of buy-outs is heterogeneous, with some remaining with the buy-out structure for long periods, while others change quite quickly (Kaplan, 1991; Wright et al., 1995). Important issues relate to the need to understand the influences on this longevity and the eﬀects on performance once the firm has exited from the buy-out structure. With respect to the first point, Wright et al. (1993) suggest that a range of institutional factors including the state of development of asset and stock markets, legal infrastructures aﬀecting the nature of private equity firms’ structures and the diﬀering roles and objectives of management and private equity firms influence the timing and nature of exits from buy-outs. Importantly, private equity firms’ desire for realization in order to achieve their target returns may influence the nature of their involvement to achieve a timely exit (Wright et al., 1994). Buy-outs funded through closed-end funds may especially seek exit within a given time period compared to those funded through other sources of finance (Chiplin et al., 1995). In order to achieve timely exit, private equity firms are more likely to engage in closer (hands-on) monitoring and to use exit-related equity-ratchets on management’s equity stakes (Wright et al., 1995). With respect to what happens following exit from the private buy-out structure, Holthausen and Larcker (1996) find that while leverage and management equity falls when buy-outs return to market (reverse buy-outs), they remain high relative to comparable listed corporations that have not undergone a buy-out. Pre-IPO, buy-outs’ accounting performance is significantly higher than the median for the buy-outs’ sector. Following the IPO, accounting performance remains significantly above the firms’ sector for four years but declines during this period. Consistent with other studies, they find that the change is positively related to changes in insider ownership but not to leverage. Bruton et al. (2002) also find that agency cost problems did not reappear immediately following a reverse buy-out but rather took several years to re-emerge. Venture-backed MBOs in the UK tend to IPO earlier than their non-venture-backed counterparts (Jelic et al., 2005). There is some evidence that they are more underpriced than MBOs without venture capital backing but not that they perform better than their non-venture capital-backed counterparts in the long run. In contrast to the grandstanding hypothesis (Gompers, 1996), private to public MBOs backed by more reputable venture capitalists in the UK tend to exit earlier, and these MBOs performed better than those backed by less prestigious venture capitalists. Summary This review has shown that there has been diﬀerential research attention to the diﬀerent elements of the buy-out life-cycle. There has been extensive attention to the deal generation and antecedent aspects, the premiums paid and the performance eﬀects of buy-outs in particular. There has been relatively little work relating to the valuation mechanisms

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used by private equity firms, structuring of deals and the processes by which value is added by both entrepreneurial management and private equity firms. This diﬀerent degree of attention reflects the emphasis, especially in the US literature, on buy-outs as a financial rather than an entrepreneurial phenomenon. More recent evidence suggests a questioning of the dominance of the traditional financial, agency cost-based arguments for buy-outs. This has been notable, for example, in respect of the role of managers’ private information and perceived undervaluation of shares in the decision to take a company private as well as with respect to the creation of value post-buy-out. Most research has also focused on buy-outs involving public corporations but there is growing recognition of the distinctive nature of buy-outs involving family firms. This increasing attention has been associated with attention to the buy-out negotiation process but little work has been conducted on such aspects as the role of auctions involving private equity firms and their impacts on valuations and financial structuring. Conclusions and topics for future research The theoretical and empirical discussion in this chapter indicates that private-equity backed buy-outs can yield large gains in shareholder value and operating performance. In this section we draw on the findings presented above to consider topics for further research. Broadly following the structure of the chapter, this section considers the main research gaps under the principal headings of the development of private equity and buyouts, and the life-cycle of buy-outs to be in terms of: changes in deal characteristics over time; international developments, sources of buy-outs; organizational forms of buy-out financiers and their involvement; generating value; and exiting buy-outs. The development of private equity and buy-outs Changes in deal characteristics over time The discussion of the trends in private equity backed buy-outs showed that the characteristics of deals have changed over time with private equity firms adapting the types of deal in which they invest. As private equity firms become more involved in buy-outs, there may be scope for deals in more innovative sectors (Robbie et al., 1999). There is a need for further research to address questions such as: how do private equity-driven MBOs diﬀer in the 1990s/2000s from those of the 1980s? What factors are influential in determining private equity deals now compared to the 1980s? Comparative analysis of the 1980s with the current period might usefully examine diﬀerences in vendor and sector deal source and consider to what extent these are associated with changes in the generation of deal opportunities, changes in regulatory conditions, developments in financing techniques and entry of new types of financiers, and so on. International aspects As has been shown, buy-out markets are developing internationally as countries come under increasing pressure to restructure their economies. Public to private LBOs have been occurring in significant volumes over the past five years in countries where they were previously absent. These developments add to the growing interest in the influence of contextual factors in finance and governance. How do the determinants of private equity deals in diﬀerent countries diﬀer from those relating to the US? The international spread of the buy-out phenomenon raises the role of internationalization by private equity firms which at present is little understood (Wright et al., 2006).

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Internationalization may take diﬀerent forms and may involve diﬀerent scope and diﬀerent modus operandi. What determines the decisions by private equity firms to internationalize? What resources distinguish those private equity firms that internationalize from those that do not? How do private equity firms investing in buy-outs decide on which markets to enter and what mode of entry to adopt? Sources of MBOs The focus in this chapter has been on two main sources of buy-outs, public to private transactions (PTPs) and buy-outs of family firms. The regulatory costs associated with a stock market listing have important implications regarding the attractiveness of the stock market for firms. Modest sized firms with growth and restructuring opportunities may find it diﬃcult to raise funds. Emphasis on accountability may stifle the ability of firms to realize entrepreneurial opportunities. In these circumstances, private equity investors can provide both finance to realize growth opportunities as well as active governance. What is the impact of regulatory changes on developments in public to private transactions? Further examination is required relating to the attractiveness to private equity firms of secondary buy-outs which, as we have noted, have become a major feature of buy-out markets. Relatedly, a further neglected area concerns the low levels of purchases by buyout funds from early stage venture capital funds. Murray (1994) suggests that greater value can be obtained through IPO or sale to a trade buyer. But we know from statistics provided by country venture capital associations that by no means all exits from early stage funds are via these exit routes. It may be that buy-out funds do not possess the appropriate skills to continue to develop relatively early stage growing firms (Lockett et al., 2002). Detailed examination of the links between early stage venture capital funds and buy-out funds might provide useful insights into this part of the private equity market. Internationally, transactions involving family firms facing succession problems account for significant shares of buy-out markets, yet relatively little work has been focused on this aspect. Increasing recognition of agency issues in family firms (Schulze et al., 2003) draws attention to the information asymmetry problems that may occur in negotiating buy-outs on succession. What are the implications of pre-buy-out governance and ownership structure in family firms for the scope for a management buy-out in addressing succession issues? How do venture-backed and non-venture-backed buy-outs of family firms compare in terms of negotiating a deal that is satisfactory to both the family owners and the non-family owners buying out? The buy-out life-cycle Life-cycle behaviour and organizational forms of financiers Perhaps because of the US emphasis of much of the work on buy-outs there has been little attention to the nature and eﬀects of the organizational form of the private equity firms involved. Private equity firms can take several organizational forms including: independent limited partnerships established and managed by professional private equity firms or leveraged buy-out associations that act as general partners in managing the fund on behalf of the limited partners; captive firms that obtain their funding from a parent financial institution; semi-captive firms that obtain their finance partly from their parent and partly by raising closed-end funds; and public sector firms. How do diﬀerent organizational forms impact

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private equity firms’ investment behaviour including the types of deals sought, screening of investments and the sources of deal value that are sought, the degree of their involvement in monitoring and value adding activities, and their investment time horizon? Relatedly, to what extent are these diﬀerent dimensions associated with the use of diﬀerent forms of financial instruments and incentives for management? Further work is also needed to examine systematically how the structure of buy-outs funds and limited partner agreements diﬀer from the structure of early stage venture capital funds. Similarly, there is an absence of work that compares the contractual structures used by buy-out firms compared with those used by early stage venture capital firms. The attractive risk–return trade-oﬀs available from private equity transactions have also encouraged new types of entrants seeking to emulate these returns. Hedge funds in particular have become attracted to making private equity investments, yet raise a number of issues regarding their transaction oriented nature and their ability to add value to investees. Further research might usefully compare the role of private equity firms and hedge funds in the buy-outs market. What is the impact of large funding availability and the entry of new types of competing bidders, such as hedge funds, on private equity deal pricing, and expected and realized returns? Relatedly, what are the implications of new forms of financial instruments and the holders of these instruments, such as hedge funds? For example, how are distressed private equity deals restructured? How do private equity firms and hedge funds compare in terms of providing governance for investee firms? Adding value in MBOs Our analysis has suggested there may need to be greater emphasis on entrepreneurial activity to improve the upside potential of these firms. Evidence on the total factor productivity improvements in buy-outs has so far not teased out the contribution of innovative activities. Research in this area may require the construction of novel datasets involving the integration of multi-level, multi-source data. Quantitative research is also required to consider the generalizability of qualitative findings regarding the role of private equity firms in enhancing entrepreneurial behaviour by buy-outs. Private equity firms may have a role in preserving value, especially where buy-outs encounter problems. What role do private equity firms play relative to that of secured creditors in reorganizing distressed buy-outs? To what extent is there evidence of conflicts between the interest of the secured lender and the private equity firm? To what extent do these cases represent examples where the private equity firm did not engage in suﬃcient monitoring? To what extent were the problems the result of the private equity firm failing to identify issues at the initial due diligence stage? In addition, how successful have private equity firms been in successfully turning around failing businesses or exiting distressed businesses through sale to another corporation? Research at the private equity firm level is probably where the greatest gap exists. A start in this area has been made by Berg (2005) who presents a framework based on Porter’s value chain approach to look at private equity firms’ strategies using evidence from their websites. Further research might adopt alternative frameworks such as a resource-based approach (Barney et al., 2001) and undertake more systematic survey research to provide richer insights. For example, in the light of Lei and Hitt’s (1995) argument that LBOs may lead to a reduced resource base for organizational learning and technology development, to what extent do private equity firms help fill this gap?

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Wright et al. (2000b; 2001) theorized the need for diﬀerent types of mindsets for diﬀerent types of buy-outs. Further systematic analysis is required to test these arguments and to identify the eﬀects of these diﬀerent types of entrepreneurs. As markets mature and extensive exits from earlier deals become prevalent, an emergent phenomenon of serial buy-out or buy-in entrepreneurs is occurring (Wright et al., 1997a; 1997b; Wright et al., 2000d; Ucbasaran et al., 2003a; 2003b). How do entrepreneurs involved in private equity-backed secondary buy-outs diﬀer from those in first time buy-outs in terms of their motivations and strategies to create value? How and to what extent do serial buy-out/buyin entrepreneurs learn from their previous experience and how is this reflected in the buyout/buy-in opportunities in which they invest, the strategies they adopt and subsequent performance? How do private equity firms identify and screen experienced entrepreneurs for buy-out and buy-in investments and how does this diﬀer from their approach to serial start-up entrepreneurs? Exiting MBOs Finally, changes in stock and takeover markets also introduce issues concerning the ability of private equity firms to realize the gains from their investments, especially for modest sized deals in mature sectors, while at the same time meeting investors’ expectations of significant returns within a particular time period. As such, private equity firms have had to develop new forms of exit, such as the widespread growth in secondary buy-outs, but these raise questions concerning the returns that can be generated and the willingness of limited partners to invest in the same deal a second time through a followon fund. At present, there is limited research on these phenomena. What is the role of secondary LBOs and releveraging in enhancing the longevity of private equity deals? What are the implications of secondary LBOs for returns to private equity funds and Limited Partners? References Amess, K. (2003), ‘The eﬀect of management buyouts on firm-level technical eﬃciency: Evidence from a panel of UK machinery and equipment manufacturers’, Journal of Industrial Economics, 51, 35–44. Amess, K. and M. Wright (2007), ‘The wage and employment eﬀects of leveraged buyouts in the UK’, International Journal of Economics and Business, forthcoming. Amit, R., L. Glosten and E. Muller (1993), ‘Challenges to theory development in entrepreneurship research’, Journal of Management Studies, 30, 815–34. Asquith, P. and T. Wizman (1990), ‘Event risk, wealth redistribution, and its return to existing bondholders in corporate buyouts’, Journal of Financial Economics, 27, 195–213. Bachkaniwala, D., M. Wright and M. Ram (2001), ‘Succession in south Asian family businesses in the UK’, International Small Business Journal, 19, 15–27. Baker, G. and G. Smith (1998), The New Financial Capitalists: Kohlberg, Kravis and Roberts and the Creation of Corporate Value, Cambridge: Cambridge University Press. Barney, J., M. Wright and D. Ketchen (2001), ‘The resource-based view of the firm: ten years after 1991’, Journal of Management, 27, 625–42. Berg, A. (2005), What is Strategy for Buyout Associations?, Academic Readings on Private Equity, Zaventem: EVCA. Bhide, A. (1992), ‘The hidden costs of stock market liquidity’, Journal of Financial Economics, 34, 31–51. Birley, S., M. Hay and D. Muzyka (1999), ‘Management buyout: perception of opportunity’, Journal of Management Studies, 36, 109–22. Black, B. and S. Gilson (1998), ‘Venture capital and the structure of capital markets: bank versus stock markets’, Journal of Financial Economics, 47, 243–77. Bruining, H. and M. Wright (2002), ‘Entrepreneurial orientation in management buy-outs and the contribution of venture capital’, Venture Capital, 4, 147–68. Bruining, H., M. Bonnet and M. Wright (2004), ‘Management control systems and strategy change in buyouts’, Management Accounting Research, 15, 155–77.

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Bruton, G., J.K. Keels and R.L. Scifres (2002), ‘Corporate restructuring and performance: an agency perspective on the complete buyout cycle’, Journal of Business Research, 55, 709–24. BVCA (2004), Report on Investment Activity, London: British Venture Capital Association. Chen, A.H. and J.W. Kensinger (1988), ‘Beyond the tax benefits of ESOPs’, Journal of Applied Corporate Finance, 1, 67–75. Chiplin, B., M. Wright and K. Robbie (1995), ‘UK management buy-outs in 1994’, Management Buy-outs Quarterly Review, Spring, pp. 3–12. Citron, D., K. Robbie and M. Wright (1997), ‘Loan covenants and relationship banking in MBOs’, Accounting and Business Research, 27, 277–96. Citron, D., M. Wright, R. Ball and F. Rippington (2003), ‘Secured creditor recovery rates from management buy-outs in distress’, European Financial Management, 9, 141–62. CMBOR (2002), ‘Recent trends in UK buy-outs and buy-ins: management buy-outs’, Quarterly Review from the Centre for Management Buy-out Research, University of Nottingham, Autumn, pp. 7–32. CMBOR (2005), ‘Recent trends in UK buy-outs and buy-ins: management buy-outs’, Quarterly Review from the Centre for Management Buy-out Research, University of Nottingham, Autumn, pp. 9–32. Cook, D.O., J. Easterwood and J.D. Martin (1992), ‘Bondholder wealth eﬀects of management buyouts’, Financial Management, 21, 102–13. Cotter, J.F. and S.W. Peck (2001), ‘The structure of debt and active equity investors: the case of the buyout specialist’, Journal of Financial Economics, 59(1), 101–47. Cumming, D. and U. Walz (2004), ‘Private equity returns and disclosure around the world’, mimeo, available at SSRN: http://ssrn.com/abstract514105. DeAngelo, L. (1986), ‘Accounting numbers as market valuation substitutes: a study of the management buyouts of public stockholders’, Accounting Review, 61, 400–420. DeAngelo, H., L. DeAngelo and E. Rice (1984), ‘Shareholder wealth and going private’, Journal of Law and Economics, 27, 367–402. Denis, D.J. (1994), ‘Organizational form and the consequences of highly leveraged transactions: Kroger’s recapitalization and safeway’s LBO’, Journal of Financial Economics, 36, 193–224. Denis, D.J. and D. Denis (1993), ‘Managerial discretion, organizational structure and corporate performance’, Journal of Accounting and Economics, 16, 209–36. Desbrieres, P. and A. Schatt (2002), ‘The impacts of LBOs on the performance of acquired firms: the French case’, Journal of Business Finance and Accounting, 29, 695–729. Easterwood, J.C., R. Singer, A. Seth and D. Lang (1994), ‘Controlling the conflict of interest in management buyouts’, Review of Economics and Statistics, 76, 512–22. EVCA (2004), EVCA Yearbook 2004, Zaventem: European Venture Capital Association. Francis, J. and A. Smith (1995), ‘Agency costs and innovation: some empirical evidence’, Journal of Accounting and Economics, 19, 383–409. Gompers, P. (1996), ‘Grandstanding in the venture capital industry’, Journal of Financial Economics, 42, 133–56. Halpern, P., R. Kieschnick and W. Rotenberg (1999), ‘Why firms engaged in levered recapitalisation rather than levered buyout’, Working Paper, University of Texas at Dallas. Harris, R., D. Siegel and M. Wright (2005), ‘Assessing the impact of management buyouts on economic eﬃciency: plant-level evidence from the United Kingdom’, Review of Economics and Statistics, forthcoming. Hatherly, D., J. Innes, J. MacAndrew and F. Mitchell (1994), ‘An exploration of the MBO–financier relationship’, Corporate Governance, 2, 20–29. Hill, C.W.L. (1985), ‘Internal organization and enterprise performance: some UK evidence’, Managerial and Decision Economics, 6, 210–16. Hite, G.L. and M. Vetsuypens (1989), ‘Management buyouts of divisions and shareholder wealth’, Journal of Finance, 44, 953–70. Holthausen, D. and D. Larcker (1996), ‘The financial performance of reverse leveraged buy-outs’, Journal of Financial Economics, 42, 293–332. Howorth, C., P. Westhead and M. Wright (2004), ‘Buy-outs, information asymmetry and the family–management dyad’, Journal of Business Venturing, 19, 509–34. Jelic, R., B. Saadouni and M. Wright (2005), ‘Performance of private to public MBOs: the role of venture capital’, Journal of Business Finance and Accounting, 32, 643–82. Jensen, M.C. (1989), ‘The eclipse of the modern corporation’, Harvard Business Review, 89, 61–74. Jensen, M.C. (1991), ‘Corporate control and the politics of finance’, Journal of Applied Corporate Finance, 4, 13–33. Jensen, M.C. (1993), ‘The modern industrial revolution: exit, and the failure of internal control systems’, Journal of Finance, 48, 831–80. Kaplan, S.N. (1989a), ‘The eﬀects of management buyouts on operations and value’, Journal of Financial Economics, 24, 217–54. Kaplan, S.N. (1989b), ‘Management buyouts: evidence on taxes as a source of value’, Journal of Finance, 44, 611–32.

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Kaplan, S.N. (1991), ‘The staying power of leveraged buyouts’, Journal of Financial Economics, 29, 287–313. Kaplan, S.N. and J.C. Stein (1993), ‘The evolution of buyout pricing in the 1980s’, Quarterly Journal of Economics, 108, 313–57. Kaplan, S. and P. Strömberg (2001), ‘Venture capitalists as principals: contracting, screening and monitoring’, American Economic Review, 91, 426–30. Kaufman, A. and E. Englender (1993), ‘Kohlberg, Kravis Roberts & Co and the restructuring of American Capitalism’, Business History Review, 67, 52–97. Kester, A. and T.A. Luehrman (1995), ‘Rehabilitation the leveraged buyout’, Harvard Business Review, 73, 119–30. Kieschnick, R. (1998), ‘Free cash flow and stockholder gains in going private transactions revisited’, Journal of Business Finance and Accounting, 25, 187–202. Knigge, A., E. Nowak and D. Schmidt (2006), ‘On the performance of private equity investments: does market timing matter?’, Journal of Financial Transformation, 16, forthcoming. Lee, D.S. (1992), ‘Management buyout proposals and inside information’, Journal of Finance, 47, 1061–79. Lehn, K. and A. Poulsen (1989), ‘Free cash flow and stockholder gains in going private transactions’, Journal of Finance, 44, 771–88. Lei, D. and M. Hitt (1995), ‘Strategic restructuring and outsourcing: the eﬀects of mergers and acquisitions and LBOs on building firms skills and capabilities’, Journal of Management, 21, 835–59. Lichtenberg, F.R. and D. Siegel (1990), ‘The eﬀects of leveraged buyouts on productivity and related aspects of firm behaviour’, Journal of Financial Economics, 27, 165–94. Lockett, A., G. Murray and M. Wright (2002), ‘Do UK venture capitalists still have a bias against high tech investments?’, Research Policy, 31, 1009–30. Long, W.F. and D. Ravenscraft (1993), ‘LBOs, debt and R&D intensity’, Strategic Management Journal, 14, 119–35. Lowenstein, L. (1985), ‘Management buyouts’, Columbia Law Review, 85, 730–84. Manigart, S., M. Wright, K. Robbie, P. Desbrieres and K. de Waele (1997), ‘Venture capitalists’ appraisal of investment projects: an empirical European study’, Entrepreneurship: Theory & Practice, 21, 29–44. Marais L., K. Schipper and A. Smith (1989), ‘Wealth eﬀects of going private on senior securities’, Journal of Financial Economics, 23, 155–91. Markides, C.C. (1992), ‘Consequences of corporate refocusing: ex ante evidence’, Academy of Management Journal, 35, 398–412. Murray, G. (1994), ‘The second equity gap: exit problems for seed and early stage venture capitalists and their investee companies’, International Small Business Journal, 12, 59–76. Muscarella, C. and M. Vetsuypens (1990), ‘Eﬃciency and organizational structure: a study of reverse LBOs’, Journal of Finance, 65, 1389–413. Nikoskelainen, E. and M. Wright (2007), ‘The impact of corporate governance mechanisms on value increase in leveraged buyouts’, Journal of Corporate Finance, forthcoming. Opler, T.C. (1992), ‘Operating performance in leveraged buyouts’, Financial Management, 21, 27–34. Opler, T. and S. Titman (1993), ‘The determinants of leveraged buyout activity: free cash flow vs. financial distress costs’, Journal of Finance, XLVIII, 1985–99. Perry, S.E. and T. Williams (1994), ‘Earnings management preceding management buyout oﬀers’, Journal of Accounting and Economics, 18, 152–79. Phan, P. and C. Hill (1995), ‘Organizational restructuring and economic performance in leveraged buyouts: an ex post study’, Academy of Management Journal, 38, 704–39. Rappaport, A. (1990), ‘The staying power of the public corporation’, Harvard Business Review, 68, 96–104. Renneboog, L., T. Simons and M. Wright (2007), ‘Leveraged public to private transactions in the UK’, Journal of Corporate Finance, forthcoming. Robbie, K. and M. Wright (1990), ‘The Maccess buy-outs’, in S. Turley and P. Taylor (eds), Case Studies in Financial Management, Oxford: Philip Allan. Robbie, K. and M. Wright (1995), ‘Managerial and ownership succession and corporate restructuring: the case of management buy-ins’, Journal of Management Studies, 32, 527–50. Robbie, K. and M. Wright (1996), Management Buy-ins: Entrepreneurship. Active Investors and Corporate Restructuring, Manchester: Manchester University Press. Robbie, K., M. Wright and M. Albrighton (1999), ‘High-tech management buy-outs’, Venture Capital, 1, 219–40. Robbie K., M. Wright and S. Thompson (1992), ‘Management buy-ins in the UK’, Omega, 20, 445–56. Sahlman, W.A. (1990), ‘The structure and governance of venture-capital organizations’, Journal of Financial Economics, 27, 473–521. Schipper, K. and A. Smith (1988), ‘Corporate income tax eﬀects of management buy-outs’, Working Paper, University of Chicago. Scholes, L., M. Wright, P. Westhead and A. Burrows (2005), ‘Succession in family businesses through venture backed management buy-outs and buy-ins’, paper presented at the Babson-Kaufmann Entrepreneurship Conference, Babson College, June.

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Schulze, W., M. Lubatkin and R. Dino (2003), ‘Toward a theory of agency and altruism in family firms’, Journal of Business Venturing, 18, 473–90. Seth, A. and J.C. Easterwood (1993), ‘Strategic redirection in large management buyouts: the evidence from post-buy-out restructuring’, Strategic Management Journal, 14, 251–73. Singh, H. (1990), ‘Management buyouts and shareholder value’, Strategic Management Journal, 11, 111–29. Smart, S.B. and J. Waldfogel (1994), ‘Measuring the eﬀect of restructuring on corporate performance: the case of management buyouts’, Review of Economics and Statistics, 76, 503–11. Smith, A. (1990), ‘Capital ownership structure and performance: the case of management buyouts’, Journal of Financial Economics, 13, 143–65. Thompson, S. and M. Wright (1988), Internal Organization, Eﬃciency and Profit, Deddington: Philip Allan. Thompson, S., M. Wright and K. Robbie (1992), ‘Management equity ownership, debt and performance: some evidence from UK management buy-outs’, Scottish Journal of Political Economy, 39, 413–30. Toms, S. and M. Wright (2005), ‘Divergence and convergence within Anglo-American corporate governance systems; evidence from the US and the UK 1950–2000’, Business History, 47, 267–95. Ucbasaran, D., A. Lockett, M. Wright and P. Westhead (2003a), ‘Entrepreneurial founder teams: factors associated with member entry and exit’, Entrepreneurship: Theory & Practice, 28, 107–28. Ucbasaran, D., M. Wright and P. Westhead (2003b), ‘A longitudinal study of habitual entrepreneurs: starters and acquirers’, Entrepreneurship and Regional Development, 15, 207–28. Warga, A. and I. Welch (1993), ‘Bondholder losses in leveraged buyouts’, Review of Financial Studies, 6, 959–82. Weir, C., D. Laing and M. Wright (2005a), ‘Incentive eﬀects, monitoring mechanisms and the threat from the market for corporate control: an analysis of the factors aﬀecting public to private transactions in the UK’, Journal of Business Finance and Accounting, 32, 909–44. Weir, C., D. Laing and M. Wright (2005b), ‘Undervaluation, private information, agency costs and the decision to go private’, Applied Financial Economics, 15, 947–61. Wright, M. (1986), ‘The make buy decision and managing markets: the case of management buy-outs’, Journal of Management Studies, 23, 443–64. Wright, M. (1994), ‘Management buy-outs – issues and evidence’, in M. Wright (ed.), Management Buy-outs, Aldershot: Dartmouth Publishing. Wright, M. and J. Coyne (1985), Management Buy-outs, Beckenham: Croom Helm. Wright, M. and M. Kitamura (2003), ‘Management buy-outs in Japan’, Journal of Private Equity, 6, 86–95. Wright, M. and A. Lockett (2003), ‘The structure and management of alliances: syndication in venture capital investments’, Journal of Management Studies, 40, 2073–104. Wright, M. and K. Robbie (1996), ‘Venture capitalists, unquoted equity investment appraisal, and the role of accounting information’, Accounting and Business Research, 26, 153–70. Wright, M. and K. Robbie (1998), ‘Venture capital and private equity: a review and synthesis’, Journal of Business, Finance and Accounting, 25, 521–70. Wright, M., S. Thompson, B. Chiplin and K. Robbie (1991) Management Buy-ins and Buy-outs: New Strategies in Corporate Management, London: Graham & Trotman. Wright, M., S. Thompson and K. Robbie (1992), ‘Venture capital and management-led leveraged buy-outs: a European perspective’, Journal of Business Venturing, 7, 47–71. Wright, M., K. Robbie, Y. Romanet, S. Thompson, R. Joachimsson, H. Bruining and A. Herst (1993), ‘Harvesting and the longevity of management buy-outs and buy-ins: a four country study’, Entrepreneurship: Theory & Practice, 18, 90–109. Wright, M., K. Robbie, S. Thompson and K. Starkey (1994), ‘Longevity and the life cycle of MBOs’, Strategic Management Journal, 15, 215–27. Wright, M., S. Thompson, K. Robbie and P. Wong (1995), ‘Management buy-outs in the short and long term’, Journal of Business Finance and Accounting, 22, 461–82. Wright, M., N. Wilson and K. Robbie (1996a), ‘The longer term eﬀects of management-led buy-outs’, Journal of Entrepreneurial and Small Business Finance, 5, 213–34. Wright, M., N. Wilson, K. Robbie and C. Ennew (1996b), ‘An analysis of failure in UK buy-outs and buy-ins’, Managerial and Decision Economics, 17, 57–70. Wright, M., K. Robbie and C. Ennew (1997a), ‘Serial entrepreneurs’, British Journal of Management, 8, 251–68. Wright, M., K. Robbie and C. Ennew (1997b), ‘Venture capitalists and serial entrepreneurs’, Journal of Business Venturing, 12, 227–49. Wright, M., C. Weir and A. Burrows (2007), ‘Irrevocable commitments and going private’, European Financial Management, forthcoming. Wright, M., B. Chiplin, K. Robbie and M. Albrighton (2000a), ‘The development of an organisational innovation: management buy-outs in the UK 1980–1997’, Business History, 42, 137–84. Wright, M., R. Hoskisson, L. Busenitz and J. Dial (2000b), ‘Entrepreneurial growth through privatization: the upside of management buy-outs’, Academy of Management Review, 25, 591–601.

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Wright, M., A. Pendleton and K. Robbie (2000c), ‘Employee ownership in enterprises in Africa and Asia’, International Journal of Human Resource Management, 11, 90–111. Wright, M., K. Robbie and M. Albrighton (2000d), ‘Secondary management buy-outs and buy-ins’, International Journal of Entrepreneurial Behaviour and Research, 6, 21–40. Wright, M., R. Hoskisson and L. Busenitz (2001), ‘Firm rebirth: buy-outs as facilitators of strategic growth and entrepreneurship’, Academy of Management Executive, 15, 111–25. Wright, M., T. Buck and I. Filatotchev (2002a), ‘Post-privatization eﬀects of management and employee buyouts’, Annals of Public and Cooperative Economics, 73, 303–52. Wright, M., S. Pruthi and A. Lockett (2002b), ‘Internationalization of western venture capitalists into emerging markets: risk assessment and information in India’, Small Business Economics, 19, 13–29. Wright, M., M. Kitamura and R. Hoskisson (2003a), ‘Management buyouts and restructuring Japanese corporations’, Long Range Planning, 36, 355–74. Wright, M., H. Sapienza and L. Busenitz (2003b), Venture Capital, Volume I, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Wright, M., J. Kissane and A. Burrows (2004), ‘Private equity and the EU accession countries of central and eastern Europe’, Journal of Private Equity, 7, 32–46. Wright, M., J. Kissane and A. Burrows (2005), ‘Management buy-outs: from Europe to Japan’, Journal of Restructuring Finance, 2, 39–54. Wright, M., S. Pruthi and A. Lockett (2006), ‘International venture capital research: from cross-country comparisons to crossing borders’, International Journal of Management Reviews, forthcoming. Wu, T.W. (1997), ‘Management buyouts and earnings management’, Journal of Accounting, Auditing and Finance, 12, 373–89. Zahra, S.A. (1995), ‘Corporate entrepreneurship and financial performance: the case of management leveraged buy-outs’, Journal of Business Venturing, 10, 225–47.

PART III INFORMAL VENTURE CAPITAL

12 Business angel research: The road traveled and the journey ahead Peter Kelly

An enduring phenomenon It’s [informal venture capital] not a new phenomenon, of course. Henry Ford’s auto empire was launched thanks to five [business] angels who plunked down $40,000 in 1903. (Conlin, 1989, p. 32)

Can you imagine what it must have been like for Henry Ford to find backers for his entrepreneurial dream more than a century ago? Finding an individual with cash to invest, expertise to share and who is not related to you, a business angel in accepted parlance of today, must have been a severe challenge for him. What is particularly striking is that if Henry asked a business angel researcher where to find backers, our suggestions would be little diﬀerent than today. Tap into your own network of contacts for leads. Look around your neighborhood for people that live in large houses or, in his day, those who owned a telephone. His search would have probably been confined geographically as he was proposing to create a mass-market transportation revolution. Once located, the deal would be consummated in a wood paneled room in private. Fast forward 100 years. In today’s world of modern communications, Henry could conduct a google search on the terms ‘business angel’ and ‘business angel network’ which would produce 45 million and 20 million hits respectively. For perspective, he could pick up a copy of a growing number of popular books about business angels (Benjamin and Margulis, 1996; 2005; Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000; Amis and Stevenson, 2001; May and Simmons, 2001; Hill and Power, 2002). If he wanted to locate angel capital in the US or Europe, he could log onto www.eban.org and www.angelcapitalassociation.org for leads and advice. For a snapshot of market activity, he could also navigate through numerous analytical reports from the Centre for Venture Research (www.unh.edu/cvr). In venture finance circles, business angels are and continue to be front page news. In no small measure, this growing awareness of the critical role business angels play in supporting the growth ambitions of entrepreneurs has been fueled by a substantial and sustained body of research undertaken by scholars around the world over the past 15 years. Business angel research traces its roots back to the early 1980s and a pioneering study conducted by William Wetzel (1983) in New England. This first ABC-study (attitudes, behaviors, characteristics) provided insights into what had been, up to that time, a largely neglected phenomenon. Wetzel discovered that business angels were diﬃcult to identify as they preferred to operate anonymously, shared common traits as they were typically wealthy, self-made males, were highly active, invested locally and early on, and relied heavily on their network to undercover investment opportunities. In putting some boundaries on our ignorance, Wetzel’s (1983) work spurred replication eﬀorts in California 315

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(Tymes and Krasner, 1983), the Sunbelt region (Gaston and Bell, 1986), the Great Lakes region (Aram, 1987), and the East Coast (Haar et al., 1988). Significantly, much of this research was funded by the US Small Business Administration who took an early and active interest to support research eﬀorts aimed at understanding the size and underlying dynamics of the business angel phenomenon (Gaston and Bell, 1988). Collectively described as the informal venture capital market, business angels were recognized from the outset to be a specialized species of equity financier, quite distinct in character from venture capital financiers. Of perhaps greater significance, this pioneering work in the US market spurred research eﬀorts internationally in the UK (Mason et al., 1991), Canada (Riding and Short, 1987), Sweden (Landström, 1993), Finland (Mason and Lumme, 1995), Norway (Reitan and Sørheim, 2000), Germany (Brettel, 2003), Australia (Hindle and Wenban, 1999), Japan (Tashiro, 1999), Singapore (Hindle and Lee, 2002), among others. On the back of this first generation of demographic studies that described what business angels look like (Mason and Harrison, 2000), researchers increasingly turned their attention towards understanding how the informal venture capital market operates. A number of these second generation studies focused on the investment decision-making process (Riding et al., 1994; Landström, 1995; 1998; Mason and Rogers, 1996; van Osnabrugge, 2000). Others were directed at policy-makers aimed at reducing the search costs incurred by entrepreneurs and investors alike through the development of business angel networks and stimulating market activity (Harrison and Mason, 1996a). Yet another significant stream of research that was undertaken at this time explored the extent to which theoretical perspectives such as decision-making (Landström, 1995; Feeney et al., 1999), agency theory (Landström, 1992; Fiet, 1995; van Osnabrugge, 2000), social capital (Sætre, 2003; Sørheim, 2003), and signaling (Prasad et al., 2000) could be usefully applied into the domain of business angels. 2006 will mark the 25th anniversary of Wetzel’s pioneering study that stimulated the creation of a specialized field of study, informal venture capital. In his pioneering study, Wetzel (1983) spoke of ‘putting boundaries on our ignorance’. The first objective of this chapter is to put some boundaries on our knowledge. What have we learned about the informal venture capital phenomenon over the past quarter century? Having said this, we as researchers are trying to describe a largely invisible market that is only partially visible to the eye. The second objective of this chapter is to highlight some of the burning issues that we need to tackle to further the development of this field of study. Finally, I want to draw out some of the implications of why research in this domain is vital for practitioners and policy-makers alike. Boundaries on our knowledge Business angel research has followed a distinct pattern over time. The formative studies were conducted in the early 1980s in the US and sought, in the first instance, to estimate the size of the informal venture capital market and to describe the ABCs (attitudes, behaviors, and characteristics) of business angels themselves. Public policy-makers, in particular the Small Business Administration (SBA), took an active interest in funding research projects throughout the US. What early researchers discovered was that across all regions studied in the US, the informal venture capital market was large, very active, discrete in nature, and that business angels shared similar traits.

Business angel research 317 Market scale Relying on a market-based approach, Wetzel (1986) estimated that the angel market in the US involved 100 000 individuals investing a total of $5 billion. In arriving at this estimate, he made assumptions about the proportion of start-ups that need external finance (5 per cent), the average amount they raised ($200k), and estimates about the proportion and investment activity levels of the population based on the Forbes 400 list of richest people. Relying on SBA Dun’s Market Identifier data (Gaston, 1989b) employed a firm-based approach extrapolating the observed propensity of firms in his sample to raise business angel finance to the nation as a whole. On this basis, he estimated that 720 000 private investors made 490 000 investments totaling $32.7 billion in equity and $23 billion in debt finance to some 87 000 ventures. Another estimate (Ou, 1987) based on data obtained from the 1983 Survey of Consumer Finance, concluded that two million families in the US held investments totaling some $300 billion in privately-held businesses in which the investor had no management involvement. In terms of size, the informal venture capital market in the US was some eight to fifteen times larger, measured in terms of number of investments made, than the formal venture capital industry. Interestingly, more contemporary research in the US reaﬃrms both the scale and highly active nature of the informal venture capital market, estimating that 300 000 to 350 000 angels invest about $30 billion a year in 50 000 ventures (Sohl, 2003). Mason and Harrison (2000) took a slightly diﬀerent tack to estimate the size of the informal venture capital market in the UK by extrapolating from the activity levels observed in the visible part of the market, namely among business angels registered in business angel networks. Based on assumptions regarding the proportion of business angels that participate in BANs, their estimates ranged from 20 000 to 50 000 investors investing £500 million to £2 billion. Van Osnabrugge and Robinson (2000) estimated that business angels do thirty to forty times as many deals as venture capital funds. Recent research completed in Sweden (Avdeitchikova and Landström, 2005) based on a large representative sample of the Swedish population, estimated that approximately 2.5 per cent of the population aged 18 to 79 (150 000) have made informal investments totaling in excess of $11 billion. Getting a handle on market scale is important as it has provided a stimulus among policy-makers, entrepreneurs, business angels and by implication, research funding bodies, that the informal venture capital phenomenon needs to be defined and understood before it can be properly stimulated. Attitudes, behaviors and characteristics: business angels in profile For the most part, formative angel research followed a familiar pattern. Business angels were uncovered through a combination of direct (contacts made through referrals, mainly business angel introduction services) and indirect (wealth indicators) approaches. Early researchers quickly discovered that business angels typically know other business angels; hence the adoption of the term ‘snowball sampling’. The challenge of finding business angels persists today both for researchers seeking insights and for entrepreneurs seeking capital. By its very nature, the business angel market is discrete in nature; it is an elusive phenomenon to study, but perhaps that is inevitable. Based on convenience samples, a number of studies have been completed around the world, relying, for the most part, on survey instruments with little theoretical guidance soliciting the views of business angels about their background, interest and means of

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investing in private companies. With remarkable consistency, business angels in the US (Gaston, 1989a; Freear et al., 1994), UK (Mason et al., 1991), Sweden (Landström, 1993), Finland (Lumme et al., 1998), Norway (Reitan and Sørheim, 2000), Canada (Riding, 1993), Germany (Brettel, 2003; Stedler and Peters, 2003), Australia (Hindle and Wenban, 1999), Singapore (Hindle and Lee, 2002), or Japan (Tashiro, 1999), exhibited common traits: ● ●

● ● ● ●

A typical business angel is a middle-aged male (40) with entrepreneurial street smarts (new venture experience). The investment decision is motivated by the prospect of financial return and significant non-financial motivations (psychic hot buttons to use William Wetzel’s terminology). Business angels rely on a close circle of business associates and friends to refer potential investment opportunities to them. A typical deal involves a syndicate of business angels and is usually made in ventures close to the home base of the investor(s). Angels are attracted to proposals where they can apply their knowledge, skills and experience thus bringing value added benefits to the venture. A substantial minority of business angels (up to 40 per cent or more) have yet to make their first investment, variously described as latent angels or virgin angels (Freear et al., 1994; Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000).

While it is appealing to conclude that business angels as a group across a number of countries share similar traits, the evidence collected to date supports the notion that the business angel market is rather heterogeneous in character (Wetzel, 1994). One of the early pieces of research that explored this issue (Postma and Sullivan, 1990) identified three distinct groups of business angels based on their motivation for investment – financial, altruistic or selforiented. Gaston (1989a) developed a ten-category classification scheme based on metrics related to investment activity, post-investment involvement, and personal characteristics.1 In much the same spirit, Benjamin and Margulis (1996) developed a nine-category classification scheme of their own.2 Coveney and Moore (1998) highlighted an important, yet largely neglected, category of business angel, namely those that want to make investments but have not yet done so.3 Early research from Freear et al. (1994) coined the term ‘virgin angels’ to describe these latent investors. Other authors (Kelly and Hay, 1996a; 1996b) have focused on the active market element, so-called serial investors, who have completed a number of deals. Finally, Sørheim and Landström (2001), have developed a four-category classification scheme based on investment activity and investor involvement. To them, a business angel is defined as being both highly active and highly involved. This early base of research, or first generation studies, provided a necessary foundation for future work, as researchers: ● ● ●

Demonstrated that the informal venture capital market was large and very active, particularly in the crucial early stages of venture development. Confirmed that indeed informal venture capital is a global phenomenon. Developed a common basis for defining the terms ‘business angel’ and ‘informal venture capital’.

Business angel research 319 ● ●

Highlighted the heterogeneous nature of the market and some of the practical diﬃculties undertaking research on a largely invisible population. Articulated questions for future research based on insights and observations from mapping the terrain.

Beyond ABCs: second generation studies Moving beyond describing the informal venture capital phenomenon, researchers began to turn their attention to issues related to: (1) how the informal venture capital market operates in practice (Riding et al., 1994; Mason and Harrison, 1996; van Osnabrugge, 2000); (2) the role of public policy-makers in stimulating and supporting market development (Harrison and Mason, 1996b; Wetzel and Freear, 1996); and (3) the introduction of an element of theoretical rigor into the field (Landström, 1992; 1995; Fiet, 1995; van Osnabrugge, 2000; Kelly and Hay, 2003). In many respects, first generation studies were the pilot from which researchers developed increasing levels of sophistication in terms of the choices made with respect to: i) framing research questions; ii) data collection; and iii) analysis. In addition a great impetus for these second generation studies, was the growing number of academic outlets in which to publish this work. Informal venture capital research was coming of age as a field of academic study. What have we learned from this large and growing body of second generation studies? How do they do it? Early work in Canada (Riding et al., 1994), provided some insights into the business angel decision-making process. The authors concluded that business angels are highly selective investors who form initial assessments based on concept feasibility, management capability, and prospective financial return. The perceived attractiveness of a given opportunity also appears to be influenced greatly by deal referrers. While adopting a rather informal approach to due diligence, a key factor in the decision to invest is the personal chemistry that develops between the entrepreneur and the angel. Mason and Harrison (1996) reached broadly similar conclusions as Riding et al. (1994) in their study of angel decision-making behavior in the UK. Relying on verbal protocol techniques, they concluded that angels form opinions about the potential trustworthiness of the entrepreneur rather quickly, so-called swift trust (Harrison et al., 1996). Early on, angels look for deal killers and over time make an assessment of both the attractiveness of the opportunity and the perceived level of competence of the management team to exploit it. Van Osnabrugge and Robinson (2000) conducted a large scale comparative study contrasting the decision-making approaches of business angels and venture capitalists. While both were attracted to opportunities with strong growth potential and driven by capable management teams, business angels spent less time investigating and relied less on outside parties to assess the attractiveness of a given investment opportunity. Landström (1995) identified two distinct strategies used by business angels to aid them in making investment decisions. Specialist investors choose to limit their activity in areas related to their particular market and/or technical expertise. Compared to investors that sought portfolio diversification, specialists examined fewer proposals and exhibited a higher propensity to invest than explicitly diversified investors. Having said this, the two groups relied on broadly similar criteria to evaluate opportunities.

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Public policy A second body of work focused on some of the challenges that impede the development and growth of the informal venture capital market and discussed some of the mechanisms by which public policy can alleviate this situation. Broadly speaking, the challenges to be addressed include: i) conditions of excess demand for equity capital in the early stages, the capital problem; ii) the diﬃculties encountered in trying to bring suppliers and users of capital together, the search problem; and iii) finding ways to stimulate market activity, the incentives problem. The capital problem was diagnosed as early as the 1930s by the Macmillan Committee on Finance and Industry of the UK government and is most acutely felt in early stage technology-based ventures requiring less than $500 000 in equity and that have exhausted other financing sources including own funds and those provided by friends and family. Mason and Harrison (1994) also confirm the existence of this gap in the UK. Sohl (1999) has also identified the appearance of a second equity gap for ventures seeking between $2 and $5 million, an amount that is too large for consideration by business angels and too small to attract the attention of venture capital funds in the US. That the capital problem persists may be symptomatic of the complex and dynamic nature of the interplay between love money (founders, family and friends), soft money (government), play money (angels) and custodial money (venture capitalists). In fact, I believe there is a strong basis to conclude that researchers and public policy-makers will always be grappling with this issue given the dynamism of the problem we are trying to solve. The search problem arises from the fact that given the largely invisible character of the informal venture capital market, it is diﬃcult for business angels and entrepreneurs to find each other. Developing forums through which capital seekers and providers can meet has been a longstanding concern of scholars both in the US (Wetzel and Freear, 1996) and the UK (Harrison and Mason, 1996a; 1996b). Governments around the world have keenly embraced the development of business introduction services and business angel networks to alleviate the search problem for entrepreneurs and business angels alike. Generally speaking, these mechanisms provide a forum for entrepreneurs and angels to develop their networks. While diﬀering greatly in terms of size, scope and method of operation, most of these forums provide guidance to entrepreneurs seeking cash and opportunities to be introduced to prospective investors. Increasingly, business angel networks have begun to address the incentives problem, acting as an important conduit through which lobbying eﬀorts have been made to influence policy. The introduction of various forms of tax relief for business angel investing in the UK owe much to the work of Harrison and Mason and to the growing number of highly active business angel networks operating in the UK. More research needs to be undertaken to determine the impact these incentives have both in terms of expanding the number of investments made and importantly the quality and sophistication of deal making in the informal venture capital market. Building bridges to theory As researchers moved beyond fact gathering to more theoretically grounded studies, a growing body of research looked to other fields of study for guidance including agency theory (Landström, 1992; Fiet, 1995; van Osnabrugge, 2000; Kelly and Hay, 2003), social capital (Kelly and Hay, 2000; Carter et al., 2003; Sætre, 2003; Sørheim, 2003), and

Business angel research 321 signaling theory (Prasad et al., 2000). Each of these theoretical anchors will be discussed in turn, beginning with agency theory. Agency theory On the face of it, the domain of the business angel is potentially rife with agency risks. Investors and entrepreneurs alike find it very diﬃcult to identify all of the options available to them (Harrison and Mason, 1996b). Once identified, it also appears diﬃcult for business angels to fully assess the intentions and competence of the entrepreneur and vice versa (van Osnabrugge, 2000). Moreover, business angels are very active participants in the venture development process; involvement that can be seen as both making a value added contribution to the venture and as a means for investors to keep tabs on or monitor the activities of the entrepreneur. Finally, the most significant negotiating issue between the parties is the distribution of equity stakes, in other words, the incentive structure (Benjamin and Margulis, 1996), a central pillar of agency theory. In a comparative study of venture capitalists and business angels, Fiet (1995) examined the extent to which investors relied on themselves as opposed to others for obtaining market (unforeseen competitive conditions) and agency (the possible divergence of interests between investor and entrepreneur) risk reducing information. He found that agency risk was the primary preoccupation for business angels whereas venture capitalists were much more concerned about market risk. Landström (1992) surveyed firms that received business angel finance. Relying on agency theory, he hypothesized that business angels would be more involved in ventures that were: a) highly innovative; b) early stage; c) operating in turbulent environments; d) managed by inexperienced entrepreneurs with lower equity stakes in the venture; e) located close to the investor’s home base of operation; and f) competing in an industry familiar to the investor. He found support only for the geographic proximity and industry familiarity predictors. In interpreting the findings, Landström concluded that: ‘it is not the required level of control which is most influential in determining the frequency of contacts and (level of) operational work. It is rather the feasibility for active involvement that seems to be most influential’ (1992, p. 216). Moreover, he stated that the relationship between the parties is highly personal and infused with trust, calling into question the inherently negative assumptions about people upon which agency theory is based. Van Osnabrugge (2000) found support for the notion that compared to venture capitalists, business angels work from a notion that contracts between themselves and the entrepreneur are necessarily incomplete (the incomplete contracts approach). For business angels, control over the entrepreneur’s behavior and the venture’s development is best achieved through being actively involved in the venture post-investment as opposed to devoting undo time, attention and detail to crafting a comprehensive contract ex ante (the principal–agent approach). In their study, Kelly and Hay (2003) found support for a central notion of agency theory, namely that the relative equity stakes of the parties matter. The higher the equity stake of the investor(s), the more attention to contractual detail particularly with regard to specific provisions that could, in some way, impact the relative equity stakes going forward. However, he concluded that the economic relationship between investor and entrepreneur appears to be infused with high levels of interpersonal trust from the outset; a finding consistent with that of Landström (1992). Moreover, the level

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and form of investor involvement with the venture post-investment appeared to be motivated more from venture need as opposed to being a means of checking up on the entrepreneur. Social capital The intuitive appeal of social capital perspectives into the field of informal venture capital is quite clear. Entrepreneurs and business angels alike need to develop and manage their network of connections to support the development of their ventures and portfolios respectively (Birley, 1985). The notion of social capital is also captured in the work of Politis and Landström (2002), who regard informal venture capital investing as part of one’s entrepreneurial career. The accumulated experience and connections an individual makes building a business as an entrepreneur, prove to be an invaluable and transferable resource that can be leveraged as a business angel. In his examination of the pre-investment behaviour of business angels, Sørheim (2003) unpacked the notion of social capital into structural (network ties), relational (trustworthiness of the parties to the deal) and cognitive (shared vision or common ground) dimensions. A key finding of his work, based on interviews with experienced business angels in Norway, is that the development of common ground is a necessary antecedent for building a long-term trusting relationship between the business angel and entrepreneur. Based on interview data obtained from companies that received angel investment in Norway, Sætre (2003) introduced the notions of competent and relevant capital. By competent capital, he means the base of new venture, general management, educational and experience gained as a business angel investor that an individual brings to the venture. What is an even more valuable commodity for entrepreneurs is business angels that bring a base of experience in the industry in which the venture competes, so-called relevant capital. Social capital has also been used as a lens to examine the challenges that female entrepreneurs face in their quest to secure equity financing (Carter et al., 2003). Raising equity finance necessitates developing and utilizing one’s social network, an area where female entrepreneurs appear to be disadvantaged (Brush et al., 2002). Establishing network connections appears to be an important conduit for entrepreneurs to uncover the informal venture market (Amatucci and Sohl, 2004). From the capital supply perspective, Harrison and Mason (2005) concluded that male and female business angels diﬀer very little but that there are gender diﬀerences evident in networking behaviors, with females being less connected with or knowing other business angels. Signaling theory There is an obvious intuitive appeal to exploring the potential utility of signaling theory in the informal venture capital domain. Entrepreneurs and investors alike need to be able to provide informative signals as to the quality of the opportunity and their capability to successfully exploit it. Prasad et al. (2000) argued that prior research demonstrates that the proportion of equity retained by the entrepreneur is a signal of project quality when personal funds available to invest in the project are unlimited. They develop a model that relaxes this assumption and concluded that a more appropriate signal in the domain of the business angel is the proportion of the entrepreneur’s wealth invested in the venture. The higher the proportion, the stronger the signal of both the venture’s perceived value and the entrepreneur’s commitment to the venture. It is important to note that this model is developed from the entrepreneur’s perspective

Business angel research 323 only and focuses on the utility of a one-dimensional signal, proportion of personal wealth invested. That researchers have looked to theoretical perspectives developed in other fields of study is in itself a signal of the growing maturity of informal venture capital as a field of study. Building on this base of emerging knowledge, where do we go from here? It is to this question that we now turn our attention. Research agenda Bridging the gap between FFFs and business angels A recent research report (Bygrave et al., 2003) based on data collected as part of the Global Entrepreneurship Monitor (www.gemconsortium.org) research initiative highlighted the importance of informal investment across a sample of 18 countries where data had been provided by 40 or more informal investors. Annual informal investment for the period 1997–2001 was estimated to be almost $200 billion, two-thirds of which occurred in the US. The vast majority of informal investment made (88 per cent) was from family members, relations, friends and neighbors. Raising money from the three Fs (family, friends and fools), is the predominant source of start-up finance, an observation consistent with analysis of sources of funding for the Inc 500 listing of America’s fastest growing private companies (Inc, 2000). Sohl (2003) highlighted the gap between what might be termed founding capital (FFFs) and business angel finance. The GEM study demonstrates that founding capital appears to be a necessary pre-condition to start-up, yet there appears to be a significant disconnect when time comes for an entrepreneur to raise money from business angels. What are the causes of this disconnect? On what terms and conditions is founding capital raised? To what extent is founding capital and business angel capital compatible? It is, in some respects, very remarkable that we know virtually nothing about the founding capital phenomenon despite the fact that this source invests more than $150 billion annually and is, in essence, a feeder to the business angel market. Demographic research: mapping the terrain Two other significant strands of research also follow from the GEM research initiative. First, we should undertake business angel demographic studies beyond developed economies to include developing nations such as Korea ($17 billion annual informal investment), Mexico ($3 billion), Argentina ($1 billion) and Brazil ($1 billion). Such research will help us to better understand the influence that contextual and environmental variables have on business angel investment activity. What framework conditions encourage or discourage business angel investment activity? A second strand of research springs forth from the finding that across the entire sample of 29 nations (including the 11 nations where the number of informal investors surveyed was less than 40), almost one-third of informal investors are female. Most of the received demographic studies conducted to date have concluded that the population of business angels is predominantly middle-aged males. Female business angels appear to be a significant source of capital for entrepreneurs. To date, very few studies have been conducted to contrast the approach of female versus male business angels (Harrison and Mason, 2005).

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Public financiers: help or hindrance Yet another under-researched area is the role and impact of public sector funding instruments targeted at bridging the equity gap between founders’ capital and obtaining business angel finance. European governments have been particularly active in this regard, establishing a wide variety of financing programs to stimulate regional entrepreneurship, the development of technology-based ventures, and university spin-outs, among countless other objectives. For example, in Finland an entrepreneur can raise money from public agencies to build a prototype and hire consultants to develop a business plan. In Sweden, the number of programs and support services have become so numerous that consultants have established thriving practices helping entrepreneurs successfully to navigate this highly crowded field. Having said this, a number of important questions need to be addressed. When is government support most needed, wanted and in what form(s)? To what extent are the goals of government funding bodies compatible with those of the entrepreneur and professional outside investors? What implications does the decision to raise funds from public sector source have in terms of subsequent fund raising? Signaling theory may be a potentially useful lens through which to address these issues. In what circumstances does the presence and involvement of a public sector catalyst send a positive or negative signal to follow-on financiers? This line of research enquiry could also be usefully extended to consider to what extent the presence and involvement of a particular business angel(s) sends positive or negative signals to other external investors. It is to a discussion of the relationship between business angels and venture capitalists to which we now turn our attention. Bridging the gap between business angels and venture capital funds We know that business angels tend to invest earlier, in smaller amounts and in more businesses than venture capital funds (van Osnabrugge and Robinson, 2000). A typical angel deal occurs at the seed or early stage of development in the range of $100 000 to $2 million from a syndicate of six to eight investors (Sohl, 2003). The observed diﬀerences in investment preferences have led some authors to conclude that business angels are the farm system for venture capitalists and thus complementary in nature (Freear and Wetzel, 1990; Harrison and Mason, 2000). Given the entrepreneurial background and experience of angels and their desire to be actively involved in the venture post-investment, there is good reason to believe that raising angel capital should enhance the fundability of a proposal by raising valuations to a level that warrants much larger venture capitalist followon investment. However, the extent to which the business angel and venture capital markets are indeed complementary in nature is still an open area for further research (Harrison and Mason, 2000). A consequence of the rapid growth in the venture capital industry, particularly in the US, is that there has been a continual movement towards larger deals at later stages of venture development. The venture capitalist comfort zone appears to be later stage deals that require $10 to $15 million in investment. Sohl (2003) has concluded that a secondary (and growing) funding gap exists for ventures requiring between $2 and $5 million, an amount too large for angels but too small for venture capital funds to provide economically. Rather than being complementary, the two markets may in fact be moving towards being distinctly diﬀerent in character, a theme that Jeﬀrey Sohl will explore in Chapter 14. We know that both business angels and venture capitalists are attracted to proposals

Business angel research 325 driven by a talented team exploiting high growth opportunities. We also know that both business angels and venture capitalists expend eﬀort evaluating opportunities, albeit the former in a much less formal and comprehensive manner (van Osnabrugge, 2000) and that an important motivation for investing is capital gains appreciation. However, the informal and formal venture capital market diﬀers in two key respects: i) angels do not face the same pressures to invest as it is their own capital at risk; and ii) angels participate for the fun element and the prospect of capital gain whereas venture capitalists are motivated, in large part, by the latter. On the face of it, the formal and informal venture capital markets appear to be complementary (Harrison and Mason, 2000) but are they in fact compatible? Further research needs to explore in what ways the informal and formal venture capital markets work together or at cross purposes. Allow me to highlight some interesting questions that, to date, have not been addressed. Complementarity presumes that business angels invest early and bring venture capitalists in as equity financiers later. We desperately need more longitudinal research to satisfy ourselves that this is, in fact, the case. Second, assuming that bridges exist between the informal and formal venture capital markets, it raises the question as to how this hand-oﬀ between business angel and venture capitalist can best be achieved and by whom. Third, it appears that the emerging venture capital financier start-up model implies a fund placing many large bets in a given opportunity space to achieve a hit. This approach is fundamentally at odds with that of business angels who prefer to invest smaller amounts of capital early on. Which raises the question, is one approach better than the other? Do these distinct styles of start-up finance actually place business angels and venture capitalists in a competitive as opposed to cooperative relationship? Fourth, what role, if any, is there for public policy-makers to stimulate more deal flow from angels to venture capital funds and vice versa (Harrison and Mason, 2000)? In short, we need to understand better how to create an environment that nurtures and supports the development of rapid growth ventures, particularly in rapidly changing knowledge-based economies. Tapping into experience Another consistent theme that has been highlighted in emerging research is that a substantial minority of individuals who deem themselves business angels have yet to consummate their first investment, so-called latent or virgin angels (Freear et al., 1994; Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000). Moreover, based on estimates in the US (Sohl, 2003), some 2 million individuals fit the business angel profile but in any given year only some 250 000 are active market participants. There is immense untapped potential in the informal venture capital market, which gives rise to a number of important research questions. First, it appears that business angel investing is a learning-by-doing experience (Kelly and Hay, 1996a; 1996b). Starting out an individual needs to learn how to tap into sources of deal flow, once uncovered evaluate opportunities, structure sensible deals, help entrepreneurs build value and hopefully realize successfully on the value created as a result. If indeed angels learn through practice, researchers ought to be focusing more attention on the minority of business angels that are highly active, so called serial investors (Kelly and Hay, 1996a; 1996b; van Osnabrugge, 2000) or deal-makers (Kelly and Hay, 2000). My own research tends to support the view that successfully cashed out entrepreneurs whose ventures relied on external equity to support growth become very active business angels soon

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after cashing out. Do these wealthy and highly experienced entrepreneurs turned investors share common traits? Do they go about the task of finding, evaluating and closing deals in a diﬀerent way from less wealthy and less experienced counterparts? Are these types of individuals more compatible in approach with venture capital funds, having probably raised money from this source before as an entrepreneur? My sense is that we have only begun to tap into this most discrete and most active segment of the business angel market. Second, we know that business angels are increasingly using syndication as means of diversifying risk, participating in larger deals than they might otherwise be able to, sharing information, and as a means for building their network of relationships with other business angels and capital providers. While the advantages of syndication are clear-cut, our understanding of how they come about and operate is rather limited. How do business angels choose syndicate partners? How are the goals of individual syndicate members reconciled? How should the interface between the syndicate and the entrepreneur be optimally managed? Does the presence of a syndicate encourage or deter followon financiers? Third, we need more detailed research profiling the similarities and diﬀerences of the distinct subsets of business angels identified as a result of previous research eﬀorts (Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000; Sørheim and Landström, 2001). In what ways are latent or virgin angels diﬀerent from highly active business angels? One of the key advantages of raising money from business angels is the ability to tap into a base of personal experience building new ventures. As a prospective business angel with new venture experience, how can I best use it? As a prospective business angel lacking this experience, how can I compensate for it? Sharing entrepreneurial knowledge Researchers often use the term smart money to describe business angel finance. Angels are attracted to proposals where their experience can be applied so as to enhance the prospects of creating economic value both for themselves and the entrepreneur. When all is said and done, the decision to invest is a highly personal one influenced to a great degree by gut feeling, particularly as it is the business angel’s own capital that is put at risk. Too often, in my opinion, we consider business angel investments as business transactions, ignoring the mating and relationship rituals that cause them to happen. Perhaps we ought to look to fields like psychology and sociology for guidance in exploring why certain business angels and entrepreneurs connect while others fail to do so. As most business angels are highly experienced in building new ventures from scratch, in choosing to back a particular entrepreneur, an angel is choosing to share their entrepreneurial experience and knowledge with them. What triggers this highly personal decision? What sort of knowledge and experience matters most in favorably skewing the odds of success? How best should this knowledge and experience be shared? Acting as a sounding board and being a mentor to the entrepreneur are often cited as key contributions made by business angels (Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000; Hill and Power, 2002). What specifically does this mean in practice? On what issues are business angels sounded out? How is the relationship between angel and entrepreneur managed in practice? Only by getting a clearer picture of what goes on both inside an angel’s head and between them and the entrepreneurs they back can we understand the dynamics of how the informal venture capital market operates in practice.

Business angel research 327 Revisiting methodological approaches Very early on, the pioneer of business angel research, William Wetzel, observed that the informal venture capital market is largely invisible in nature. As a result, the size and characteristics of the angel marketplace is ‘unknown and probably unknowable’ (Wetzel, 1983). In the absence of knowing what the population looks like, any sample that researchers have drawn upon for insight is, by definition, unrepresentative and will, despite our best eﬀorts, remain so in the future. As our body of accumulated research grows, so too does our understanding of how the informal venture capital market operates. Early eﬀorts to define market demographics relied on replicating studies made in the US in the early 1980s. For the most part, researchers have relied on surveys administered to convenience samples drawn mainly from formalized networks of angels, business introduction services. As the received base of business angel research has grown, so too has our sophistication in identifying and dealing with some of the significant methodological challenges we face. In an eﬀort to guide future research eﬀorts with the aim of expanding and deepening our knowledge of a complex social phenomenon, I wish to highlight a number of issues here. First, by relying on insights from business angels who have chosen to register in a formal network, we may be excluding a substantial proportion of deal-makers (van Osnabrugge, 1998; Kelly and Hay, 2000; Sørheim and Landström, 2001) who appear to have little need for the services of network providers such as business angel networks to generate investment leads. A convenience sample drawn from a network is, pardon the pun, convenient. Future research eﬀorts should consider ways to engage business angels that have, so far, eluded our attention. One potentially useful resource to identify new leads is to engage and identify active business angels from within a university’s alumni base. Second, in markets where numerous studies of business angels have been conducted, particularly in the US, UK, Canada and Scandinavia, there has, at times, been heavy reliance on respondents drawn from similar network organizations over time. To the extent that these networks attract new blood, fresh insights are obtained. We must be mindful, however, of the potential biases introduced by continuing to seek out information from individuals positively inclined to participate in any and all research studies. Third, much of the received research undertaken to date has been cross-sectional in nature. That is to say, we rely too much on surveys designed to collect data at a particular moment in time. In doing so, we tend to have focused on informal venture capital as an economic transaction as opposed to a highly fragile, personal commitment of two parties to work together. What is desperately needed is longitudinal transaction-based research relying on the deal as the unit of analysis. With this longitudinal perspective, we are better able to understand the complex dynamics of what brings entrepreneurs and business angels together, what keeps them together, what drives them apart and why some deals succeed while others fail. To capture the richness and complexity of these relationships, researchers should undertake more studies that employ structured interviewing and participant observation, among others. Fourth, the primary focus of research undertaken to date has sought out the views of investors only. While this is eminently sensible in situations where an individual alone decides whether to invest or not and on what terms, we need to balance the views of capital providers with that of entrepreneurs in need of capital. We know that both angels and entrepreneurs find it very diﬃcult to find each other in a timely manner. A great deal of

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literature has examined the role of network intermediaries to facilitate this introduction. Having said this, a number of pressing research questions remain. Why do deal-makers appear to shun network intermediaries? How do deal-makers build their network? How do entrepreneurs seeking funding build their network? We know a great deal about what attracts angels to particular investment proposals. On the flip side, what attracts a particular entrepreneur to an angel? We also know that angels, at least the successful ones, want to be actively involved in the venture post-investment. How do entrepreneurs feel about this interaction? How do they manage it? There also appears to be a growing consensus that business angels tend to want to invest in a project with other business angels. How do entrepreneurs manage a syndicate? Business angel research: the journey ahead Looking back, considerable progress has been made mapping the business angel terrain, but much work remains to be done. We have reached what Malcolm Gladwell has termed a ‘tipping point’ where both the volume and sophistication of business angel research is set to explode. We know that business angels are the second most important source of capital next to founders, family and friends. We know that business angels fill the everincreasing vacuum being left by venture capital fund managers funding seed stage ventures. We know that business angels are a diﬃcult domain to study and a diﬃcult force to mobilize given the discrete and invisible nature of informal venture capital. Researchers, practitioners and policy-makers alike have a shared interest to cultivate a deeper understanding of how the informal venture capital operates. Developing this understanding entails significant challenges for all of these three interlinked stakeholder groups. If informal venture capital is to develop into a mainstream field of academic study, researchers will need to pay more attention to the following issues. The term ‘business angel’ has, at times, been expanded to include related investors such as family and friends. My preference is to see the term ‘business angel’ retained for arm’s length investors and that related investors be explored as a distinct class of investor. Second, researchers will need to move beyond convenience surveys to employ more sophisticated sampling and research designs. Third, we need to anchor more studies in theoretical perspectives drawn from other fields and importantly, developed within the informal venture capital field itself. For practitioners, including business angels and various intermediaries who seek to bring investors and entrepreneurs together, three significant challenges need to be addressed. First, I believe we are working under the presumption that market transparency is a desirable end objective; with clarity more deals would be consummated. The venture capital market is highly transparent but for most entrepreneurs inaccessible. My own belief is that the invisible character of the informal venture capital market is both its defining trait and an important stimulus for investment itself. In short, business angels are attracted to invest in private companies precisely because the market is demonstrably ineﬃcient. Second, mechanisms need to be explored to facilitate the sharing of experience and risk-taking among active business angels and importantly between active and virgin business angels. Third, business angels and particularly intermediaries, have a crucial role in bridging the two gaps between FFFs and venture capital funds. Public policy-makers will need the courage to move beyond promoting business angel capital as an important source of finance to creating conditions where business angel capital can be optimally mobilized. My sense is that we treat business angel finance at

Business angel research 329 times as a public good finding ways to make the market more visible (like that for venture capital) and more active. My own view is that the market is attractive for business angels because it is diﬃcult to access. Public policy-makers also need to look at the impact that tax incentives and other stimuli have on business angel investing activity. I also believe public policy-makers have a vital role to play to provide transactional lubrication between love money (FFFs) and custodial money (venture capital). Finally, I appeal to the public sector to continue to fund business angel research as we are only now beginning to attack this challenging field of study in the sophisticated manner in which research has been undertaken in the venture capital field over the past 30 years. Our journey has just begun. Notes 1. ‘Devils’ – angels who gain control of the company; ‘Godfathers’ – successful, semi-retired consultants or mentors; ‘Peers’ – active business owners helping new entrepreneurs, with vested interest in the market, industry, or individual entrepreneur; ‘Cousin Randy’ – a family-only investor; ‘Dr Kildare’ – professionals such as MDs, CPAs, lawyers and others; ‘Corporate Achievers’ – business professionals with some success in large corporate organizations but who want to be more entrepreneurial and in top-management roles; ‘Daddy Warbucks’ – the minority of business angels who are as rich as all angels are commonly, and incorrectly, believed to be; ‘High-Tech Angels’ – investors who invest only in firms manufacturing hightechnology products; ‘The Stockholder’ – an angel who does not participate in the firm’s operations; and ‘Very Hungry Angels’ – angels who want to invest over 100 per cent more than deal flow permits. 2. ‘Value-Added Investors’ – very experienced individuals who invest in syndicates and want to be actively involved in the venture development process; ‘Deep-Pocketed Investors’ – individuals who have built and sold a business of their own, have corporate experience, seek control and some level of involvement with the venture; ‘Consortium of Individual Investors’ – individuals who have built new ventures, prefer passive involvement with the business and who invest as a group in a wide variety of diﬀerent proposals including early stage ventures; ‘Partner Investors’ – a buyer in disguise who has high needs for control, wants an executive position but lacks the funds to buy out a business outright; ‘Family of Investors’ – represents a pool of funds supplied by family members, astutely managed and desirous of being intensely involved over short periods of time; ‘Barter Investors’ – focus on early-stage growth businesses providing needed resources to support growth in exchange for equity; ‘Socially Responsible Investors’ – seek intense interaction with ventures that share a common cause with them; ‘Unaccredited Investors’ – less experienced, less aﬄuent individuals who invest small amounts of capital in a diversified manner; and ‘Manager Investors’ – individuals who have a low tolerance for risk and want to buy into a challenging job by making one personally significant investment in a venture in which they are actively involved. 3. ‘Virgin Angels’ – individuals with funds available who are looking to make their first investment; ‘Latent Angels’ – rich individuals who have made angel investments, but not in the past three years; ‘Wealth Maximizing Angels’ – rich individuals and experienced businessmen who invest in several businesses for capital gain; ‘Entrepreneur Angels’ – very rich, very active entrepreneurial individuals who back a number of businesses both for the fun of it and as a better option than investing in the stock market; ‘Income Seeking Angels’ – less aﬄuent individuals who invest some funds in a business to generate an income or even a job for themselves.

References Amatucci, F. and J. Sohl (2004), ‘Women entrepreneurs securing business angel finance: tales from the field’, Venture Capital, 6(2/3), 181–96. Amis, D. and H. Stevenson (2001), Winning Angels: The 7 Fundamentals of Early Stage Investing, London: Prentice Hall. Aram, J.D. (1987), Informal Risk Capital in the Great Lakes Region, Washington DC: Small Business Administration. Avdeitchikova, S. and H. Landström (2005), ‘Informal venture capital: scope and geographical distribution in Sweden’, paper presented at the 2005 Babson Entrepreneurship Research Conference, Glasgow, Scotland. Benjamin, G. and J. Margulis (1996), Finding Your Wings: How to Locate Private Investors to Fund Your Venture, New York: John Wiley & Sons. Benjamin, G. and J. Margulis (2005), How To Raise Early-Stage Private Equity Financing, New York: Wiley. Birley, S. (1985), ‘The role of networks in the entrepreneurial process’, Journal of Business Venturing, 1, 107–17. Brettel, M. (2003), ‘Business angels in Germany: a research note’, Venture Capital, 5(3), 251–68.

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Brush, C., N. Carter, P. Greene, M. Hart and E. Gatewood (2002), ‘The role of social capital and gender in linking financial suppliers and entrepreneurial firms: a framework for future research’, Venture Capital, 4(4), 305–23. Bygrave, W., M. Hay, E. Ng and P. Reynolds (2003), ‘A study of informal investing in 29 nations composing the global entrepreneurship monitor’, Venture Capital, 5(2), 101–16. Carter, N., C. Brush, P. Greene, E. Gatewood and M. Hart (2003), ‘Women entrepreneurs who break through to equity financing: the influence of human, social and financial capital’, Venture Capital, 5(1), 1–28. Conlin, E. (1989), ‘Adventure capital’, Inc., September, pp. 32–48. Coveney, P. and K. Moore (1998), Business Angels: Securing Start-Up Finance, Chichester: Wiley. Feeney, L., G. Haines and A. Riding (1999), ‘Private investor’s investment criteria: insights from qualitative data’, Venture Capital, 1(2), 121–45. Fiet, J. (1995), ‘Reliance upon informants in the venture capital industry’, Journal of Business Venturing, 10, 195–223. Freear, J., J. Sohl and W. Wetzel (1994), ‘Angels and non-angels: are there diﬀerences?’, Journal of Business Venturing, 9(2), 109–23. Freear, J. and W. Wetzel (1990), ‘Raising venture capital: entrepreneur’s view of the process’, in N. Churchill, B. Bygrave, D. Muzyka, J. Hornaday, K. Vesper and W. Wetzel (eds), Frontiers of Entrepreneurship Research, Wellesley: Babson College. Gaston, R. (1989a), Finding Private Venture Capital for Your Firm: A Complete Guide, New York: Wiley. Gaston, R. (1989b), ‘The scale of informal venture capital markets’, Small Business Economics, 1, 223–30. Gaston, R. and S.E. Bell (1986), Informal Risk Capital in the Sunbelt, Washington DC: Small Business Administration. Gaston, R. and S.E. Bell (1988), The Informal Supply of Capital, Washington DC: Small Business Administration. Haar, N., J. Starr and I. Macmillan (1988), ‘Informal risk capital investors: investment patterns on the East Coast of the USA’, Journal of Business Venturing, 3, 11–29. Harrison, R. and C. Mason (1996a), Informal Venture Capital: Evaluating the Impact of Business Introduction Services, Hemel-Hempstead: Prentice Hall. Harrison, R. and C. Mason (1996b), ‘Developments in the promotion of informal venture capital in the UK’, International Journal of Entrepreneurial Behavior and Research, 2(2), 6–33. Harrison, R. and C. Mason (2000), ‘Venture capital market complementarities: the links between business angels and venture capital funds in the United Kingdom’, Venture Capital, 2(3), 223–42. Harrison, R. and C. Mason (2005), ‘Does gender matter? Women business angels and the supply of entrepreneurial finance’, Hunter Centre for Entrepreneurship Working Paper, University of Strathclyde. Harrison, R., M. Dibben and C. Mason (1996), ‘The role of trust in the informal investor’s investment decision: an exploratory analysis’, Entrepreneurship: Theory & Practice, 21(4), 63–81. Hill, B. and D. Power (2002), Attracting Capital from Angels: How their Money – and their Experience – can help you Build a Successful Company, New York: John Wiley & Sons. Hindle, K. and L. Lee (2002), ‘An exploratory investigation of informal venture capitalists in Singapore’, Venture Capital, 4(2), 169–81. Hindle, K. and R. Wenban (1999), ‘Australia’s informal venture capitalists: an exploratory profile’, Venture Capital, 1(2), 169–86. Inc. (2000), ‘The Inc. 500: America’s fastest-growing private companies’, Inc Magazine, 17 October, p. 65. Kelly, P. and M. Hay (1996a), ‘Serial investors: an exploratory study’, in P. Reynolds (ed.), Frontiers of Entrepreneurship Research, Wellesley: Babson College, pp. 1–14. Kelly, P. and M. Hay (1996b), ‘Serial investors and early stage finance’, Journal of Entrepreneurial and Small Business Finance, 5(2), 159–74. Kelly, P. and M. Hay (2000), ‘Deal-makers: reputation attracts quality’, Venture Capital, 2(3), 183–202. Kelly, P. and M. Hay (2003), ‘Business angel contracts: the influence of context’, Venture Capital, 5(4), 287–312. Landström, H. (1992), ‘The relationship between private investors and small firms: an agency theory approach’, Entrepreneurship and Regional Development, 4, 199–223. Landström, H. (1993), ‘Informal risk capital in Sweden and some international comparisons’, Journal of Business Venturing, 8, 525–40. Landström, H. (1995), ‘A pilot study on the investment decision-making behavior of informal investors in Sweden’, Journal of Small Business Management, 33(3), 67–76. Landström, H. (1998), ‘Informal investors as entrepreneurs’, Technovation, 18, 321–33. Lumme, A., C. Mason and M. 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Business angel research 331 Mason, C. and R. Harrison (2000), ‘Informal venture capital and the financing of emergent growth businesses’, in D. Sexton and H. Landström (eds), Handbook of Entrepreneurship, Oxford: Blackwell, pp. 221–9. Mason, C. and A. Lumme (1995), ‘The value-added impact of business angels’, paper presented at the 5th Global Entrepreneurship Research Conference, Salzburg, Austria. Mason, C. and A. Rogers (1996), ‘Understanding the business angel’s investment decision’, Venture Finance Research Project Working Paper No. 14, Southampton: Southampton University. Mason, C., R. Harrison and J. Chaloner (1991), ‘Informal risk capital in the UK: a study of investor characteristics, investment preferences and investment decision-making’, Venture Finance Research Project Working Paper No. 2, Southampton: Southampton University. May, J. and C. Simmons (2001), Every Business Needs an Angel: Getting the Money You Need to Make Your Business Grow, New York: Crown Business. Ou, C. (1987), Holdings of Privately-held Business Assets by American Families: Findings From the 1983 Consumer Finance Survey, Washington: Small Business Administration. Politis, D. and H. Landström (2002), ‘Informal investors as entrepreneurs: the development of an entrepreneurial career’, Venture Capital, 4(2), 78–101. Postma, P. and M.K. Sullivan (1990), ‘Informal risk capital in the Knoxville region’, Working Paper, Knoxville: University of Tennessee. Prasad, D., G. Bruton and G. Vozikis (2000), ‘Signaling value to business angels: the proportion of the entrepreneur’s net worth invested in a new venture as a decision signal’, Venture Capital, 2(3), 167–82. Reitan, B. and R. Sørheim (2000), ‘The informal venture capital market in Norway: investor characteristics, behaviour and investment preferences’, Venture Capital, 2(2), 129–41. Riding, A. (1993), ‘Informal investors in the Ottawa-Carleton area: a statistical profile’, paper prepared for the OCEDCO Investor Development Subcommittee of the SIO Project, Ottawa: Ottawa-Carleton Economic Development Corporation. Riding, A. and D. Short (1987), ‘On the estimation of the investment potential of informal investors: a capture/recapture approach’, Journal of Small Business and Entrepreneurship, 5(4), 26–40. Riding, A., L. Duxbury and G. Haines (1994), Financing Enterprise Development: Decision-Making by Canadian Angels, Ottawa: Carleton University monograph. Sætre, A. (2003), ‘Entrepreneurial perspectives on informal venture capital’, Venture Capital, 5(1), 71–94. Sohl, J. (1999), ‘The early stage equity market in the USA’, Venture Capital, 1(2), 101–20. Sohl, J. (2003), ‘The private equity market in the USA: lessons from volatility’, Venture Capital, 5(1), 29–46. Sørheim, R. (2003), ‘The pre-investment behaviour of business angels: a social capital approach’, Venture Capital, 5(4), 337–64. Sørheim, R. and H. Landström (2001), ‘Informal investors: a categorization with policy implications’, Entrepreneurship and Regional Development, 13, 351–70. Stedler, H. and H.H. Peters (2003), ‘Business angels in Germany: an empirical study’, Venture Capital, 5(3), 269–76. Tashiro, Y. (1999), ‘Business angels in Japan’, Venture Capital, 1(3), 259–73. Tymes, E. and O. Krasner (1983), ‘Informal risk capital in California’, in J. Hornaday, J. Timmons and K. Vesper (eds), Frontiers of Entrepreneurship Research, Wellesley: Babson College, pp. 347–68. van Osnabrugge, M. (1998), ‘Do serial investors and non-serial investors behave diﬀerently’, Entrepreneurship: Theory & Practice, 22(4), 23–42. van Osnabrugge, M. (2000), ‘A comparison of business angel and venture capital investment procedures: an agency theory-based analysis’, Venture Capital, 2(2), 91–109. van Osnabrugge, M. and R. Robinson (2000), Angel Investing: Matching Start-Up Funds With Start-Up Companies, San Francisco: Jossey-Bass. Wetzel, W. (1983), ‘Angels and informal risk capital’, Sloan Management Review, Summer, 23–34. Wetzel, W. (1986), ‘Informal risk capital: knowns and unknowns’, in D. Sexton and R. Smilor (eds), The Art and Science of Entrepreneurship, Cambridge: Ballinger, pp. 85–108. Wetzel, W. (1994), ‘Venture capital’, in W. Bygrave (ed.), The Portable MBA in Entepreneurship, New York: Wiley, pp. 172–94. Wetzel, W. and J. Freear (1996), ‘Promoting informal venture capital in the United States: reflections on the history of the venture capital network’, in R. Harrison and C. Mason (eds), Informal Venture Capital: Information, Networks and Public Policy, Hemel-Hempstead: Prentice-Hall, pp. 61–74.

13 Investment decision making by business angels Allan L. Riding, Judith J. Madill and George H. Haines, Jr

Introduction It is widely acknowledged that business angel investors (BAs) are important sources of financing for early-stage growth-oriented new businesses (see Chapter 12 by Kelly). The focus of this chapter is to review the research literature with respect to the investment decision-making process employed by business angels. This is important for several reasons. First, understanding business angels’ decision-making is important to public policy makers. Governments have recognized the importance of business angels and are seeking ways of encouraging higher levels of business angel investment activity. This goal prompts two debates. One issue is whether governments ought to encourage participation of more business angels; the other issue is how to encourage additional investment by business angels. As to the first issue, Gompers and Lerner (2003) argue that encouraging amateur informal investors may be counterproductive from a societal perspective in part because their investment decisions may not be well-founded. As to the second issue, Bygrave and Hunt (2005) advocate a ‘tax break and other [unspecified] incentives’ for business angels and other informal investors (examples of which are described by Lipper and Sommer, 2002); however, the design of any such incentives should be grounded in a thorough understanding of business angels’ motivations, decision-making processes and criteria. Accordingly, understanding business angels’ decision-making process may be a key to the appropriate design of public policy initiatives that seek to expand the supply of business angel investment without encouraging less-than-competent informal investors. Second, the study of the decision process employed by business angels is of potential importance to researchers. As van Osnabrugge (2000) observes, decision-making at this level provides a unique laboratory in which to examine the impacts of agency theory and how investors deal with agency risk. At the heart of the process, a single business angel investor must decide whether or not to invest personal funds in a risky venture. This venue strips away the eﬀects of a corporate environment in which investment decisions are often made by a group of managers in the context of a stewardship function. Likewise, the business angel situation diﬀers from the setting faced by institutional venture capital investors who typically make investment decisions as agents of the funds providers. Accordingly, the decision processes and criteria employed by business angels potentially provide a baseline setting against which investment decisions of other types of investor may be compared and thereby gain an improved understanding of investment decision-making in general and of principal–agent relationships in particular. Third, gaining a still better understanding of business angels’ decision-making is of potential value to entrepreneurs and to business angels themselves. To the extent that entrepreneurs understand the kinds of information that business angels seek and how various components of information are weighted in business angels’ decisions, they may be better able to present the relevant information and to negotiate from a better informed perspective. 332

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Therefore, this chapter examines the recent literature with regards to how business angels make investment decisions. To provide a framework for the review of research literature that comprises the task of this chapter, the five-stage structure shown in Table 13.1 will be employed. In drawing on this five-stage categorization, it is not intended that this should be construed as ‘the’ model of angels’ decision-making process; rather, it is simply a means of structuring this particular review of the literature. To report on the state of research about the decision process, this paper is organized such that the research literature relating to each of these stages is described in turn. First, to provide a setting for this discussion, a brief consideration of business angels’ investment process is in order. On business angels’ investment process Within the research literature, there are few models of the process by which business angels make investment decisions. In most instances the models are essentially based on prior models of how institutional venture capitalists make decisions (Tyebjee and Bruno, 1984 and their successors). For example, among the first to model business angels’ investment decision process were DalCin et al. (1993) and Duxbury et al. (1997). Based on indepth interviews from a national (Canadian) survey of almost 300 business angels this research team outlined one plausible model of business angels’ decision process. They concluded that the decision process could reasonably be characterized as a five-activity, or five-step, linear process. The stages were: (a) deal origination and first impressions; (b) review of business plan; (c) screening and due diligence; (d) negotiation; and (e) consummation and deal structuring. DalCin and her colleagues argued that business angels in fact make investment decisions at several stages as the process unwinds and that criteria would logically diﬀer from stage to stage. At each stage, the business angel investor could decide immediately to invest, immediately to reject, or to continue on to the next stage. This research appears to be the only published study that documents business angels’ rejection rates at each stage of the investment process. This process is echoed in van Osnabrugge’s (2000) comparison of the decision-making processes employed by business angels and venture capitalists. Agency theory predicts that business angels and institutional venture capitalists diﬀer in fundamental ways (van Osnabrugge, 2000). Business angels invest personal funds and are principals in the process, coping with incomplete contracts through active involvement in the firms in which they invest. Venture capital fund managers, as paid employees, act as agents on behalf of their funders and create more ‘professional’, often bureaucratic, decision structures. Accordingly, the decision-making process and criteria are also likely to diﬀer. However, implicit in van Osnabrugge’s reasoning is a five-stage investment process much like that developed by DalCin et al. (1993) and Duxbury et al. (1997). Table 13.1 summarizes this investment process and suggests ways in which business angels and institutional venture capitalists might diﬀer at each point. In addition to the investment process models postulated by DalCin and her colleagues and van Osnabrugge, other researchers have advanced models, explicitly or implicitly, of the business angel decision process; however, these models are quite similar to that described in Table 13.1. For example, Stedler and Peters (2003) implicitly model the process as a linear progression that proceeds from deal flow to due diligence to monitoring. Likewise, Amatucci and Sohl (2004) invoke a process that is comparable to that

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Events

This stage involves encountering and engaging businesses in which investments might follow and a ‘first sight’ informal evaluation.

This stage involves examination of the business plan and conducting due diligence. Investors meet with the founders, consult with potential syndicate partners as appropriate, and conduct external and internal evaluation of the opportunity and the entrepreneurial team.

In this stage, the investor(s) and the entrepreneur(s) negotiate the terms of the deal.

In this stage, the investor(s) work with the firm in various capacities and in various levels of involvement to develop the business further.

At this point, the business angel sells the investment in the firm (or writes it oﬀ!).

Sourcing of potential deals and first impressions

Evaluation of the proposal

Negotiation and consummation

Post-investment involvement

Exit

Stages of business angel investment decisions

Stage

Table 13.1

Investor can either reach an agreement with founder(s) or terminate the relationship.

This stage concludes with the investor’s decision to enter into negotiations, or not.

This stage concludes with the investors’ decision to reject the opportunity out of hand or to invest additional time to investigate the proposal.

Business Angel Decision

VCs are more concerned about exiting than BAs.

BAs monitor post-investment more actively than VCs in large part because of the nature of their postinvestment hands-on value added (see Manigart and DeClercq, Chapter 7 of this volume).

VCs create contracts that provide more control over investments than BAs.

VCs conduct more due diligence. VCs place more emphasis on observable criteria; BAs place more emphasis on investment criteria related to ex post involvement.

VCs generate and maintain a higher deal flow than business angels (BAs). VCs are more selective at the initial screening.

Potential VC-Angel Diﬀerences (Van Osnabrugge, 2000)

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depicted in Table 13.1. A common element of all approaches is that they depict the decision process as proceeding in a linear stepwise manner from deal sourcing through exit. As van Osnabrugge (2000, p. 98) points out, however, a linear model would not capture the fact that there may be feedback and looping within each activity and presumably investors may cycle across stages and activities. Alternatively, it is conceivable that stages could be skipped entirely. It also seems reasonable to expect that criteria may vary across stages. Further, one could conceive of the decision process as being populated by multiple participants on both the supply side (business angels, syndicate members, advisors, angels’ family members) and the demand side (business owners, partners, advisors). Even though these models of the decision process argue that investors make decisions at various stages, most research studies focus on particular stages in the investment process without necessarily situating the work in the context of a decision-making process. For example, several studies have undertaken to document angels’ decision criteria, often without consideration of the stage of the decision process; others have sought to document non-financial contributions, and others have tried to measure realized rates of return and exit mechanisms. Landström (1998, pp. 322–3) observes that ‘there are few studies which have attempted to bring out the nuances in informal investors’ decisionmaking criteria by considering investment as a process in which decision-making criteria may vary in the course of time.’ Consequently, it would appear that there remains considerable room for research on the nature of the investment process itself. Research might profitably investigate the investment process from both the investor and entrepreneur perspectives. Moreover, both marketing and social psychology have posited models of how individuals arrive at decisions, models that do not as yet appear to have been considered with respect to business angels. Further study is indicated on how the various decision criteria are weighted at diﬀerent points in the process. It would also be of considerable interest to understand better how those individuals who work with angels (such as lawyers, accountants, family) and those who might work with the entrepreneurial team (consultants, family, partners, and so on) might interact as the decision process progresses. In this context, decision models such as the theory of planned behaviour first developed by Ajzen (1988) and Fishbein and Ajzen (1981) might provide a means of assessing how the relative weightings of the investors’ values, salient others, and perceived feasibility are weighted throughout the decision process. Deal sourcing and initial screening The first opportunity at which business angels can make a decision is when they initially learn of the investment opportunity – at first sight and even before they have read a proposal document or a business plan. While business angels rarely make the decision to invest at this point, they frequently make decisions to reject the opportunity. DalCin and her colleagues (1993) found that, on average, 70 per cent of rejections occurred out of hand – on first sight of the proposal, confirming that investment decisions were being rendered even as deals are being sourced. Riding et al. (1997) report that at the initial screening stage, ‘the most important criterion . . . is the fit between proposal and investor.’ There is evidence that rejection rates depend on the mechanism by which business angels learn of an opportunity (Riding et al., 1997). Van Osnabrugge and Robinson (2000, pp. 77–84) list and describe ten ways, including professional networks, through

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which business owners seeking informal investors find potential investors (though they present no data on relative frequencies). Since Wetzel’s (1983) seminal study, it is generally accepted that the primary means by which investors learn about potential investment opportunities is through referrals from business associates (DalCin et al., 1994; Mason and Harrison, 1994; 1996a; Sohl, 1999). DalCin et al. (1993, p. 195) conclude that business angels prefer to rely on close associates ‘with whom they have had extensive investment experience’. However, she also notes that introductions from acquaintances were more typical of business angel informants but that referrals from close associates were relatively rare. She nonetheless suggests that entrepreneurs would be well advised to seek introductions to angels through angels’ close associates. This is consistent with the finding that rejection rates were lower for opportunities that were referred to investors from business associates (Riding et al., 1997). It is worth noting that most of the research on business angels’ investment process is based on data gathered from business angels: there is little information that outlines the deal origination process from the viewpoint of the entrepreneur. With that caveat, there is a high level of consistency to the eﬀect that individual business angels do not generally seek out potential investments; on the contrary, business angels are often profiled as desiring anonymity. More generally, entrepreneurs seek out business angel investors, with potential investors frequently being approached to consider a wide range of investment opportunities. There is evidence that this process of deal origination is changing. Two forces are driving these changes. First, governments at all levels and trade associations have supported business angel matchmaking initiatives. The last fifteen years have witnessed a proliferation of market-making facilities that range from the equivalent of computer dating services, to business angel networks (BANs) that are national in scope, to localized introduction mechanisms that also include early stage entrepreneur training and prescreening. Mason and Harrision (1996b) review several of these market-making initiatives and Sohl provides an updated and comprehensive review in Chapter 14 of this volume. Second, business angels – once loosely and informally networked – are increasingly entering into more formal business angel groupings. Sohl (1999) and de Noble (2001, p. 362) have both commented that formal angel ‘clubs’ and ‘groups’, as well as angel side funds, are becoming increasingly important sources of potential deals, most notably in the US. Other countries appear to be lagging in this regard. There is little published research that examines the decision-making process and criteria of these more formal syndicates – another potential area for future research. Evaluation and due diligence Those potential deals that have survived the initial screening stage then become subject to more detailed evaluation and due diligence. DalCin et al. (1993) report that another 20 per cent of investment opportunities are rejected at this stage of the process. Due diligence This stage often involves extensive information gathering by investors. Little theoretical work has been reported about business angels’ evaluation and due diligence processes. Prasad et al. (2000, p. 167) are among the few to use a theoretical approach to explore business angel decision-making. They use a signaling theory approach to suggest that the

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proportion of the entrepreneur’s initial wealth invested in the project ought to be an important criterion for angels because ‘it indicates both the project’s value and the entrepreneur’s commitment to the project’. It will be seen that there is little work that examines this factor directly and that other factors appear to be more important. Van Osnabrugge (2000) used an agency-theoretic approach to derive a series of hypotheses that compared the approaches of business angels with those of institutional venture capitalists. He argues (p. 99) that managers of institutional venture capital funds who act as agents working on behalf of the fund providers (principals) ‘must demonstrate competent behaviour’. This entails (p. 99) ‘an additional level of the agency relationship for VCs [venture capital managers] to deal with that BAs do not’. As a result of this reasoning, van Osnabrugge contends that business angels would conduct relatively less, and less formal, pre-investment due diligence than would managers of institutional venture capital funds. Van Osnabrugge hypothesizes that business angels would place more emphasis on ex post involvement in the firms. Empirically, he found support for this hypothesis but that diﬀerences may be sensitive to the regional business and legal context: ‘it is apparent that BAs [business angels] in the UK tend to be less sophisticated and more ad hoc in their due diligence activities than VCs and possible BAs in other countries’ (p. 103). In the Canadian setting, Haines et al. (2003) find support for van Osnabrugge’s prediction and report that business angel investors use a wide range of due diligence approaches. At one extreme, business angels indicate that their due diligence process is ad hoc and informal: the business angels ‘go over’ the financial statements and projections that are available about the potential opportunity, they ‘meet with the principals and get to know them’ over a period of time, and they conduct informal reference checks on the track records of the principals. Using these informal approaches, some business angel investors indicate that they depend on ‘gut feel’ and have to trust the people involved in potential deals and have to want to work with them. This same wording was also expressed by van Osnabrugge (2000, p. 104) that ‘they (business angels) invest on a gut feeling rather than based on comprehensive research’. At the other extreme, a small number of business angels who participated in the study by Haines and his colleagues indicated that their due diligence process is very sophisticated and involved extensive checklists, thorough documentation checks and an active search for independent evidence about the principals of the firm seeking investment. These tended to be larger scale investors. Decision criteria This discussion of how business angels conduct due diligence and arrive at investment decisions prompts an examination of their investment criteria. Most of the studies of the business angel decision process have indeed focused on the decision criteria that business angels employ. In an early study, Mason and Harrison (1994) adopted a case study approach and analysed the transcripts of interviews with one experienced private investor in the UK. They found that the majority of the investment proposals (22 out of 35) were rejected following a detailed examination of the business plan. Of the remaining 11 proposals which passed the initial review, nine were rejected after the syndicate had conducted its own research on the marketplace and the principals.

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In subsequent work, Mason and Harrison (1996a; 1996c) returned to the issue of business angels’ decision criteria. In their 1996a study, Mason and Harrison drew on interview data with 31 business angels who made investments in unquoted companies as well as with 28 owner-managers who had raised capital from private investors. They found that ‘the key considerations in the investors’ decisions to invest were associated with the attributes of the entrepreneurs and the market-product characteristics of the business’ (p. 109). The most important attributes of the entrepreneurs were their expertise, their enthusiasm, and other personal qualities of honesty and trustworthiness. The growth potential of the business idea was the most important of the business attributes. Mason and Harrison (1996c, p. 45) also noted that ‘the most common deal rejection factors are associated with the entrepreneur/management team, marketing and finance’. Among the most frequently mentioned deal killers were: ‘one man shows’ and where there were significant gaps in the management team; flawed or incomplete marketing strategies; and incomplete or unrealistic financial projections. In their 1997 article, Harrison, Dibben and Mason explore the question of trust as a factor in business angels’ investment decision. Harrison et al. (1997, p. 67) define trust as ‘the expectation that arises, within a community, of regular honest and cooperative behavior, based on commonly shared norms, on the part of other members of that community.’ Although the research reported by Harrison et al. (1997) and Dibben et al. (1998) focused on the initial screening stage – at which time the above authors show swift trust to be the most frequently invoked trust concept – it seems clear that trust is also relevant in subsequent stages. Drawing on both a theoretical framework and the use of a real-time verbal protocol analysis of a business angel’s decision process, this work found that ‘the building of trust relationships between the entrepreneur and the informal investor appears to be essential for successful capital investments on the part of the investor to take place’ (p. 77). Several other teams of researchers have also sought to examine the decision criteria employed by business angels (Haar et al., 1988; Harrison and Mason, 1992; van Osnabrugge, 1998; Erikson et al., 2003). There is a high level of agreement among these studies: business angels attach great importance to the competence, integrity and capability of the management team and to the market potential of the firm’s product or service. Stedler and Peters (2003) present data from Germany that show that German angels are influenced by a greater number of factors than have been identified in earlier studies based on UK, Canadian and US data. In Germany, key decision factors include: the entrepreneur/management team, product/service uniqueness and competitiveness, growth potential, profit margins and being able to move into a profitable position quickly. Stedler and Peters also note that the opportunities’ exit options, rates of return, and degree of self-financing are also important. It is therefore possible that decision processes and criteria vary across cultures. Also, angels are not a homogeneous population. Hence, it is reasonable to expect that decision criteria would vary across diﬀerent types of business angels. For example, van Osnabrugge (1998) compared decision criteria employed by ‘serial angels’ with those used by ‘non-serial angels’. He found that serial angels are ‘less concerned with agency risks and more concerned with market risks’ than their less-experienced counterparts (p. 23). He also found that, relative to non-serial angels, serial angels appear to conduct more research, are more likely to co-invest, and are less concerned with the location of the venture.

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Two further issues arose. The first is the extent to which criteria change as the process unwinds. The second is whether factors leading to rejection diﬀer from factors leading to acceptance. In terms of the first issue, Harrison and Mason (2002) and Fiet (1995) both contend that business angels emphasize the qualities of the entrepreneurial team more than the product or service itself. This conclusion is also consistent in spirit with van Osnabrugge (2000). In particular, the role of trust in the decision process appears to be a noncompensatory decision criterion in that trust is a prerequisite for investment (Manigart et al., 2001; Kelly and Hay, 2003). While the development of trust is initiated during the due diligence/evaluation process, it is furthered in the negotiation and consummation phase. However, the debate over which matters most – the importance of the business or the quality of the entrepreneur(s) – is perhaps addressed by Mason and Harrison (1996a) who noted that decision criteria vary by the stage of the decision process, that what matters most changes over the unwinding of the process: ‘deals rejected at the initial review stage tended to be on the basis of the cumulation of a number of deficiencies rather than for a single reason; conversely, opportunities rejected after further research were more likely to be characterised by a single deal killer.’ This result is consistent with the findings of Duxbury et al. (1997) who also found that criteria weights used by informal investors shifted across stages and that as the process unwinds the importance of the principals and of financial rewards both increase. These findings suggest that researchers’ conclusions about the importance of particular factors depend on the stage of the investment process being considered. This is a result that might usefully guide future research in that it would appear that identification and importance of decision criteria are both dependent on the stage of the investment process and the context. Feeney et al. (1999) sought to address the second issue: whether factors leading to rejection diﬀer from factors leading to acceptance. To identify factors that discouraged private investors from making investments, they asked a sample of 115 ‘active’ business angel investors and 38 ‘occasional’ business angel investors: ‘In your experience, what are the most common shortcomings of the business opportunities you have reviewed recently?’ To identify attributes that prompted investors to decide to invest, they asked: ‘What are the essential factors that prompted you to invest in the firms you chose?’ The researchers concluded that informal investors consider both the attributes of the business and the attributes of the entrepreneur as important when they consider whether to invest in or reject a proposal. Mason and Stark (2004) reinforce these findings in their analysis of what attributes of entrepreneurs’ business plans business angel investors sought. They report (2004, p. 240), ‘BAs [business angels] . . . emphasize financial and market issues . . . [and] give . . . emphasis to investor fit considerations.’ Negotiation, consummation, and deal structure The next stage, negotiation and potential consummation, occurs when the investor(s) have completed enough of the due diligence process to undertake formal pricing negotiations. This can be a contentious stage in the investment process. This is often because founders and business angels disagree about the relative values of their respective contributions to the firms. Typically, founders provide the original innovation and energy about a potential

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product or services. Angel investors then provide the capital necessary (as well as substantive non-financial contributions) to take the innovation to commercialization. Mason and Harrison (1996c, p. 42) reported that the overriding issue at this stage of the decision process was disagreement on valuation and that this led to a high proportion of proposals not being consummated. DalCin et al. (1993) confirm this observation and report that of the 10 per cent of investments that reach the negotiation stage, half of those do not survive negotiations. Elitzur and Gavious (2003) address this through a game-theoretic analysis of the process of negotiation and consummation between an entrepreneur and a potential angel investor. They argue that the process will result in a moral hazard problem, where moral hazard is defined (2003, p. 718) as ‘the form of post-contractual opportunism that arises when actions required or desired under the contracts are not freely observable’. Certain kinds of behaviour are specified which alleviate the moral hazard problem: payment in the form of stock options, the angel sitting on the board of directors of the business in which the angel has invested, specialization by the angel, staged financing rather than all-in-one financing, and use of convertible preferred stock. Conceivably, this explains the widespread use of shareholder agreements. Hatch and MacLean (1995) provide a summary of the typical attributes found in shareholder agreements and the high frequency with which business angels remain actively involved in the firms in which they invest (van Osnabrugge, 2000; Madill et al., 2005). Elitzur and Gavious also analyse a situation where the initial investment by an angel is followed by a later investment by a venture capitalist. They conclude (2003, p. 721): ‘that the opportunistic behavior of both the entrepreneur and VC leads to a moral hazard problem, with these two players becoming “free riders”, coasting on the investment made by the angel.’ The argument that moral hazard issues may arise during the negotiation and consummation phase of the decision process is particularly interesting in the light of the relevance of the concept of trust. In addition to the work of Harrison et al. (1997), Manigart et al. (2001) investigated the impact of trust on private equity contracts. They concluded: Trust between investor and entrepreneur is essential to help overcome control problems, especially in an environment with severe agency risks and incomplete contracts. In this study . . . we find that trust has an impact on the desired contracts of entrepreneurs, but not on that of investors. [The] findings suggest that for parties, faced with potentially large agency problems (investors), trust and control seem to play complementary roles. On the other hand, for parties with smaller agency problems (entrepreneurs), trust seems to be a substitute for control.

The issue of trust also arises in Kelly and Hay’s (2003) examination of the content of contracts between business angels and entrepreneurs. On the basis of their interpretation of agency theory, Kelly and Hay hypothesize that contracts are likely to be ‘tighter’ when either the angel or entrepreneurs has more experience, investors are syndicated, the investor is highly involved in the firm, and ‘looser’ when the entrepreneur is referred to the business angel by a trusted associate or when trust between angel and entrepreneurs has already been established. Kelly and Hay identify five non-negotiable aspects of the contract terms: veto rights over acquisitions/divestitures; prior approval of strategic plans and budgets; restrictions on management’s ability to issue share options; non-compete contracts; restrictions on addition financing. Negotiable aspects included: forced exit

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provisions; approval for senior hires/fires; need for investors to countersign bank cheques; equity ratchet provisions; specification of dispute resolution provisions. It is interesting that Kelly and Hay (2003) conclude that contracts are a complement to high degrees of involvement. Van Osnabrugge (2000) regards active involvement of business angels as a key means of reducing ex ante uncertainty. Empirical findings of the importance of active involvement by business angels are reported by Haines et al. (2003, pp. 24–5). Their work, based on analysis of qualitative interview data with business owners and business angels suggests that the opportunity for the business angel to be able to add significant non-financial value may be so important as to qualify as a decision criterion, one that is especially significant at the negotiation stage. This latter result is in keeping with van Osnabrugge’s (1998) hypothesis that business angels would stress postinvestment involvement as a factor in their decision criteria. Post-investment involvement It is important to include a discussion of post-investment involvement in this discussion of business angels’ investment decision process. This is so for three reasons. First, business angels’ investment decision must take account of the moral hazard problem inherent in such investments. Perhaps the single most eﬀective means of dealing with the moral hazard problem is to reduce the information asymmetry between the founders and the investor, and the best way to do so is to become a principal within the firm. Second, and to some extent related to the moral hazard issue, recall that Madill and her colleagues (2005) have found that the opportunity to add mentoring and other forms of nonfinancial value-added appears to be a parameter of the decision process itself. Third, (DalCin et al., 1993) found that business angels have high internal loci of control as well as high needs for achievement. The fact that angels have their own funds at stake such that they are principals, rather than agents, provides them with incentive to help the firms prosper. Again, this suggests that post-investment involvement plays an important role in the decision process. With expectations of a 30–40 per cent annualized rate of return, high needs for achievement, internal loci of control, and in the face of moral hazard it appears reasonable to expect angels to take on proactive roles in the firms in which they invest. Landström (1998, p. 328) reports that ‘informal investors tend to see their investments as “subjects”, where the prime motive to invest is the chance to create business opportunities and a desire to participate in the process.’ In this regard, it is widely accepted and understood that angels do make non-financial contributions to the firms in which they invest. Wetzel (1994), Mason and Harrison (1996a), and Lumme and her co-workers (1998) are among those who argue that the nonfinancial role of angels can be important to themselves and to the business enterprise. Mason and Harrison (1996a) explored this in their study of both the supply side (angel investors) and the demand side (businesses that had received angel investment). From a sample of 20 dyads and eight additional owner-managers, Mason and Harrison identified contributions that included: strategic advice, networking, marketing, management functions, finance and accounting functions, financial advice, and general administration. A minority of investors made no contributions aside from their financial stake. Half of the entrepreneurs reported that the investors’ contributions were either helpful or extremely helpful. Likewise, Madill et al. (2005) document contributions that include: ongoing advice particularly with respect to financing and business strategy; contacts that

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include additional sources of financing as well as potential customers; participation on boards of directors; involvement in hands-on day-to-day operations of the firm; business and market intelligence; and, credibility. Given the frequency of high levels of post-investment involvement, the question arises as to whether firms financed by business angels exhibit superior performance. There is some evidence to this eﬀect. First, Farrell (1998) found that the incidence of business failure among 264 firms that had not received ‘private investment’ (in Farrell’s study, it is not clear if this is exclusively from business angels) was 20.5 per cent while the failure rate among 46 enterprises that had received private investment was lower, 17.4 per cent. However, this small diﬀerence may equally be attributable to the counterfactual problem: that firms that had received business angel financing may have been, in the first place, better quality investments. Second, Madill and her colleagues (2005) report that firms financed by business angels were more likely to obtain institutional venture capital than other firms. Again, it is possible that the counterfactual is attributable for this but it is also possible that non-financial contributions of angels may better qualify such firms for being able to grow and access institutional venture capital. Third, firms financed by business angels may experience better exit events. Landström (1993) reports on expected rates of return and holding periods for business angels. According to various studies, modal expected rates of return appear to be in the range of 30 to 40 per cent on an annualized after-tax basis. However, a small but significant fraction of angels expect a rate of return of less than 20 per cent, while others expect a rate of return of over 60 per cent. Aside from the exploratory study by Lumme et al. (1996), Mason and Harrison’s (2002) study appears to be the only published examination of realized rates of return and exits. Their work was based on 127 exits reported by 126 Scottish angels. They found that trade sales of the businesses was the most frequent form of profitable exit. They also demonstrated that business angels experienced superior returns to those obtained from a sample of UK venture capital firms, finding that 34 per cent of angels’ reported exits were total losses, but that 23 per cent were exits in which the annualized rate of return exceeded 50 per cent. It is diﬃcult to find other studies reporting realized rates of return on the part of informal investors. This is an important topic for future research. This importance stems from the growing realization by policy makers of the importance of business angels and their attempts to stimulate business angel investment. Likewise, there is a need to address Gompers and Lerner’s (2003) questioning of public policy initiatives that seek to ‘encourage amateur informal investors’. The informal market comprises a variety of investor types that include business angels as well as the category sometimes referred to as ‘family, friends, and fools’. Examination of realized returns is one way of informing this discussion. Post-investment involvement appears to be an important aspect of business angels’ investment decision process. Through this involvement, business angels are better able to assess and control the moral hazard inherent in such investments. Because business angels have high internal loci of control as well as high needs for achievement, they have powerful incentives to help actively with the development of the firms. There is some preliminary evidence to the eﬀect that angel-financed firms perform relatively well. Accordingly, it

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seems reasonable that Madill and her colleagues (2005) have found that the opportunity to add mentoring and other forms of post-investment non-financial value-added may be a parameter of the decision process itself. Conclusions and directions for future research This chapter has provided a review of the state of the literature regarding investment decision-making by business angels. Table 13.2 provides an overview of this process and a Table 13.2

Business angel investment decisions: key references

Stage

Events

Key References

Sourcing of potential deals and first impressions

This stage involves encountering and engaging businesses in which investments might follow and a ‘first sight’ informal evaluation.

DalCin et al. (1993) Mason and Harrison (1994; 1996b) Fiet (1995) Riding, Duxbury and Haines (1997) Sohl (1999) Van Osnabrugge and Robinson (2000)

Evaluation of the proposal

This stage involves examination of the business plan and conducting due diligence. Investors meet with the founders, consult with potential syndicate partners as appropriate, and conduct external and internal evaluation of the opportunity and the entrepreneurial team.

Haar, Starr and MacMillan (1988) Harrison and Mason (1992) DalCin et al. (1993) Mason and Harrison (1994; 1996a; 1996c) Harrison, Dibben and Mason (1997) Van Osnabrugge (1998; 2000) Feeney, Haines and Riding (1999) Prasad, Bruton and Vozikis (2000) Manigart, Korsgaard, Folger, Sapienza and Baeyens (2001) Erikson, Sørheim and Reitan (2003) Haines, Madill and Riding (2003) Kelly and Hay (2003) Stedler and Peters (2003) Mason and Stark (2004)

Negotiation and consummation

In this stage, the investor(s) and the entrepreneur(s) negotiate the terms of the deal.

Mason and Harrison (1996c) Harrison, Dibben and Mason (1997) Manigart, Korsgaard, Folger, Sapienza, and Baeyens (2001) Elitzur and Gavious (2003) Kelly and Hay (2003)

Post-investment involvement

In this stage, the investor(s) work with the firm in various capacities and in various levels of involvement to develop the business further.

Landström (1993) Mason and Harrison (1996a) Farrell (1998) Madill, Haines and Riding (2005)

Exit

At this point, the business angel sells the investment of the firm (or writes it oﬀ!).

Lumme, Mason and Suomi (1996) Mason and Harrison (2002)

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tabular summary of some of the key references. An overview of this literature reveals several recurring issues that researchers have not yet fully surmounted. Each of these therefore provides fertile ground for future work. This review suggests that one important direction for future research lies in the development of a comprehensive model of investment decision-making. Several models of decision-making have been developed in other fields, some of which have been applied to entrepreneurship research (but not to research on business angels). For example, Orser et al. (1998) successfully applied the theory of planned behaviour (Fishbein and Ajzen, 1981; Miniard and Cohen, 1981) to entrepreneurs’ decision of whether or not to pursue growth as an objective for their firms. This approach allows for both the primary players (investors and firm founders) to have a role but also allows for the participation of others (syndicate partners, spousal partners, and so on) to have input into decisions. This may prove to be a fruitful direction for future work. A second direction relates to the identification of the ways in which decision criteria (or the weightings accorded these criteria) might systematically change as the decision process unwinds. Previous research has suggested that such changes occur; however, this line of enquiry does not appear to have been pursued to the extent that might be possible. A third area of enquiry relates to the ways in which post-investment involvement mitigates the moral hazard problem. While it appears that business angels are actively involved in the firms in which they invest, it is not clear to what extent this is a response to the moral hazard aspect of the investment process. The moral hazard issue can be addressed through contracting or through monitoring mechanisms. An alternative explanation for active involvement could relate business angels’ high internal loci of control and their high needs for achievement. Fourth, there is virtually no work on the ways in which business angels, founders and later stage investors interact. Findings that firms financed by business angels are more likely to obtain institutional venture capital prompt the need to examine how the founders and the angels comprise a team that together seeks to ensure success of the enterprise. To the extent that this is true, the role of business angels in economic development may continue to be underestimated. A related aspect of this issue is the ways in which business angels’ roles might change with the arrival of venture capital. While not strictly related to the issue of decision-making, this topic is nonetheless a potentially useful direction for future research. Methodological issues Notwithstanding the many potential directions for future research, ongoing investigation of business angel decision-making must contend with several important methodological challenges, problems that pervade much of the literature on business angel decision-making. First, much of the work is empirical and lacks a theoretical framework. While there are obvious exceptions to this rule, studies that are rooted in a theoretical perspective are rare. This is particularly surprising when it comes to modelling the investment decision process. The literature of social psychology and marketing is rich with theory-based models of decision-making; yet none appear to have been applied to the business angel context. Examples of potential models include the theory of planned behaviour (Fishbein and Ajzen, 1981) among other possible frameworks, some from the theories of consumer

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decision-making. This appears to be one area in which future research might help us better understand the decision-making process. Second, almost all of the empirical studies (again with a few notable exceptions) use data drawn exclusively from the supply side of the informal market. While this may be appropriate for many of the research objectives, it is not suﬃcient to address other research goals. In particular, one-sided data cannot fully characterize the decision process, nor can it fully describe business angels’ non-financial value added. Useful directions here might be examination of the factors that prompt business owners to seek business angels as financing sources and the examination of how attributes of firms financed by business angels might diﬀer from other firms. Third, definitional problems and inconsistencies persist. The terms ‘informal investor’ and ‘business angel’ are often used interchangeably; but just as often are distinguished one from the other. Studies of business angels refer to them as informal investors, and vice versa. Business angels and other types of informal investor do diﬀer in significant ways (Erikson et al., 2003) including how they make decisions (van Osnabrugge, 1998). This debate prompts the need to decompose the informal market into relevant segments and to examine more precisely the behaviour and experiences of investors in each of the constituencies of the informal market. References Amatucci, F.M. and J.E. Sohl (2004), ‘Women entrepreneurs securing business angel financing; tales from the field’, Venture Capital, 6, 181–96. Ajzen, I. (1988), Attitudes, Personality, and Behaviour, Open University: Open University Educational Enterprises Limited. Bygrave, W. and S. Hunt (2005), ‘Global entrepreneurship monitor financing report for 2004’, Babson College and London Business School, www.gemconsortium.org/download/1145988486593/GEM_2004_Financing_ Report.pdf. DalCin, P., A. Riding, L. Duxbury and G. Haines, Jr (1994), ‘Financing enterprise development: the decisionmaking process employed by Canadian angels’, Proceedings of the 10th Canadian Conference of the Canadian Council for Small Business and Entrepreneurship, Moncton. DalCin, P., L. Duxbury, G. Haines, Jr., A. Riding and R. Safrata (1993), Informal Investors in Canada: The Identification of Salient Characteristics, Toronto, Canada: Industry Canada and the Ministry of Economic Development and Trade of the Province of Ontario. De Noble, A.F. (2001), ‘Review essay: raising finance from business angels’, Venture Capital, 3, 359–67. Dibben, M., R. Harrison and C. Mason (1998), ‘Swift trust, cooperation and coordinator judgement in the informal investment decision making process’, www.babson.edu./entrep/fer/papers 98/, 15 October. Duxbury, L., G. Haines, Jr. and A. Riding (1997), ‘Financing enterprise development: decision-making by Canadian angels’, in S.L. Tracy and E.M. Tracy (eds), Proceedings of the Association of Management and International Association of Management, Montreal: pp. 17–22. Elitzur, R. and A. Gavious (2003), ‘Contracting, signaling, and moral hazard: a model of entrepreneurs, “angels”, and venture capitalists’, Journal of Business Venturing, 18, 709–25. Erikson, T., R. Sørheim and B. Reitan (2003), ‘Family angels vs. other informal investors’, Family Business Review, 16(3), 163–71. Farrell, A.E. (1998), ‘Informal venture capital activity in Atlantic Canada: Generating accurate estimates to understand industry growth’, paper presented at the 15th Annual Conference of the Canadian Council for Small Business and Entrepreneurship, Halifax, NS, Canada. Feeney, L., G.H. Haines, Jr. and A.L. Riding (1999), ‘Private investors’ investment criteria: Insights from qualitative data’, Venture Capital, 1, 121–45. Fiet, J. (1995), ‘Reliance upon informants in the venture capital industry’, Journal of Business Venturing, 10, 195–223. Fishbein, M. and I. Ajzen (1981), ‘On construct validity: a critique of Miniard and Cohen’s paper’, Journal of Social Psychology, 17, 340–50. Gompers, P. and J. Lerner (2003), ‘Equity financing’, in Z. Acs and D. Audretsch (eds), Handbook of Entrepreneurial Research, New York: Springer, pp. 267–98.

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Haar, N.E., J. Starr and I.C. MacMillan (1988), ‘Informal risk capital investors: investment patterns on the East Coast of the USA’, Journal of Business Venturing, 3(1), 11–29. Haines, Jr. G., J. Madill and A. Riding (2003), ‘Informal investment in Canada: financing small business growth’, Journal of Small Business and Entrepreneurship, 16(3/4), 13–40. Harrison, R., M. Dibben and C. Mason (1997), ‘The role of trust in the informal investor’s investment decision: an exploratory analysis’, Entrepreneurship: Theory & Practice, 21(4), 63–81. Harrison, R.T. and C.M. Mason (1992), ‘International perspectives on the supply of informal venture capital’, Journal of Business Venturing, 7, 459–75. Harrison, R.T. and C.M. Mason (2002), ‘Backing the horse or the jockey? Agency costs, information and the evaluation of risk by business angels’, paper presented at the Babson-Kaufmann entrepreneurship conference, www.babson.edu./entrep/fer/BABSON2002, 15 October. Hatch, J.E. and J. MacLean (1995), ‘A note on designing shareholder agreements’, Item 9A95B008, Ivey Publishing, London, ON, Canada. Kelly, P. and M. Hay (2003), ‘Business angel contracts: the influence of context’, Venture Capital, 5(4), 287–312. Landström, H. (1993), ‘Informal risk capital in Sweden and some international comparisons’, Journal of Business Venturing, 8, 525–40. Landström, H. (1998), ‘Informal investors as entrepreneurs’, Technovation, 18(5), 321–33. Lipper, G. and B. Sommer (2002), ‘Encouraging angel capital: what the US states are doing’, Venture Capital, 4(4), 357–62. Lumme, A., C. Mason and M. Suomi (1996), ‘The returns from informal venture capital investments: an exploratory study’, Journal of Entrepreneurial Small Business Finance, 5(2), 139–53. Lumme, A., C. Mason and M. Suomi (1998), Informal Venture Capital: Investors, Investments and Policy Issues in Finland, Boston, MA: Kluwer Academic Publishers. Madill, J., G. Haines, Jr. and A. Riding (2005), ‘The role of angels in technology SMEs: a link to venture capital’, Venture Capital, 7, forthcoming. Manigart, S., M. Korsgaard, R. Folger, H. Sapienza and K. Baeyens (2001), ‘The impact of trust on private equity contracts’, www.babson.edu/entrep/fer/Babson2001/, 15 October. Mason, C.M. and R.T. Harrison (1994), ‘The informal venture capital market in the UK’, in A. Hughes and D. Storey (eds), Financing Small Firms, London: Routledge, pp. 64–111. Mason, C.M. and R.T. Harrison (1996a), ‘Informal venture capital: a study of the investment process, the postinvestment experience and investment performance’, Entrepreneurship and Regional Development, 8, 105–26. Mason, C.M. and R.T. Harrison (eds) (1996b), Informal Venture Capital, London: Prentice-Hall International. Mason, C.M. and R.T. Harrison (1996c), ‘Why “business angels” say no: a case study of opportunities rejected by an informal investment syndicate’, International Small Business Journal, 14(2), 35–52. Mason, C.M. and R.T. Harrison (2002), ‘Is it worth it? The rates of return from informal venture capital investments’, Journal of Business Venturing, 17, 211–36. Mason, C. and M. Stark (2004), ‘What do investors look for in a business plan?’, International Small Business Journal, 22(3), 227–48. Miniard, P. and J. Cohen (1981), ‘An examination of the Fishbein–Ajzen behavioural-intentions model’s concepts and measures’, Journal of Experimental Social Psychology, 17, 309–39. Orser, B., S. Hogarth-Scott and P. Wright (1998), ‘Opting for growth: gender dimensions of choosing enterprise development’, Administrative Sciences Association of Canada, Saskatoon. Prasad, D., G. Bruton and G. Vozikis (2000), ‘Signaling value to business angels: the proportion of the entrepreneur’s net worth invested in a new venture as a decision signal’, Venture Capital, 2(3), 167–82. Riding, A., L. Duxbury and G. Haines, Jr. (1997), ‘Financing enterprise development: decision-making by Canadian angels’, in S.L. Tracy and E.M. Tracy (eds), Proceedings, 15th Annual International Conference, Montrea1, Canada: AOM/IAOM, pp. 17–22. Sohl, J.E. (1999), ‘The early-stage equity market in the USA’, Venture Capital, 1, 101–20. Stedler, H. and H. Peters (2003), ‘Business angels in Germany: an empirical study’, Venture Capital, 5(3), 269–76. Tyebjee, T.T. and A.V. Bruno (1984), ‘A model of venture capitalist investment activity’, Management Science, 30, 1051–66. Van Osnabrugge, M. (1998), ‘Do serial and non-serial investors behave diﬀerently? An empirical and theoretical analysis’, Entrepreneurship: Theory & Practice, 22(4), 23–42. Van Osnabrugge, M. (2000), ‘A comparison of business angel and venture capitalist investment procedures: an agency theory-based analysis’, Venture Capital, 2(2), 91–109. Van Osnabrugge, M. and R. Robinson (2000), Angel Investing: Matching Start-up Funds with Start-up Companies, San Francisco: Jossey-Bass. Wetzel, W.E. (1983), ‘Angels and informal risk capital’, Sloan Management Review, Summer, pp. 23–34. Wetzel, W.E. (1994), ‘Venture capital’, in W. Bygrave (ed.), The Portable MBA in Entrepreneurship, New York: Wiley, pp. 172–94.

14 The organization of the informal venture capital market Jeﬀrey E. Sohl

Introduction In spite of the volume of business angel investing, the early stage equity market is fraught with ineﬃciencies. For firms with established financial records and tangible assets, financial markets supply an extensive assortment of financing instruments. These markets are relatively accessible and the owner is left to decide the optimum mix of a financial structure based on the cost of capital (Brophy, 1997). However, the high growth entrepreneurial firm seeking early stage equity capital is faced with significant problems in finding this risk capital due to the ineﬃciency of the early stage equity market. Thus, the type of early stage financing required by high growth entrepreneurial firms, namely high risk equity capital, is not readily available. While variations in the availability of early stage capital exist across countries, and regionally within countries, overall there is a persistent lack of high risk capital for entrepreneurial ventures (Riding and Short, 1987; Gaston, 1989; Mason and Harrison, 1992; Harrison and Mason, 1993; Landström, 1993; Freear et al., 1994a). Business angels, who collectively comprise the informal venture capital market, are the major supply of early stage equity capital, and improvements in the eﬃciency of this market will increase both the size and the accessibility of early stage equity capital. There are three main reasons for the ineﬃciencies, and thus the lack of early stage capital, in the informal venture capital market. First is the invisibility of business angels, second, the high search costs for both business angels seeking investment opportunities and entrepreneurs seeking investors and third, an inadequate supply of capital (Freear et al., 1994b; Mason and Harrison, 1995). As a consequence of the suppliers of capital (business angels) seeking a degree of anonymity consistent with the need to maintain reasonable deal flow, information flows very ineﬃciently (Freear et al., 1994b; Mason and Harrison, 1996a). This diﬃculty in finding business angels and the lack of ‘investor ready’ quality deals, combined with an inadequate supply of capital, results in a primary seed gap. Further compounding the ineﬃciencies in the informal venture capital market is a second funding gap, the secondary post-seed gap. These larger capital requirements have traditionally been considered too large for business angels and, as the venture capital industry migrates to later stage and larger deal size, are deemed too small for venture capitalists. Recent research indicates that business angels are increasing their investments in this secondary post-seed gap (Table 14.1) as market conditions require business angels to provide some follow-on financing for their investments (Center for Venture Research, 2004; 2005). However, this movement by business angels to second stage financing is a redistribution of risk capital and as such, exacerbates the primary seed gap (Sohl, 2003). These systemic market ineﬃciencies and persistent funding gaps (primary seed gap and secondary post-seed gap) have led the angel market to adopt various organizational 347

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Table 14.1

Funding gaps % of angel investments

Primary seed gap Secondary post-seed gap

2002

2003

2004

2005

50% 33%

52% 35%

43% 44%

55% 43%

structures and market mechanisms to increase the eﬃciency of quality deal flow and increase the availability of capital. Adapting to changing market conditions, multifaceted angel organizations, or angel portals, have evolved. Collectively, the business angel portals comprise today’s business angel market. These portals represent how entrepreneurs find potential investors, how business angels find and screen deals, how they syndicate into small groups to make an investment and how business angels interact within the larger angel market. Angel portals shed considerable light on the angel market and provide a potential lens to the future of the market. The scope of this chapter is a discussion of the current structure of the business angel market with respect to the various types of angel portals in existence today. A business angel portal is an organization that provides a structure and approach for bringing together entrepreneurs seeking capital and business angels searching for investment opportunities. The primary goal of angel portals is to increase the eﬃciency in the early stage market, increase deal flow for business angels and provide entrepreneurs with access to angel capital. The portals range from informal collections of business angels to duespaying members with investment requirements for each member. Most require their business angel members to meet a minimum net worth/income requirement, which serves as a proxy for ascertaining if the business angel has suﬃcient knowledge of the risks and illiquidity inherent in angel investing. The remainder of the chapter is organized as follows: an examination of the previous research on business angel portals, a discussion of the types of business angel portals that exist today including a description, an example and a discussion of the eﬀectiveness of each type, and some concluding remarks. Early research on business angel portals The early research on angel portals focused on measuring the eﬀectiveness of business introduction services in various countries (Blatt and Riding, 1996; Landström and Olofsson, 1996; Mason and Harrison, 1996a; Wetzel and Freear, 1996). In general, these studies define eﬀectiveness as meeting the needs of the angel market. Although these needs vary across countries, the literature has considered eﬀectiveness to include changes with respect to higher quality deal flow, improving the eﬃciency of the angel market, raising the awareness of business angels as a source of equity financing, and increasing the availability of angel capital and the level of angel investments. Initiatives in the United States The first angel portal in the world, Venture Capital Network, was organized in 1984 as a not-for-profit matching network aﬃliated with the Center for Venture Research at the University of New Hampshire in the United States. An evaluation of the operations of Venture Capital Network (VCN) noted some of the problems with both assessing the

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eﬀectiveness of networks and in developing and growing a matching network (Wetzel and Freear, 1996). In the case of VCN, investment security regulations prohibited VCN from any role in the process beyond the initial introduction. As such, data on the success or failure of the introduction, the quality of the deal flow as perceived by the investors and the amount of funding generated were diﬃcult to obtain. However, research indicates that it was diﬃcult and time consuming to find investors to join the network, that funding for operations was a persistent issue and the likelihood of profitability was slight, and that there was an acute need to demonstrate to investors an adequate level of high quality deal flow (Wetzel and Freear, 1996). In a study of VCN investors it was determined that approximately 10–15 per cent of entrepreneurs received funding through the matching service and approximately 40 per cent of the entrepreneurs received funding through the venture forum format (Sohl, 1999). However, it is important to note that the venture forum format included fewer entrepreneurs, higher levels of screening, and received coaching from VCN before their presentation to investors. Initiatives in Canada One of the early studies on the eﬀectiveness of an angel portal was the examination of the Canada Opportunities Investment Network (COIN), a national angel network (Blatt and Riding, 1996). The goal of COIN was the development of a matching service to meet the unsatisfied demand by Canadian entrepreneurs and to access the large pool of private savings held by Canadians. Unfortunately, these goals were not realized. Research indicates that investors did not consider COIN to be a valuable service. Over 60 per cent of investors surveyed reported that it was diﬃcult to find high quality investment opportunities within the COIN network and most did not find COIN to be an essential, or even important, component of their investment sourcing (Blatt and Riding, 1996). In addition, business angels registered with COIN noted that they often used their own leads and referrals to find deals. It appears COIN was ineﬀective in that it was designed to solve a problem that did not exist. COIN sought to increase the opportunity for business angels and entrepreneurs to make contact, but the underlying problem was not the inability of business angels to contact entrepreneurs, but rather the scarcity of high-quality investments. In essence, the low barrier of entry with respect to entrepreneurs submitting business plans and little screening of these ventures resulted in investors concluding that COIN was of little value (Blatt and Riding, 1996). Initiatives in the United Kingdom In contrast to the COIN approach (building a national network that seeks to address needs at a local level), the Local Investment Networking Company (LINC) in the UK adopted the strategy of aggregating local enterprises into a national business introduction service. Founded in 1987, LINC oﬀers several approaches to assist entrepreneurs, including a matching service, an investment bulletin (a short description of firms seeking capital) and the venture forum format. Early research on the eﬀectiveness of LINC indicated that the impact on marshaling the pool of angel capital had been modest (Mason and Harrison, 1996b). Reasons for this modest impact included the relatively small database of firms and investors that existed, a limited marketing budget that resulted in a low awareness among investors and entrepreneurs, a need to be more selective in accepting firms for listing and a fragmented organizational structure. On the positive

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side, it is noted that LINC was a relatively eﬃcient source for investors and that entrepreneurs received several ancillary benefits from LINC membership, especially the advice from the LINC business advisors and feedback from investors (Mason and Harrison, 1996b). Similar to the bottom-up approach of LINC, an early initiative in facilitating the growth of the angel market in the UK was the Department of Trade and Industry Informal Investment Demonstration Projects. This program provides direct government financial assistance to create a number of local business angel networks. An evaluation of these demonstration projects found the initiative to be quite successful. Specifically, it appears that the Informal Investment Demonstration Projects have resulted in a significant pool of capital, have stimulated demand for equity capital and succeeded in facilitating an increase in the level of angel investment activity (Harrison and Mason, 1996). However, it should be noted that these conclusions are based on a small number of projects (5) and it is possible that a substantial expansion of this program could result in some diminishing returns or possibly an overcapacity of government subsidied angel networks competing with each other for the same market. Initiatives in Sweden In contrast to the proliferation of angel networks in the UK, Sweden has shown less of a penchant for these introduction services. In an early study of individual investors in Sweden, very few business angels noted the need for an introduction service since the search for new investments was not considered troublesome in the informal market (Landström and Olofsson, 1996). Previous research on the first angel network in Sweden, the Chalmers Venture Capital Network (CVCN), appeared to corroborate this lack of need. The CVCN had the primary goal of facilitating the commercialization of technology that originated in the Chalmers University of Technology. A classic matching network modeled after the Venture Capital Network in the US, the CVCN was a two-stage computerized subscription network that matched entrepreneurs with angel investors. Research indicates that CVCN is relatively unknown within the angel community, partially as a result of a small regional focus. More importantly, given that proposals are not evaluated before inclusion in the listing, there exists a high potential for low quality in the deals oﬀered to investors (Landström and Olofsson, 1996). Initiatives in Denmark Danish business angels invest in a robust cross-section of business sectors, with a major emphasis on the seed and start-up stage. The holding period of 3–6 years compares favorably with business angels in other countries, as does the sale of the company as the major exit vehicle (Vækstfonden, 2002). For business angels in Denmark, networking among business associates is the dominant form of finding investment opportunities. However, it appears that this informal networking does not have the optimal impact since over 40 per cent of Danish business angels claim they have diﬃculty in identifying potential entrepreneurs and investment opportunities (Vækstfonden, 2002). In addition, two thirds of business angels in Denmark co-invest with other business angels, which is a higher syndication rate than business angels in the UK but less than those in the US (Vækstfonden, 2002). Research also indicates that capital from Danish business angels is available provided that quality investments can be found (Koppel, 1996). Thus, the desire for

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syndication and the need for a more eﬃcient method to find investments indicate that angel portals should have a place in the Danish informal venture capital market. In addition, research indicated that Danish business angels noted the need for a government entity to act as an intermediary or facilitator between business angels and entrepreneurs (Koppel, 1996). In 1991, with the support of the National Agency of Industry and Trade, the Business Innovation Center initiated the Business Introduction Service (BIS). The BIS was created for the purpose of assisting entrepreneurs in developing their financial plan, introducing the entrepreneur to a potential business angel, and mediating the negotiation between the entrepreneur and business angel. Despite the apparent need and desire for a business angel portal the BIS initiative was not successful for a number of reasons (Koppel, 1996). First, the description of the investor’s criteria for investments was too narrow, resulting in a decreased chance of finding a suitable proposal. Second, the work involved in matching entrepreneurs and business angels is labor intensive and relies heavily on the personal characteristics of the entrepreneur and business angel. This resulted in a considerable expense to the BIS and the business angels were not interested in paying for the full cost of this service. Third, the pool of business angels in the BIS was not large enough to provide a reasonable chance for the entrepreneur to receive financing (Koppel, 1996). Initiatives in Finland Research on business angels in Finland identified several key factors for the successful implementation of an angel portal. Among Finnish business angels the favored model for an angel portal is a computer based matching service (Lumme et al., 1998). In this type of angel portal (discussed in detail in the following section) the entrepreneur submits an executive summary of the business plan, along with a short form detailing some key characteristics of the business. The computer system matches the investment preferences of business angels with those of the submitted business plans. If the business angel is interested, then the matching service provides the introduction. It is interesting to note that venture forums, essentially forums for pre-screened entrepreneurs to present their business concept to an audience of business angels, did not appear to be of particular interest to Finnish business angel service (too much eﬀort to attend), nor did on-line data bases (too complex to use) (Lumme et al., 1998). In 1996 a consortium of public and private sector entities launched Matching-Palvelu, a Helsinki based computer matching service for business angels and entrepreneurs. Venture forums were also part of MatchingPalvelu. Based on an evaluation of Matching-Palvelu, it appears to be quite successful for several reasons (Lumme et al., 1998). First, the service was designed based on research on the needs of the business angel. Second, heavy investor recruitment to Matching-Palvelu was conducted through an investment fair. Third, extensive media coverage and presentations on the concept to business organizations helped to develop interest and awareness of Matching-Palvelu. A similar model has also enjoyed success in Finland. Sitra PreSeed Finance introduced INTRO Venture Forums. Every 12 months five INTRO Venture Forums are organized to bring pre-screened entrepreneurs to present their business concept to business angels. Sitra PreSeed Finance also coordinates the investment negotiations between the entrepreneur and business angel. To date, the INTRO Venture Forums have been quite successful, with one out of every three companies securing financing (Sitra PreSeed Finance, 2006).

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Initiatives in Singapore Business angels in Singapore represent a significant source of funding for entrepreneurs, with a mean investment amount of S$350 000 and a total investment amount close to S$30 million, which indicates that a substantial business angel market exists in Singapore (Hindle and Lee, 2002). In 2001 the Business Angel Network Southeast Asia (BANSEA) was established to promote development of the angel investment community in Asia through education and facilitating the matching of start-ups with angel investors (Kam and Ping, 2003). BANSEA also initiated the BANSEA Mentoring Program to assist entrepreneurs in the development of start-ups to provide quality deal flow to business angels. To date there has not been any independent evaluation of the eﬀectiveness of BANSEA. It is important to note that while business angels in Singapore are similar to their western counterparts, a distinguishing characteristic is the prior relationships with the entrepreneur. The majority of business angels in Singapore have an established relationship with the entrepreneur prior to the investment, with more than 80 per cent knowing the entrepreneur at least one year prior to the investment, and over half having known the entrepreneur for more than five years (Hindle and Lee, 2002). In addition, 54 per cent of the business angels invested in ventures started by friends or neighbors and 40 per cent in ventures begun by family members (Kam and Ping, 2003). These findings on the prior relationship appear to indicate that any evaluation of the eﬀectiveness of angel portals in Singapore must adopt a long term approach. That is, while the business angel network is in the business of introducing business angels to entrepreneurs with the goal of securing an investment for the entrepreneur, the measurable eﬀects of these initiatives would likely not occur for over a year, and may take close to five years to come to fruition. Thus, researchers should be cautioned when conducting an evaluation of angel networks in Singapore, and possibly in Asia in general, since such analysis would need to be longitudinal and conducted over a considerable period of time. Initiatives in Australia Business angels in Australia, while similar to business angels in other countries, have several distinguishing characteristics (Hindle and Wenban, 1999). Most notably, Australian business angels are younger than the average business angel. In terms of education, Australian business angels fall into two distinct categories: older business angels with little more than a high school education but with much entrepreneurial work experience and highly educated young professionals. With respect to the size of investments two categories emerge: business angels that tend to make only large investments in the range of $200 000 to $500 000 and those that restrict their investments to much smaller amounts, typically below $50 000 (Hindle and Wenban, 1999). Of note is that the size of the business angel market in Australia appears to be 35 to 50 per cent of the venture capital market, which is significantly lower than that of Canada, the US and UK (Caslon Analytics, 2006). To provide these business angels with investment opportunities there has been a proliferation of business angel portals in Australia with 16 angel portals in operation today. The largest of these portals is the Founders Forum, which operates in three regions of Australia: Brisbane, the Gold Coast and Perth. Started in 2000, the Founders Forum has invested over $20 million in entrepreneurial ventures (Founders Forum, 2006). Another large business angel portal is Enterprise Angels, which provides a range of services, including an online matching service for companies seeking less than $2 million in

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angel investment (Murphy, 2003). While there is a wide range of angel portals in operation in Australia, to date there does not exist any comprehensive research on the eﬀectiveness of these portals. Initiatives in Germany The predominant angel portal in Germany is BAND (Business Angel Network Deutschland) which is aﬃliated with, and provides services for, over 40 business angel networks in Germany and is involved with providing introduction services between business angels and entrepreneurs. BAND was established in 1998 and operates under the patronage of the Federal Ministry for Economy and Labor and is financed by sponsorship and member fees. The multi-faceted goals of BAND include the establishment of contacts between business angels and young innovative ventures, services to the business angel networks throughout Germany, engagement in political lobbying and public relations, and the development of workshops for both business angels and entrepreneurs (Günther, 2005). Research indicates that BAND and its aﬃliated networks play an important role in the German business angel community. While business contacts provide German business angels with over 90 per cent of the investment opportunities and close to 80 per cent of the investments, investment clubs and matching services account for 35 per cent of the investment opportunities and close to 20 per cent of the investments (Brettel, 2003). In a similar study, 41 per cent of German business angels use networks to gain access to potential investments (Stedler and Peters, 2003). In addition, over half of German business angels work in syndicates, predominately for the purpose of raising suﬃcient funds to make an investment (Brettel, 2003). The type of activities, finding investment opportunities and syndication, valued by German business angels, are activities that BAND has been an active participant in. Since the inception of BAND in 1998 the concept of business angels has gained traction and BAND has raised the interest of the individuals in the angel market, and the economy has responded successfully (Kosztopulosz, 2004). Lessons from early business angel networks Some valuable lessons can be learned from the early attempts to develop business angel networks, many of which are pertinent in today’s informal venture capital market. One of the greatest, and lasting, contributions of the early angel portals was to increase the awareness of business angel investing and the important role played by business angels in the early stage equity financing of entrepreneurial ventures. Thus, while the majority of the early attempts at angel portals were not necessarily successful in their stated goals, many did have some modest ancillary eﬀects with respect to awareness elevation among entrepreneurs and potential business angels. In addition, these early angel portals provided the foundation for both the design and success of many of the later attempts. The lessons that can be gleaned from the early angel portals are centered on four issues: investor membership, quality deal flow, funding and awareness. Much of the early research on angel networks points to the diﬃcult, and time consuming, task of finding investors to join the network. As a result, many of these networks had a small data base of business angels. Networks that were successful, such as Matching-Palvelu, conducted intensive investor recruitment through venture fairs and the media. Quality deal flow was a persistent problem for the early networks. It was often cited that the low barrier of entry

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for entrepreneurs to submit business plans and the diﬃculty for the networks in finding quality deals resulted in an overall lack of quality deals in the data base. The general conclusion is that the networks either did not evaluate the business plans before they were presented to investors or that the network operators needed to be more selective in deciding what investments to oﬀer to their members. Thus, the underlying problem was not necessarily the inability of business angels to contact entrepreneurs, but rather the paucity of high-quality investments. Funding was also a continuing issue for these early networks. Funding issues centered on the general lack of funding for operations, a limited marketing budget and the labor-intensive, and thus costly, nature of matching entrepreneurs with investors, finding quality deals and screening potential investment opportunities. The awareness of the existence and value of the networks among the business angel community was perceived to be low for many of the early networks. Thus, investors did not perceive the networks as providing value to them and often used their own leads and referrals to find deals rather than the network. It should be noted that this inability to create suﬃcient awareness of the existence and value of the networks is likely to be related to the inability of the networks to attract a substantial membership of angel investors. Those networks that were successful, such as LINC and Matching-Palvelu, undertook extensive eﬀorts to develop interest and awareness. The early work on evaluating the eﬀectiveness of angel portals raises five serious concerns that should be addressed during any evaluative study. First, most of the angel portals do not have a cost eﬀective mechanism to track the investments of their business angel members and thus any data needed to conduct an evaluation is diﬃcult to obtain. Second, since business angel investments often take over five years to reach an exit, any comprehensive evaluation of the portal must be conducted over the long term. Unfortunately, the inherent long term nature of the evaluation process does not often match the short term needs of the angel portal in judging eﬀectiveness. Third, any reasonable and accurate evaluation of the eﬀectiveness of an angel portal requires a significant commitment of funds and is labor intensive, two resources that angel networks have in short supply. Fourth, developing measures of success pose a significant challenge, and this is compounded by the fact that it is often diﬃcult to even determine the goals of the angel portal, let alone the measures of success. Lastly, in any evaluative study the importance of an independent third party assessment is critical, which would require funding from an equally independent source and not from any organization with an inherent interest in the success of angel portals. Types of angel portals The angel market can be characterized along six diﬀerent forms of angel portals, each representing a distinguishable type of angel portal through which business angels interact with entrepreneurs. The primary goal of each of these types of portals is to increase the eﬃciency in the early stage market, increase deal flow for business angels and provide entrepreneurs access to angel capital. With high transaction costs for the entrepreneur, raising private equity capital involves a costly and time-consuming personal networking process. For the investor considerable time and dollars are spent searching and evaluating investment opportunities. Angel portals seek to mitigate some of these time-consuming activities. Preservation of the anonymity of angel investors is also an important consideration in the structure of these portals. The six types of portals or angel

The organization of the informal venture capital market Table 14.2

355

Angel portals

Matching networks Facilitators Informal angel groups Formal angel alliances Electronic networks Collection of individual angels

Proportion of total market investments

Membership criteria

Visibility

Organizational structure

Percentage of latent angels

LOW

MED

HIGH

HIGH

MED

MED HIGH

LOW LOW

MED MED

LOW LOW

MED-HIGH LOW

MED

HIGH

HIGH

HIGH

HIGH

VERY LOW

MED

HIGH

MED

HIGH

HIGH

LOW

LOW

LOW

LOW

organizations may be categorized as: matching networks, facilitators, informal angel groups, formal angel alliances, electronic networks and individual angels. Table 14.2 provides a summary of the characteristics of the types of angel portals. In Table 14.2 five characteristics are used to describe angel portals: the proportion of total market investments, membership criteria, visibility, organizational structure and the percentage of latent angels. The proportion of total market investments is a measure of the market share, in terms of the total number of investments made by members of the angel portal as a percentage of the total investments by all types of angel portals. Membership criteria is defined as the criteria that members of the angel portal must have. Thus, a rating of ‘high’ for membership criteria indicates that the portal requires the members to meet several requirements, such as minimum yearly investment activity, annual dues and/or contributions to an investment fund. Visibility is the degree of awareness that entrepreneurs and business angels have of the existence of the portal. Organizational structure is the level of structure in the angel portal. An angel portal with a high organizational structure would include such organizational components as a paid executive director, the election of oﬃcers, a formal investment committee and organization bylaws that govern the activities of the portal. The percentage of latent angels is the percentage of the individual members of the angel portal that have the necessary net worth, but have never made an investment. Matching networks Matching networks, or business introduction services, are the oldest form of an angel portal and for a decade after their inception they were the only type of organized angel portal in existence. The matching networks represent the first attempt to increase the eﬃciency of the early stage market by providing a mechanism for investors to evaluate opportunities, and for entrepreneurs to gain access to business angels. These networks are typically not-for-profit organizations with an established connection to the investor and entrepreneur community in their respective region. The first matching network, founded

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at the University of New Hampshire by William Wetzel in 1984, at that time called the Venture Capital Network (VCN), provided the model for matching networks that is still followed today. VCN was based on four fundamental principles: the need to protect investor anonymity, to provide access to capital for entrepreneurs, to have an eﬃcient mechanism for business angels to screen investment opportunities and the importance of face-to-face interaction between business angels and entrepreneurs. These principles set the stage for the foundation for the majority of matching networks in operation today, such as Business Angels Party Limited in Australia, Halo in Northern Ireland and Euregional Business Angel Network in Germany. Over time, this last principle, face-to-face interaction, has been demonstrated to be a key element of angel investing. Amit et al.’s (1990) examination of the implications of the relationship between entrepreneurs and venture capitalists found that the significant information asymmetries inherent in the private equity market highlight the importance of the principal–agent relationship and allow for significant agency risks, particularly adverse selection problems. Business angels attempt to overcome these inherent diﬃculties with an increased reliance on personal communications with the entrepreneur and the ability to judge the character through face-to-face communications and interactions in a variety of settings. Bearing out this point, the angel market has been one that conducts business on a faceto-face level for both deal sourcing (Freear et al., 1994a; Coveney and Moore, 1998; Reitan and Sørheim, 2000; Sørheim and Landström, 2001) and investment decisions (Landström, 1992; Fiet, 1995a; Harrison and Mason, 2002). Likewise, business angels tend to depend on the entrepreneur to protect them from losses due to market risk and are thus more concerned with agency risk than market risk. To accomplish this, business angels develop a close working relationship with entrepreneurs in the post-investment stage as a way to mitigate risk and bring value to the investment (Fiet, 1995b). To address the need to protect investor anonymity, provide access to capital for entrepreneurs, have an eﬃcient screening mechanism and the face-to-face interaction, VCN implemented a three-tiered approach: (i) a matching database; (ii) the venture forum format; and (iii) educational seminars. The matching database requires the submission of an executive summary of the business plan by the entrepreneur. Investors list investment preferences, including size, stage and location. The network screens for those business plans that match investor criteria and forward an anonymous copy of those business plans satisfying the criteria to the individual investor. The investor, if interested, contacts the network for information on the entrepreneur and the network facilitates the introduction and then exits from the process. All subsequent contact is between the investor and the entrepreneur directly (Sohl, 1999). These matching networks initiated the venture forum format, where pre-screened entrepreneurs are given the opportunity to present their business plan to groups of early stage investors. In this context, investors were aﬀorded the opportunity to have a face-to-face interaction with several entrepreneurs, to view several presentations within a reasonable period of time, and initiate contact if the venture appeared promising. The venture forum also provided the opportunity for investors to interact with each other and to syndicate around a deal. The importance of education was underscored, and the matching networks were the first to produce educational seminars, for both the entrepreneur and investor, on

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investing in the early stage market, market trends, and similar timely investment information. These educational seminars became an integral component of the matching network concept. At the high point of their tenure matching networks were the dominant form of angel portal for nearly a decade. During that time, in terms of facilitating early stage investments, statistics indicate that the success rate for the network member entrepreneur in receiving equity financing was in the 10 to 15 per cent range for the matching service and approximately 40 per cent for the venture forum format (Freear et al., 1994a). Today, very few classic matching networks are in existence in the US, although their numbers are greater in Europe. Some have evolved into providing only venture forums or educational seminars, while others have ceased to exist. However, the importance of this initial eﬀort to increase the eﬃciency of the angel market cannot be understated. This first model spawned an entire industry. The unique combination of matching service, venture forum format and educational initiatives set the stage for the development of these important initiatives that have educated a generation of entrepreneurs and investors on the central mysteries of angel investing. Also, the initial success of the venture forum has been adopted as one of the predominant mechanisms in today’s market for bringing entrepreneurs and investors together. Facilitators The second model of angel portal, facilitators, is one of the least organized of the angel portals. These facilitators generally do not have any formal angel membership but rather maintain a list of interested parties, including private investors, entrepreneurs and service providers. They are often considered ‘event planners’ in the sense that they plan events that seek to bring business angels and entrepreneurs together. These events are organized around a specific issue, with a speaker, or panel of speakers, addressing a topic germane to the angel market. These topics include valuations, setting terms and conditions, preparing a presentation and organizing a business plan. Thus, to some extent, facilitators provide educational opportunities for the angel and entrepreneur community. These events will also include the venture forum format. With ample time for networking, the real focus of these facilitators is to assist, in a passive manner, the introduction of entrepreneurs to business angels. Examples (cases) of facilitators are the Technology Capital Network and the 128 Innovation Capital Group in the US, the ‘netzwerknordbayern’ in Germany and Gate2Growth in Belgium. These facilitators take on two organizational forms: private sector for profit organizations and public/private sector hybrids. The hybrids, often some form of economic development agency, have as their primary focus the fostering of economic development in their geographic area. Examples of this type of facilitator are International Angel Investors in Tokyo, Japan and TechInvest in Wales, UK. The geographic footprint can be as small as a mid-sized town of 150 000 residents to as large as a state or province. While angel investing is not their core business, they often view angel capital as a key component in increasing the economic vitality of their region. The facilitators embark on initiatives to begin to encourage angel investing in the community or, within an established entrepreneurial sector, to sustain and grow angel investing. At the present time, there are close to 100 active angel portals in the US that would be considered facilitators and probably as many in Europe (Sohl, 2003).

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It is diﬃcult to assess the eﬀectiveness of the facilitators since they often do not keep records of their success in these entrepreneur and angel interactions. One of the diﬃculties is that the business angel–entrepreneur interactions are serendipitous in nature and the facilitators do not have a formal list of either their entrepreneur or business angel members. It does appear that these facilitators have been successful in three facets of the business angel market. First, the facilitators have raised the visibility of the business angel community in the region within which they operate. Second, they provide an informal meeting structure for business angels to meet other business angels and possibly syndicate with each other around a particular deal. Third, the facilitators provide a venue for entrepreneurs to present their business concept, and through interactions with the business angels and entrepreneurs at the meetings they often gain an assessment of the quality of their presentation and the business plan. Informal angel groups The third type of angel portal is the myriad collection of informal angel groups. These groups have members, although the membership criteria are quite broad, typically involving attendance at meetings and an interest, ability, and net worth, to engage in angel investing (Table 14.2). These groups can be as small as a handful of members to as large as 50 private investors (Center for Venture Research, 2005). Collectively, informal angel groups represent the second largest of the six types of angel portals, in terms of total number of members and investment activity. In the US there are several hundred of these informal angel groups. Examples of informal angel groups are Envestors in London, UK, CatCap in Germany, Founders Forum in Australia, and eCoast Angels and Walnut Ventures in the US. The key distinguishing feature of the informal angel group, in addition to their size, is the reliance on members to perform many of the ‘back oﬃce’ functions of the portal. The informal angel groups rely on the members to bring the majority of the investment opportunities to the group for investment consideration. Thus, initial screening is the member referral, and in some cases, the commitment of one member to invest funds is required before the entrepreneur can present to the group. As such, the trust relationship among members appears to be a mechanism to mitigate some of the risk inherent in angel investing. Members perform due diligence and are free to invest when they wish, usually without any stated minimum investment activity required to remain a member of the group. Members often syndicate with other members of the group based on a specific deal, with one of the business angels assuming the role of lead investor. However, not all members of the group invest in all deals, thus preserving the ability to manage their own angel investment portfolio. The informal angel group aﬀords the opportunity for members to archive a level of sector diversification through this co-investing. That is, research indicates that business angels typically invest in technologies in which they have experience that has been garnered either as former successful entrepreneurs in the particular industry or through prior sector investing experience. Thus, through a reliance on other members with expertise in the particular industry, and the trust relationship they have developed, business angels can achieve some industry-level portfolio diversification. The venture forum format, although quite informal in nature, is the predominant mechanism for assessing the investment opportunity. These informal angel groups have a small number of latent angels, indicating that investment activity, while not a formal requirement for membership, appears to be at least an implicit one.

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The informal angel groups have been quite eﬀective in several facets of the angel market. Since the screening of the investment opportunities is through a member referral or a commitment of one member to invest funds, the investment opportunities presented to their members are consistently of high quality. Informal angel groups also oﬀer business angels the opportunity to achieve some market diversification through co-investing with other members. In addition, since most informal angel groups have a low percentage of latent angels, the entrepreneur has a higher chance of securing investment capital. Formal angel alliance The fourth model of angel portal is the formal angel alliance. These alliances are distinguishable from the informal angel groups in that they tend to have a larger membership per group and have a higher degree of visibility. However, the collective membership (and investment activity) of informal angel groups and the individual angel market (discussed below) exceeds that of the formal angel alliances. The angel alliance phenomenon began in 1994 with the formation of the Band of Angels in Silicon Valley by Hans Severiens. The original concept was to form a group of private investors with a ‘storefront’ that gives visibility to the group but not to the individual members, and to have a more rigid organizational structure than the informal angel group. This formalized organizational structure is a distinguishing feature of the formal angel alliance. Most alliances have specified articles of incorporation and are organized as limited partnerships, general partnerships, limited liability corporations or corporate entities (Table 14.2). The alliances often have criteria for membership in addition to accredited investor status. These additional requirements include education, referral by a member in good standing and past investment experience. Members may also include venture capitalists and most alliances have some form of annual membership fee. Decisions on investments include individual member decision making, voting by members, or decisions by an investment committee. The high visibility of the formal angel alliance was conceived as a mechanism to attract deal flow but had the unintended consequence of attracting a multitude of deals with variegating quality, resulting in the need for screening committees, staﬀ support and the increased burden of screening these deals. This deal flow volume and entrepreneur inquiries led to the need for paid back oﬃce staﬀ, board of directors and an executive director that assumes the ‘face’ of the portal for the entrepreneurial community. Examples of the formal angel alliance include the Angels Forum and BlueTree Allied Angels in the US, Advantage Business Angels and London Business Angels in the UK, Nippon Angels Forum in Japan, and Mentor Investor Network Events for Business Angels in New Zealand. The original concept of the formal angel alliance has spawned a myriad of hybrid alliance organizations that can be categorized by membership investment requirements, investment decisions and the source of capital. The classic angel is an individual that manages their own money and decides when, and how much, risk capital to invest in entrepreneurial ventures. Some of the hybrid formal angel alliances have increased the burden on members by specifying a minimum number, and size, of annual investment activity. An example of this type of hybrid is the Tech Coast Angels in the US. This requirement may lead to less than optimal investment decision making since angel investments are related to the portfolio of private equity holdings of the individual angel and the investment opportunity, rather than an artificially imposed investment frequency.

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In another hybrid of the angel alliance, the decision making ability of the individual is often restricted by certain forms of group decision making. Robin Hood Ventures in the US operates as this type of hybrid. These group decisions take the form of voting, either by members or by an investment committee, with a positive vote requiring all members to invest in the venture. As such, the individual angel’s decision making authority is usurped by the alliance. The last form of hybrid angel alliance results from the pooling of funds. In this instance, all members are required to invest in the angel alliance fund and this fund is the sole source of capital for alliance investments. An example of this type of angel portal is the Mid Atlantic Angel Group in the US. In some cases business angels may make an additional investment, but only after the fund has decided to make the investment. In this case, angel investing has morphed into classic venture capital funds, with limited/general partners (the general partners are wealthy individuals), and the name ‘angel fund’ is the only similarity to angel investing. These ‘angel funds’ result in a reallocation of angel capital away from individual investing (and possibly seed stage investing) to venture capital fund investing. While the investment objective of the fund may be seed stage, fund size may dictate later stage investing and a diminishment in the value-add of the angel investor. The formal angel alliance has achieved much success, but this success is not without a cost. The formal angel alliance has increased the visibility of angel investing and has achieved a large number of member business angels per angel portal. However, while this increased visibility has increased the number of deals for the alliance, this has not corresponded with an equal increase in the quality of the deals. This variability in deal quality has necessitated the initiation of screening committees and additional staﬀ to review the quality of the investment opportunities, which has resulted in increased operating costs. In addition, the rigid organizational structure of the formal angel alliance is not in alignment with the general individualistic behavior of business angels and as such, these formal angel alliances may be more attractive to inexperienced wealthy individuals seeking a passive investment vehicle, rather than a value-added and active angel investor. Electronic networks The fifth, and smallest in terms of investment activity, type of angel portal is the electronic network. These electronic networks were a product of the Internet bubble of 2000 and are close to extinction in today’s angel market. Electronic networks were largely a misguided eﬀort and in some cases an attempt to profit from the irrational behavior of unseasoned investors that entered the angel market during the dot.com bubble of 1999/2000. During their peak in 2000 about thirty of these electronic networks sprouted on the World Wide Web (Sohl, 1999). The electronic networks attempted to mirror the matching networks through the medium of the Internet. Examples of electronic networks include Local Fund and Funding Match in the US, and the Private Equity and Entrepreneur Exchange and Aussie Opportunities in Australia. Unlike the matching networks, these electronic networks typically do not engage in any educational function nor do they use the venture forum paradigm. Requirements for the entrepreneur cover the spectrum from the submittal of a two-page executive summary to detailed business plans. Pending investor accreditation and an annual fee, individual investors peruse the network for investment opportunities.

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Electronic networks have been largely unsuccessful, with less than 1 per cent of equity capital raised harvested on-line (Private Equity Week, 1998). Several factors attributed to the demise of the electronic network. Strategies of many electronic networks were to develop a national angel market operating with one platform and structure, which failed to address the regional nature of the market and the necessity of being grounded in the regional entrepreneurial market. One especially misguided government-sponsored eﬀort envisioned a central database for the US and over 50 local networks, the majority of which had absolutely no understanding of the angel market. Also, angel investing is a face-toface phenomenon and no amount of electronic interfacing, in the present form, will replace a seasoned investor’s ability and desire to review the deal, and the entrepreneur, up close. In addition, in light of the overwhelming success of the venture forum format, electronic networks provide no such venue. The future for electronic networks most probably lies in providing an eﬃcient method for deal screening. Unfortunately, in many, if not all, of the initiatives, the failure to grasp key concepts of the angel market resulted in poor strategic selection and hampered the penetration of electronic networks into the early stage equity market. Collection of individual investors The last type of angel portal, the collection of individual investors, is the largest and oldest segment of the angel community. This is also the least understood of the angel portals, since the individual angel market is largely invisible, and reliable data is diﬃcult to acquire. The individual investor portal accounts for the majority of deals and investment dollars in the angel market. Although the largest segment of the angel market, this collection of individual angels is the least organized of the angel portals. These individual angels are not directly aﬃliated with any angel portal, although loose connections with informal angel groups and, to some extent, formal angel alliances, do exist and the individual angels may co-invest with members of these other portals. Despite the lack of organization, deal flow does not appear to be an issue, and the deals may be of higher quality, on average, than those of the other portals (Table 14.2). Drawing on their social and human capital, individual angels rely on referrals to generate deal flow. These gatekeepers, such as other entrepreneurs, lawyers and service providers, often provide that crucial initial introduction for the entrepreneur. Since the referral sources are often trusted friends and business associates, who know what type of deals they invest in with respect to sector, stage and size, there appears to be less need for screening. Tapping into the individual angel portal is often a random occurrence and a time-consuming process punctuated by many misguided approaches. As such, transaction costs for the entrepreneur may be substantial. Conclusion Systemic market ineﬃciencies and two persistent funding gaps – the primary seed gap and the secondary post-seed gap – have led the angel market to assume several organizational strategies to increase the eﬃciency of quality deal flow and increase the capital available. Adapting to changing market conditions, multifaceted angel portals have evolved. Collectively, individuals and angel portals comprise today’s angel market. Angel portals have increased the visibility, and importance, of business angels, and have provided entrepreneurs with a venue in their search for seed funding. An examination of these types of

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angel portals sheds considerable light on the angel market and provides a potential lens to the future of the market. Six types of angel portals – matching networks, facilitators, informal angel groups, formal angel alliances, electronic networks and individual angels – were examined. Hybrid forms were noted where appropriate. The existence and market penetration of these types of portals vary across nations. In the future, it is important to understand why some angel portals may be more apposite for certain regions and countries and not for others. Implications for portals Based on this examination of angel portals it appears that for angel portals to be eﬀective in solving the primary seed gap and the secondary post-seed gap they should adopt some basic features that reflect the fundamental tenets of the angel market. Perhaps most importantly, angel portals should maintain an informal structure that has few rules or restrictions for membership, such as minimum investment requirements, member voting for deal investment approval and conditions that all portal members invest in all the deals that are approved by the membership. Business angels invest in markets where opportunities exist, such as in the primary seed gap and secondary post-seed gap, and thus restrictions on investment activities would prevent capital from being used where it is most needed. The three portal types, informal angel groups, the collection of individual angels and matching networks, are most suited for investing in the primary seed gap. It is in this primary seed gap that the angel and entrepreneur relationship is most critical and the position where business angels can be most eﬀective in their value-add. That is, since business angels bring much start-up experience to their investments, this experience and expertise is most eﬀective in the early stages of development of the entrepreneurial venture. In addition, this start-up experience aﬀords business angels the opportunity to use their expertise in evaluating the potential investment opportunity. In contrast, the formal angel alliance, and in some instances the matching network, are best positioned in investing in the secondary post-seed gap. The formal angel alliance, with extensive membership criteria including minimum investment requirements and the presence, in many cases, of an investment fund, allows the angel alliance to participate in these larger post-seed investment rounds. However, it is important to note that this extensive organizational structure of the formal angel alliance may have some unintended consequences. Specifically, these ‘angel’ funds can be viewed as venture capital funds with wealthy individuals as limited partners and such a structure represents a redistribution of business angel capital away from the individual angel investor to a fund structure. Such redistribution would only result in an exacerbation of the persistent, and troublesome, seed financing gap facing entrepreneurs seeking early stage capital. This potential institutionalization of the business angel market could present a significant impediment to the viability of the business angel investor as the major provider of seed capital to entrepreneurial ventures (Amatucci and Sohl, forthcoming). There are four key considerations for angel portals to be successful. First, portals should be based on a regional model, rather than one that is national or state/province in scope. Since business angels predominately invest in deals within a half-day travel time from their principal residence, this regional approach is most appropriate and would assist in solving local capital gap issues. Second, angel portals need to provide for a face-to-face

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interaction between business angels and entrepreneurs since the investment decision often relies on the quality of the management team. Certainly, angel groups should be connected to the regional entrepreneur and angel community and strive to develop an understanding of these regional communities within which they operate. Related to this connection to the angel and entrepreneur community, angel portals should undertake a marketing eﬀort that includes building awareness among angels and those entrepreneurs oﬀering quality deal flow. Such a marketing eﬀort requires an allocation of resources to marketing initiatives. Third, portals should strive to provide quality deal flow for their members. As such, angel portals should conduct some level of screening and develop some hurdles for entrepreneurs to increase the proportion of proposals that are investorready. This screening should focus on deals that occupy the primary seed gap and secondary post-seed gap, since this spectrum is where business angels have the opportunity to be eﬀective and realize returns commensurate with the risk they face. Fourth and most important, portals must remember that they are collections of angel investors who make individual investment decisions and that they are not venture capitalists that manage a pool of capital. Such movement to the institutionalization of the angel market would have serious consequences for the supply of critical seed and start-up capital. In the worst case, an institutionalization of the angel market could result in a movement to later stage investments, which would only exacerbate the primary seed and secondary post-seed gaps. Once angel portals adopt the basic tenets outlined above for an organizational structure, they will be in a better position to solve some of the inherent ineﬃciencies and capital shortages that exist in the two capital gaps. While angel portals have emerged, and evolved, over the years, and the angel market has gained visibility, the angel market is still very informal, and relies on a collection of individuals who are willing to invest a portion of their portfolios in high risk entrepreneurial ventures. Business angels are independent by nature and they invest their own money where and when they want to. The market is a highly personalized one characterized by individuals (business angels) investing in individuals (entrepreneurs). When business angels syndicate around a deal, they syndicate with other trusted business angels of their choosing. The value-added component of angel investing, and the psychic income the business angel acquires from investing is derived from the individual angels working with the entrepreneurs they invest in. These individuals are the real adventure investors in today’s market for risk capital. Policy implications Public policy can play a role in facilitating the development of a vibrant and active angel market at a regional level and enhancing the flow of early stage equity capital to entrepreneurial ventures. Specifically, four levels of policy recommendations are oﬀered: (i) linkages; (ii) research; (iii) education; and (iv) monetary incentives. With respect to linkages, an active angel market requires the presence of innovators who develop the idea, entrepreneurs who form a business around the innovation, and business angels who provide the capital to move the idea from the laboratory to the marketplace. While some, or all of these, are present in communities, it is important that the linkages between these groups be established and public policy can play a role in fostering and nurturing these linkages. Specifically, an active public policy to support the development of the business side of the innovation (the innovator to entrepreneur linkage) would support both an

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information clearing house for innovators and entrepreneurs to find each other, and a sponsored venue for these meetings to take place. In addition, a physical location, such as an accelerator, would further the development of the innovator–entrepreneur interaction. To foster the growth of the business angel linkage with both the innovator and entrepreneur requires a pro-active public policy to facilitate, and act as a catalyst for, these interactions to take place. Also, since angel investing requires substantial screening of opportunities, public support of this screening function would assist business angels in their search for quality deals. Public policy can also play a role in supporting research to increase the understanding of the changing nature of the angel market. The angel market is a myriad collection of angel portals and a diﬃcult market to gain access to for research purposes. Research eﬀorts in this context are labor intensive, costly and must be longitudinal in nature. Such an extensive and comprehensive research undertaking is beyond the purview and the resources of local governments and private sector firms. Research eﬀorts of this magnitude are best supported through public policy agencies or a public/private sector partnership to provide the patient capital to design and undertake business angel research on a national scale. This research can assist governments in making informed policy decisions regarding the growth and sustainability of the business angel market. Educational programs should be developed that target both the supply and demand. Namely, education should be directed to latent angels to assist in understanding the central mysteries of angel investing and for entrepreneurs to appreciate the requirements necessary to become investor ready. Successful educational programs would result in an increase in both available capital and quality deal flow. There exist some limited private sector initiatives in this area, such as the Power of Angel Investing in the US and Angel Academies in Europe. While private sector initiatives can play a limited role in education, the public sector is uniquely positioned to marshal the appropriate individuals and garner the resources necessary to develop and implement a comprehensive education program that is available to all entrepreneurs and business angels at a subsidized price. The public sector, in combination with existing research and funded research projects, can ensure the consistency of the educational content. In addition, public sector involvement and funding of educational programs will ensure that the content is based on research studies, avoiding the incidence of anecdote-based training that occurs in a number of existing private sector programs. Public policy monetary incentives should focus on enhancing the flow of early stage equity capital to entrepreneurial ventures. First, to increase a supply of start-up capital and to leverage existing angel resources, a pool of capital, the Archimedes Fund, needs to be created at a regional or national level. This Archimedes Fund would be the source of leverage for angel investors. The creation of a fund with a 3 to 1 leverage would both increase the available start-up capital and provide a form of downside risk protection for angel investors. As an example, in an investment of US$1 000 000 the angel would provide US$750 000 and draw US$250 000 (3 to 1 match) from the Archimedes Fund. At the exit event, any capital gains would be redistributed to the Archimedes Fund, in the 3 to 1 ratio, for future investments. It is important to note that the Archimedes Fund is not a venture capital fund, but rather a matching fund for business angels. As such, management of the fund would be substantially less burdensome than a classic venture capital fund. It is important that the source of capital for the Archimedes Fund be corporate partners or

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governments and not individual investors, to enhance the creation, rather than the redistribution, of equity capital. An example of such a monetary initiative is the Scottish Enterprise Business Growth Fund and the Scottish Co-investment Fund. These two funds accounted for 7 per cent of the total monies invested in Scottish early stage companies in 2004 and were represented in 55 per cent of all the deals recorded (Don and Harrison, 2006). In addition, the leverage eﬀect of the Scottish Co-investment Fund is substantial, with the average business angel deal size in 2004 increasing from £179 to £475 when business angels co-invested with the fund (Don and Harrison, 2006). Second, to enhance the quality of deal flow, it is suggested that a web-based system be created for entrepreneurs to submit business plans for potential angel funding. Utilizing the resources of university business schools, students would provide initial screening and due diligence for the proposals and complete a short assessment of the investment opportunity. This assessment would be available to business angels to help manage deal flow and also available to entrepreneurs as a timely feedback mechanism in their search for equity capital. Funds for this web-based screening system can be garnered from a small management fee that is part of the Archimedes Fund and government support. Future research While the angel portal has received considerable attention from researchers, there exist many potential research topics that would add greatly to the understanding of this important equity market. Much of the angel portal research to date has been based on a cross-sectional analysis of the market taken at various points in time. A longitudinal approach would provide for the opportunity to track changes in various portals over time. One potential approach for longitudinal investigation is using the deal level as the unit of analysis. In this scenario, the angel deal from each angel portal is tracked from the time of investment to the exit. Such an approach would provide valuable insights into changing valuations and understanding the conditions for deals that exit when funding is restricted to angel portals without any institutional venture capital. This longitudinal deal tracking would also illuminate some of the conditions why an angel deal was not successful across portals. Through longitudinal tracking at periodic intervals of time, information as to how and why angel deals fail with respect to the type of angel portal would be available for study. With respect to the myriad of angel portals that exist, it is important to understand why some angel portals may be more appropriate for certain regions and not for others. In this context, regional level angel portal investment data, combined with regional R&D investments, measures of the entrepreneurial climate, industry infrastructure, workforce characteristics and other economic variables could help in explaining the diﬀerences between angel portals. In addition, such an analysis would provide economic planners with a potential map of how best to organize business angels within their region. Another potential area of future research is the evolving relationship between angel portals and venture capitalists. While these two entities are understood to be complementary and to occupy diﬀerent places in the private equity market, these lines are becoming less distinct, especially with the emergence of the formal angel alliance and the angel fund. The potential for conflict exists and an understanding of the nature of these venture capital–angel portal relationships and how best they can be nurtured for the benefit of both parties would be an important contribution to the literature.

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Another potentially interesting line of inquiry is the role of angel portals in regional economic development. While angel portals typically restrict their investment activity to the regions within which they operate, there has been little study on how angel portals interact within the larger sphere of regional economies and with other portals within the region. Screening and due diligence conducted by angel portals has often been studied through interviews and cases. Research into the actual due diligence, through the direct analysis of actions (reject, continue due diligence or invest) by the screening and due diligence committees of angel portals, could assist entrepreneurs in developing business plans more compatible with the criteria of the type of angel portal that is their target. While it has been noted that the angel market is experiencing an increase in organization, the potential for the institutionalization of the angel market and the subsequent abandonment of the seed and start-up stage market has serious considerations. Research into this potential institutionalization, the conditions for development and the consequences within angel portals, are of vital concern to the future of the angel market. There exists a notable lack of a theoretical framework for business angel research in general and for angel portals in particular. Since angel portals are essentially collections of individuals that operate within a group, one potential theoretical development for angel portals is the eﬀectiveness of group structure on the investment decision process. The concept of the interplay of group dynamics and the interaction within and among portals could also provide a valuable theoretical perspective. While it may be possible to examine which portal structure operates best with respect to the quality and quantity of investments, theories of group dynamics and eﬃcacy could provide the why behind these empirical findings. It appears that social capital also has an important role in business angel investing. Many of the sources of deals are from referrals from trusted associates and the practice of angels syndicating around a deal is a relationship based on trust. Theories of social capital and social networks, as a way of building trust within these business angel relationships, has the potential for providing a valuable lens into this behavior. In a similar context, social networks and homogeneity theory may provide a foundation for the diﬀerences between male and female angel portals with respect to the seek rates for women entrepreneurs. To clarify, would women entrepreneurs be more likely to seek, and receive, funding from angel portals that have a high proportion of women business angels? Following this gender construct, feminist theory would be helpful in exploring whether structural and social barriers impede women’s access to angel portals or their ability to pass the screening process in these portals, and thus they may seek funding from angel portals at a lower rate than men. Business angels invest in the entrepreneur, in the context of agency theory, as a means to mitigate the risk inherent in investing in early stage ventures with little or no historical financial or operating data. Extending the principal–agent theory to angel portals is a potentially fruitful area of research. In this context, angel portals appear to be conducting a heightened level of screening of entrepreneurs before presenting these investment opportunities to their members, partially as a means to reduce the risk for business angels. Could this additional screening change the dynamics of the principal–agent relationship away from the business angel–entrepreneur framework? That is, would the principal–agent relationship shift to one between the angel and the deal and mitigate the influence of the entrepreneur? While there is considerable knowledge about the angel market, there remain many facets that are misunderstood and much research to be undertaken. Through high quality,

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well designed and timely academic research, business angels, entrepreneurs and policymakers will be in a better position to make informed decisions regarding their role in the development of a vibrant, and sustainable, angel market. References Amatucci, F.M. and J.E. Sohl (forthcoming), ‘Business angels: investment processes, outcomes and current trends’, in A. Zacharakis and S. Spinelli (eds), Praeger Perspectives on Entrepreneurship – Volume II, Westport, CT: Greenwood Publishing Group. Amit, R., L. Glosten and E. Muller (1990), ‘Entrepreneurial ability, venture investments and risk sharing’, Management Science, 36(10), 1232–45. Blatt, R. and A. Riding (1996), ‘ “Where angels fear to tread”: some lessons from the Canada Opportunities Investment Network experience’, in R.T. Harrison and C.M. Mason (eds), Informal Venture Capital: Evaluating the Impact of Business Introduction Services, Hertfordshire, UK: Woodhead-Faulkner Limited, pp. 75–88. Brettel, M. (2003), ‘Business angels in Germany: a research note’, Venture Capital, 5(3), 251–68. Brophy, D.J. (1997), ‘Financing the growth of entrepreneurial firms’, in D. Sexton and R. Smilor (eds), Entrepreneurship 2000, Chicago, IL: Upstart Publishing, pp. 5–27. Caslon Analytics (2006), ‘e-capital guide’, www.caslon.com.au/ecapitalguide3.htm, accessed 23 March. Center for Venture Research (2004), ‘The angel investor market in 2003: the angel market rebounds, but a troublesome post seed funding gap deepens’, wsbe.unh.edu/Centers_CVR/2003AR.cfm, 21 April. Center for Venture Research (2005), ‘The angel investor market in 2004: the angel market sustains a modest recovery’, wsbe.unh.edu/Centers_CVR/2004analysisreport.cfm, 22 March. Coveney, P. and K. Moore (eds) (1998), Business Angels: Securing Start-Up Finance, Chichester, UK: Wiley Press. Don, G. and R.T. Harrison (2006), ‘The equity risk capital market for young companies in Scotland 2000–2004’, report published by Scottish Enterprise, Glasgow, January. Fiet, J.O. (1995a), ‘Reliance upon informants in the venture capital industry’, Journal of Business Venturing, 10(3), 195–223. Fiet, J.O. (1995b), ‘Risk avoidance strategies in venture capital markets’, Journal of Management Studies, 3(4), 551–74. Founders Forum (2006), ‘Raising start-up funds’, www.foundersforum.com.au/, accessed 23 March. Freear, J., J.E. Sohl and W.E. Wetzel, Jr. (1994a), ‘The private investor market for venture capital’, The Financier, 1(2), 7–15. Freear, J., J.E. Sohl and W.E. Wetzel, Jr. (1994b), ‘Angels and non-angels: are there diﬀerences?’, Journal of Business Venturing, 9(2), 109–23. Gaston, R.J. (1989), Finding Private Venture Capital for your Firm: A Complete Guide, New York, NY: John Wiley and Sons. Günther, U. (2005), ‘Successful approach for increasing growth and access to investment’, presentation at Swedish Foundation for Small Business Research seminar ‘The arena of informal capital – huge demand but who supplies?’, Brussels, 4 June. Harrison, R.T. and C.M. Mason (1993), ‘Financing for the growing business: the role of informal investment’, National Westminster Quarterly Review, May, 17–29. Harrison, R.T. and C.M. Mason (1996), ‘Developing the informal venture capital market: a review of the Department of Trade and Industry’s informal investment demonstration projects’, Regional Studies Association, 30(8), 765–71. Harrison, R.T. and C.M. Mason (2002), ‘Backing the horse or the jockey? Agency costs, information and the evaluation of risk by informal venture capitalists’, paper presented to the 22nd Babson College–Kauﬀman Foundation Entrepreneurship Research Conference, University of Colorado at Boulder, 6–8 June. Hindle, K. and L. Lee (2002), ‘An exploratory investigation of informal venture capitalists in Singapore’, Venture Capital, 4(2), 169–81. Hindle, K. and R. Wenban (1999), ‘Australia’s informal venture capitalists: an exploratory profile’, Venture Capital, 1(2), 169–86. Kam, W.P. and H.Y. Ping (2003), ‘Business angels in Singapore’, Working Paper at NUS Entrepreneurship Centre, Singapore, September. Koppel, P. (1996), ‘Equity finance and the role of a business introduction service in Denmark’, in C.M. Mason and R.T. Harrison (eds), Informal Venture Capital: Evaluating the Impact of Business Introduction Services, Hertfordshire, UK: Woodhead-Faulkner Limited, pp. 286–303. Kosztopulosz, A. (2004), ‘Informal venture capital in Hungary’, paper presented at the 3rd International Conference for Young Researchers, Szent István University, Gödöllö.

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Landström, H. (1992), ‘The relationship between private investors and small firms: an agency theory approach’, Entrepreneurship & Regional Development, 4, 199–223. Landström, H. (1993), ‘Informal risk capital in Sweden and some international comparisons’, Journal of Business Venturing, 8(6), 525–40. Landström, H. and C. Olofsson (1996), ‘Informal venture capital in Sweden’, in R.T. Harrison and C.M. Mason (eds), Informal Venture Capital: Evaluating the Impact of Business Introduction Services, Hertfordshire, UK: Woodhead-Faulkner Limited, pp. 273–85. Lumme, A., C. Mason and M. Suomi (eds) (1998), Informal Venture Capital: Investors, Investments and Policy Issues in Finland, Boston, US: Kluwer Academic Publishers. Mason, C.M. and R.T. Harrison (1992), ‘The supply of equity finance in the UK: a strategy for closing the equity gap’, Entrepreneurship and Regional Development, 4, 357–80. Mason, C.M. and R.T. Harrison (1995), ‘Closing the regional equity capital gap: the role of informal venture capital’, Small Business Economics, 7, 153–72. Mason, C.M. and R.T. Harrison (1996a), ‘Informal venture capital: a study of the investment process and postinvestment experience’, Entrepreneurship and Regional Development, 8(2), 105–26. Mason, C.M. and R.T. Harrison (1996b), ‘LINC: a decentralized approach to the promotion of informal venture capital’, in R.T. Harrison and C.M. Mason (eds), Informal Venture Capital: Evaluating the Impact of Business Introduction Services, Hertfordshire, UK: Woodhead-Faulkner Limited, pp. 119–41. Murphy, A. (2003), ‘Section 2: business angels’, Queensland Venture Capital Report 2003, Queensland Department of State Development and Innovation, pp. 49–59. Private Equity Week (1998), published by Securities Data Publishing, New York, NY, 5(23), 8 June. Reitan, B. and R. Sørheim (2000), ‘The informal venture capital market in Norway – investor characteristics, behaviour and investment preferences’, Venture Capital, 2(2), 129–41. Riding, A. and D. Short (1987), ‘Some investor and entrepreneur perspectives on the informal market for risk capital’, Journal of Small Business and Entrepreneurship, 5(2), 19–30. Sitra PreSeed Finance (2006), http://194.100.106.125/eng/FMPro?-DBnews_.fp 5&-Formatetusivu.html&view, accessed 8 March. Sohl, J. (1999), ‘The early stage equity market in the USA’, Venture Capital, 1(2), 101–20. Sohl, J. (2003), ‘The private equity market in the USA: lessons from volatility’, Venture Capital, 5(1), 29–46. Sørheim, R. and H. Landström (2001), ‘Informal investors – a categorization with policy implications’, Entrepreneurship and Regional Development, 13, 351–70. Stedler, H.R. and H.H. Peters (2003), ‘Business angels in Germany: an empirical study’, Venture Capital, 5(3), 269–76. Vækstfonden (2002), ‘Business angels in Denmark’, www.vaekstfonden.dk/download_media.asp? media_id 1442, December. Wetzel, W.E. and J. Freear (1996), ‘Promoting informal venture capital in the United States: reflections on the history of the Venture Capital Network’, in R.T. Harrison and C.M. Mason (eds), Informal Venture Capital: Evaluating the Impact of Business Introduction Services, Hertfordshire, UK: Woodhead-Faulkner Limited, pp. 61–74.

PART IV CORPORATE VENTURE CAPITAL

15 Corporate venture capital as a strategic tool for corporations Markku V.J. Maula

Introduction Corporate venture capital, that is, equity or equity-linked investments in young, privately held companies, where the investor is a financial intermediary of a non-financial corporation, has become an increasingly important phenomenon in venture capital. Although many active companies scaled down their corporate venture capital after the peak of the IT bubble in 2000, when the annual global corporate venture investments reached over 20 billion dollars or over 15 per cent of the whole venture capital market, corporate venture capital has still remained as an important tool in the corporate venturing toolbox of many major corporations (Chesbrough, 2002; Maula and Murray, 2002; Dushnitsky and Lenox, 2005a). Recently, after a few slower years following the burst of the IT bubble, many corporations have again started to set up new corporate venture capital funds, such as Intel Capital, which has established four new corporate venture capital funds targeted in China, India, the Middle East and Brazil in 2005–2006. Before the latest wave of corporate venture capital investment, research on corporate venture capital was quite limited (for some early contributions, see Fast, 1978; Rind, 1981; Hardymon et al., 1983; Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990). However, during the past few years the research on corporate venture capital has become significantly more active (for example, Maula, 2001; Hellmann, 2002; Maula and Murray, 2002; Maula et al., 2003a; 2003b; 2005; Dushnitsky, 2004; Dushnitsky and Lenox, 2005a; 2005b; Hill et al., 2005; Rosenberger et al., 2005; Schildt et al., 2005; Bassen et al., 2006; Dushnitsky and Lenox, 2006; Mathews, 2006; Maula et al., 2006b; Schildt et al., 2006; Riyanto and Schwienbacher, forthcoming). However, the body of literature on corporate venture capital is still quite fragmented and has not been systematically reviewed. It is the purpose of this chapter to summarize and synthesize the literature on corporate venture capital with a particular emphasis on research examining corporate venture capital from the corporate perspective.1 The rest of the chapter is structured as follows. After the introduction, a brief discussion of the definitions of corporate venture capital is provided. Thereafter, the research on the motives of corporations to invest in corporate venture capital is reviewed. Then, the factors influencing the decisions of corporations to invest in corporate venture are summarized. Thereafter, research examining how corporations invest in corporate venture capital is reviewed. This is followed by a review of the research on the performance of corporate venture capital. Then, the theories and methods applied in the research on corporate venture capital are reviewed. Finally, some concluding remarks are made and potential avenues for future research are discussed.

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Defining corporate venture capital Before analyzing the role of corporate venture capital as a specific tool in the corporate venturing toolbox of corporations, it is important to clarify our understanding of the domain and the terminology of corporate venturing. To sharpen the picture, an important distinction made in the earlier literature on corporate venturing is the distinction between internal corporate venturing and external corporate venturing (Ginsberg and Hay, 1994; Sharma and Chrisman, 1999; Keil, 2000; Miles and Covin, 2002). Internal corporate venturing refers to new innovations developed at various levels of the firm but within the boundaries of the firm (Burgelman and Sayles, 1986; Keil, 2000). Sharma and Chrisman (1999) defined internal corporate venturing as ‘corporate venturing activities that result in the creation of organizational entities that reside within an organizational domain’. However, corporate venture capital is clearly a boundary spanning operation and belongs to the other class of venturing tools labeled as external corporate venturing. Sharma and Chrisman (1999) defined external corporate venturing as ‘corporate venturing activities that result in the creation of semi-autonomous or autonomous organizational entities that reside outside the existing organizational domain’. Based on extensive case research of seven leading corporations in the information and communications technology sector in the United States and Europe, Keil (2000) developed a classification of external corporate venturing modes. The classification is shown in Figure 15.1 (direct corporate venture capital is in bold). In this framework, Keil (2000) first distinguished external venturing from internal venturing and thereafter grouped external venturing modes into three: corporate venture capital, venturing alliances and transformational arrangements. Corporate venture capital resembles the operations of traditional venture capital firms in referring to programs residing at various levels of corporations where investments are made in independent external companies. In the case of corporations, investments were made directly into ventures or indirectly through dedicated funds or pooled funds managed by external venture capital firms. These modes are fairly well in line with the extant literature on corporate venture capital (Bleicher and Paul, 1987; Sykes, 1990; McNally, 1997; Kann, 2000). Some additional distinctions have been made concerning the organization of direct investments. McNally (1997) proposed distinction between ‘ad hoc’ investments and a more formal fund.

Corporate venturing

Internal venturing

Corporate venture capital

Third party Dedicated Selffunds funds managed funds

External venturing

Venturing alliances

Non-equity alliances

Joint Direct Acquisitions ventures minority investments

Source: Adopted from Keil (2000)

Figure 15.1

Transformational arrangements

External corporate venturing modes

Spin-offs

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Similarly, Winters and Murfin (1988), Sykes (1990), and Mast (1991) recognized varying levels of formality in the organization of corporate venturing activities. An important point to remember from these distinctions is that the present chapter focuses on the direct investments made by corporations. This focus is highlighted in bold in Figure 15.1. To summarize, in this chapter, corporate venture capital is considered as a specific tool in the external corporate venturing tool portfolio as outlined by Keil (2000). However, it also recognizes that corporations have varying motives for making corporate venture capital investments (Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990; Alter and Buchsbaum, 2000; Kann, 2000; Keil, 2000; Maula and Murray, 2002; Dushnitsky and Lenox, 2006), and varying strategies regarding the level of hands-on involvement with the ventures in addition to financial investment (McNally, 1997; Kann, 2000; Kelley and Spinelli, 2001; Henderson and Leleux, 2002). Relationships stemming from corporate venture capital investments made for financial purposes may develop over time into relationships that may appear more like a direct minority investment (McNally, 1997; Kann, 2000; Kelley and Spinelli, 2001; Henderson and Leleux, 2002). Furthermore, there are several ways to define and map the concept of corporate venture capital. The two main alternative perspectives are viewing corporate venture capital: (1) as a mode of external corporate venturing from the perspective of the corporation (for example, Kann, 2000; Henderson and Leleux, 2002; Keil, 2002; Keil et al., 2004; Dushnitsky and Lenox, 2005a; 2005b; Schildt et al., 2005; Dushnitsky and Lenox, 2006); or (2) as an alternative source of funding from the perspective of an entrepreneurial company (for example, Gompers and Lerner, 1998; Maula, 2001; Maula and Murray, 2002; Maula et al., 2003a; 2005; 2006a; Rosenberger et al., 2005). This chapter primarily employs the former perspective, while the next chapter in this Handbook (Chapter 16) examines the entrepreneur’s perspective. Why do companies invest in corporate venture capital? In the research on corporate venture capital, one of the most active areas of research has been the stream on the goals and objectives of corporations that invest in corporate venture capital. Several studies have compared the relative importance of the various goals corporations have for their corporate venture capital operations (Siegel et al., 1988; Sykes, 1990; Silver, 1993; McNally, 1997; Bannock Consulting, 1999; Alter and Buchsbaum, 2000; Kann, 2000; Keil, 2000; Chesbrough, 2002; Dushnitsky and Lenox, 2006). However, no single goal appears to be consistently most important. Instead, corporations tend to have multiple goals and diﬀerent strategies in their corporate venture capital activities. For instance, Siegel et al. (1988) found that return on investment was the most important goal of corporations, followed by exposure to new technologies and markets. Sykes (1990) found that identifying new opportunities and developing business relationships were the most important goals for corporations investing directly. Silver (1993) found in his survey that finding acquisition targets, getting exposure to new markets, adding new products to existing distribution channels, externalizing R&D, exposing middle management to entrepreneurship, training managers, and utilizing excess plant space, time and people were the most important objectives. McNally (1997) surveyed UK corporations regarding their goals and found that identifying new markets, exposure to new technologies, financial return, identifying new products, and developing business relationships were the five most important corporate objectives for direct

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corporate venture capital. Bannock Consulting (1999) found in their survey of 150 European corporations that on average 62 per cent had strategic goals, and 27 per cent had financial goals, as their primary motivations for corporate venture capital investments, while many had several goals. In her analysis of 152 observed corporate venture capital programs, Kann (2000) classified 45 per cent of the programs as being primarily focused on external R&D, 30 per cent as investing with the goal of accelerated market entry, and 24 per cent investing in order to enhance demand for their products. Comparing the role of financial goals and various strategic goals, recent research has shown that strategic and financial objectives are not substitutes; instead both are very important motivations for corporations (Bannock Consulting, 1999; Alter and Buchsbaum, 2000; Keil, 2000). Keil (2000) concluded that, while strategic objectives are often the driver for setting up a corporate venture capital program, investments are often made using financial criteria. Financial investment goals and investments in the financially most promising companies give a window to the best companies (where there is more to learn from) and minimize conflicts of interests (Keil, 2000). Most of the research on corporate objectives has been based on rankings of long lists of potential objectives by the respondents (Siegel et al., 1988; Sykes, 1990; Silver, 1993; McNally, 1997). Besides these long lists and the distinction between strategic and financial objectives, some more fine-grained classifications of goals have also been made in the recent literature (Kann, 2000; Keil, 2000). Based on an extensive archival research of 152 corporate venture capital programs, Kann (2000) distinguished three classes of strategic objectives for corporations; external R&D, accelerated market entry, and demand enhancement. External R&D is the most ‘aggressive’ goal referring to the intent of corporations to enhance their internal R&D by acquiring resources and intellectual property from ventures. Accelerated market entry refers to corporations trying to access and develop resources and competences needed to enter a new product market. Enhancing demand refers to corporations leveraging their strong resource base and stimulating new demand for their technologies and products by sponsoring companies that use and apply those technologies and products. Finally, Keil (2000; 2002) identified four primary strategic objectives; monitoring of markets, learning of markets and new technologies, option building, and market enactment. Monitoring of markets refers to a warning system or antenna for gathering weak signals on the future developments of the markets. Learning new markets and technologies refers to learning from the relationships with ventures and requires more collaboration with them. Options to expand refers to placing bets to be ready if certain markets prove important and valuable. Market enactment refers to a more proactive approach where corporate venture capital investments are used to shape markets, set standards and stimulate demand. In the following, the literature on corporate venture capital goals is summarized and a summary classification is illustrated in Table 15.1. In this classification, the first distinction is between strategic and financial goals. Financial goals of corporate venture capitalists have been reported in several studies; the term refers to gaining financial gains from investments (Siegel et al., 1988; Silver, 1993; McNally, 1997; McKinsey & Co., 1998; Bannock Consulting, 1999; Alter and Buchsbaum, 2000; Keil, 2000). However, there are a wide variety of strategic goals reported in the extant literature. In this classification, strategic goals are divided into three main categories; learning, option building and leveraging. All these main categories have subcategories, which are discussed below.

Corporate venture capital as a strategic tool Table 15.1

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Potential benefits for corporations from corporate venture capital

Objectives Financial objectives Financial gains

Strategic objectives Learning Market-level learning

Venture-specific learning Indirect learning

Examples • (Siegel et al., 1988; Silver, 1993; McNally, 1997; McKinsey & Co., • 1998; Bannock Consulting, 1999; Alter and Buchsbaum, 2000; • Keil, 2000)

• • • • • • • • • • • •

Radar-like identification of, monitoring of, and exposure to new technologies, markets, and business models (Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; McNally, 1997; Keil, 2000; Maula et al., 2003b) External R&D (Sykes, 1990; Silver, 1993; McNally, 1997; McKinsey & Co., 1998; Kann, 2000), Improving manufacturing processes (Siegel et al., 1988; McNally, 1997) Change corporate culture (Sykes, 1990; McNally, 1997) Train junior management (Silver, 1993) Learn about venture capital (Sykes, 1990; McNally, 1997) Improve internal venturing (Winters and Murfin, 1988; Keil, 2000) Complementary contacts (Winters and Murfin, 1988)

Option building Options to acquire • Identify and assess potential acquisition targets (Siegel et al., 1988; companies • Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; McNally, 1997; • Alter and Buchsbaum, 2000; Maula and Murray, 2000; Benson and • Ziedonis, 2004) Options to enter • Accelerated market entry (Kann, 2000) new markets • Option to expand (Sykes, 1986; Chesbrough, 2000; Keil, 2000) Leveraging Leveraging own technologies and platforms

Leveraging own complementary resources

• • • • • • • • • • •

Increase demand for technology and products (Kann, 2000; Keil, 2000; Chesbrough, 2002; Gawer and Cusumano, 2002; Riyanto and Schwienbacher, forthcoming) Shape markets (Kann, 2000; Keil, 2000; Maula et al., 2006b) Steer standard development (Kann, 2000; Keil, 2000) Support development of new applications for products (McKinsey & Co., 1998) Add new products to existing distribution channels (Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; Alter and Buchsbaum, 2000) Utilize excess plant space, time, and people (Silver, 1993)

Learning motives Learning can take place in corporate venture capital investments in many ways (Keil et al., 2004). Three categories of learning benefits in this classification are market-level learning, venture-specific learning and indirect learning. Market-level learning refers to learning from constantly monitoring the new ventures and therefore being exposed to developments of markets, technologies and business

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models (Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; McNally, 1997; Keil, 2000; Keil et al., 2003; Maula et al., 2003b; Keil et al., 2004; Schildt et al., 2005; Schildt et al., 2006). Some corporations use their corporate venture function to support their strategy process (Keil, 2000). Weak signals can be derived from deal flow, without having to invest in every opportunity in order to learn (Keil, 2000; Maula et al., 2003b). This allows investments in the financially most attractive companies while still delivering strategic benefits (Keil, 2000). Venture-specific learning refers to learning from the relationships with portfolio companies. Some corporations use corporate venture capital as a form of external R&D to develop their knowledge base, competencies, technologies, products and processes (Siegel et al., 1988; Sykes, 1990; Silver, 1993; McNally, 1997; McKinsey & Co., 1998; Kann, 2000; Dushnitsky and Lenox, 2005a; 2005b). Realizing this type of benefit often requires closer collaboration and frequent communication with portfolio companies (Sykes, 1990; Kann, 2000; Keil, 2000). Most investments with the goal of venture-specific learning and external R&D are made in ventures operating in the same or related industries (Kann, 2000). Indirect learning refers to learning from the corporate venture capital process. Corporate venture capital has been used to change corporate culture (Sykes, 1990; McNally, 1997), train junior management (Silver, 1993), learn about venture capital (Sykes, 1990; McNally, 1997), support the development of internal venturing processes (Winters and Murfin, 1988; Keil, 2000), and to provide contacts with related actors like investment banks, scientists and venture capitalists (Winters and Murfin, 1988). Option building motives There are two categories of option building; options to acquire companies and options to diversify to new markets. These are explained in the following. Options to acquire companies refers to corporate venture capital investments made as options to acquire the portfolio company later if it proves strategically valuable. Identification and assessment of potential acquisition targets has been reported as a goal of corporations in several studies (Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; McNally, 1997; Alter and Buchsbaum, 2000). However, many studies have also argued that this goal does not work well because of the inherent conflicts of interest with entrepreneurs and other, financially oriented, investors (Winters and Murfin, 1988; Sykes, 1990; Keil, 2000; Maula and Murray, 2000). Maula and Murray (2000) found that only a very small share of acquired corporate venture capital-backed companies had been acquired by one of the corporate venture capital investors. Most of the acquisitions had been made by outsider companies. Similarly, Intel Capital had acquired only two companies from the 450 companies in their portfolio by 2000 (Christopher, 2000). It has been suggested that a more successful way to view corporate venture capital as a supportive tool for acquisitions is to refer potential acquisition targets identified in the deal flow to the M&A department or business units of the parent corporation (Maula and Murray, 2000). Options to enter new markets refers to another form of options to enter new businesses. Besides building options to acquire portfolio companies, corporations can also prepare for entering new markets and use corporate venture capital investments as probes (Brown and Eisenhardt, 1997; Eisenhardt and Brown, 1998) to learn the necessary skills and ensure right timing (Kann, 2000; Keil, 2000). Investments made with the goal of facilitating potential entry to new markets are made in ventures operating in industry sectors diﬀerent

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from those in which the corporation currently operates (Kann, 2000). Extant literature demonstrates that corporations use pre-entry alliances with new firms to prepare for entering new markets (Mitchell and Singh, 1992). Similarly, corporations use corporate venture capital to hedge their bets and to ensure that they have some stakes in emerging technological platforms, in order to be prepared when the dominant design emerges (Keil, 2000). Resource leveraging motives There are two categories of leveraging; leveraging own technologies and platforms and leveraging own complementary resources. These categories are explained in the following. Leveraging own technologies and platforms refers to corporations using corporate venture capital to stimulate demand for their technologies and products by sponsoring companies using and applying them (McKinsey & Co., 1998; Kann, 2000; Keil, 2000; Maula et al., 2006b). Corporations can also use corporate venture capital to shape markets proactively, and steer and promote the development of de facto standards around their technologies, by supporting favorable companies through corporate venture capital (Kann, 2000; Keil, 2000). As an example of proactive shaping of the industry, Intel, who has been highly dependent on the development of Microsoft operating systems in their own development, recognized the emergence of Linux as an alternative and made very early phase corporate venture capital investments in the most promising Linux operating system supplier, Red Hat Linux in 1998 (Young and Rohm, 1999). Thereafter, Intel invested in many other Linux companies together with other companies, such as IBM, Compaq, Dell, Oracle and Novell, who also wanted to reduce their dependence on Microsoft operating systems. These investments have been critically important in making the Linux a more credible alternative in the corporate world (Young and Rohm, 1999). Leveraging own complementary resources refers to corporations leveraging their complementary assets such as distribution channels and production facilities. Companies have been reported to use corporate venture capital to add new products to existing distribution channels (Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; Alter and Buchsbaum, 2000) and find use for excess plant space, time and people (Silver, 1993). Technology-based ventures are acknowledged to be better at adopting and commercializing new technology than large corporations, meaning that they are superior in pursuing the highly focused rapid paced development of new product opportunities after the research phase is complete. This process often leads to opportunities for the corporate investor to acquire licenses for state-of-the-art technologies (Winters and Murfin, 1988). Furthermore, technology-based new ventures have often limited distribution networks, at least when compared to any multinational corporation acting as a corporate venture capital investor. Even if the start-up would not like to license the technology, there is an opportunity for marketing agreements, especially in areas that the start-up could not otherwise access. This is especially important when the start-up operates in a small home market and has a foreign or global corporation as an investor. Taken together, these studies show that the goals of corporations engaging in corporate venture capital has been one of the most actively researched areas of corporate venture capital. The research clearly highlights that companies typically have multiple goals when engaging in corporate venture capital. While financial goals often play some part in motivating corporate venture capital programs, in order to be sustainable, corporate venture capital activity should have a strategic role for the parent corporation. While many goals

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have been recognized, there is still quite limited understanding on the circumstances under which diﬀerent goals can create value for corporation as well as the proper design of eﬀective corporate venture capital programs depending on the goals and other circumstances. When do companies invest in corporate venture capital? Cyclical history of corporate venture capital When examining the history of corporate venture capital, three diﬀerent ‘waves’ of corporate venture capital activity have been identified (Gompers and Lerner, 1998; Maula and Murray, 2002; Dushnitsky and Lenox, 2006). First, in the late 1960s, corporations engaged in corporate venture capital in order to gain a ‘window on technology’. More than 25 per cent of the Fortune 500 corporations were engaged in corporate venture capital activities in the late 1960s and early 1970s (Gompers and Lerner, 1998). Following the collapse in the market for initial public oﬀerings in 1973, the returns on venture capital rapidly declined and most of the corporate venture capital programs were soon dissolved. The second wave in corporate venture capital took place in the 1980s, when it was used as a diversification tool. This wave peaked in 1986 when 12 per cent of the total venture capital investments were managed by corporate venture capital programs (Gompers and Lerner, 1998). However, not a great number of the corporate venture capital programs were successful and most of them were again quickly dissolved after the stock market crash at the end of the 1980s. Finally, during the latter half of the 1990s, corporate venture capital emerged again, this time in a much larger scale than ever before, both in absolute terms, and in relative terms compared to traditional venture capital. Direct venture capital investments made by the subsidiaries and aﬃliates of industrial corporations more than doubled during each of the last six years of the decade. However, after the peak in 2000, the economic slowdown resulted in a rapid decrease in the volume of corporate investments in the beginning of 2001. Since then, the number of active firms and the amount of annual investments have stabilized on a level that still exceeds the levels before 1999. For many major corporations corporate venture capital has been a strategic instrument and the activity has been sustained independent of the financial cycles. The development of corporate venture capital is depicted in Figure 15.2. Industry and firm level drivers of corporate venture capital investment Although aggregate statistics highlight the overall cyclicality and the impact of economic climate on corporate venture capital investment, from a corporate perspective it is important to understand the firm and industry level circumstances that influence the usefulness and eﬀectiveness of corporate venture capital. Although there are not many studies examining the determinants of corporate venture capital investments, there are a few recent studies that have examined this issue (for example, Chesbrough and Tucci, 2004; Dushnitsky and Lenox, 2005a; Basu et al., 2006; Gaba and Meyer, 2006; Li and Mahoney, 2006). Some of the findings of this stream of research are summarized in Table 15.2. In their recent study, Dushnitsky and Lenox (2005a) examined the firm and industry level drivers of corporate venture capital investments. At the industry level, it has been found that weak intellectual property protection, high technological ferment and high importance of complementary distribution capability are positively related to the level of corporate

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Annual volume of investments by CVC investors in U.S. portfolio companies Annual number of active CVC investors Source: Based on Venture Economics data, May 2006

Figure 15.2 Annual volume of corporate venture capital investments and number of corporate venture capital investors in 1980–2005 Table 15.2

The determinants of corporate venture capital investments

Level

Factor

Examples

Industry

Industry IPR regime

Weak intellectual property protection (Dushnitsky and Lenox, 2005a) Importance of complementary distribution capability (Dushnitsky and Lenox, 2005a) Systemic nature of innovations (Maula et al., 2006b) High technological ferment (Dushnitsky and Lenox, 2005a)

Industry capability needs and types of innovations Industry dynamics Firm

Firm free cash flow Firm absorptive capacity

Firm size

Firm’s free cash flow (Dushnitsky and Lenox, 2005a) Firm’s absorptive capacity measured as Internal R&D (Chesbrough and Tucci, 2004; Dushnitsky and Lenox, 2005a) or patent stock (Dushnitsky and Lenox, 2005a) Firm size (Dushnitsky and Lenox, 2005a)

venture capital investments (Dushnitsky and Lenox, 2005a). Similarly, Maula et al. (2006b) argue that the systemic nature of innovations in an industry increases the usefulness of corporate venture capital. At the firm level, it has been found that firms’ cashflow and absorptive capacity are positively related to the level of corporate venture capital investments (Dushnitsky and Lenox, 2005a). At the firm level, several studies suggest that corporate venture capital investments will be actively used by companies who are in a position to drive a market ecosystem (Chesbrough, 2002; Gawer and Cusumano, 2002; Maula et al., 2006b). Taken together, research on explaining the development of corporate venture capital investments has evolved from focusing on the cyclicality of corporate venture capital investments over time to developing increasingly sophisticated theory-based explanations

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of under what circumstances corporations invest in corporate venture capital. The industry and firm level determinants of corporate venture capital investments have started to receive increasing attention in the evolving literature. Quite recently this area has become an active area of research with several theory-based analyses on the drivers of corporate venture capital investments employing robust longitudinal research designs. However, despite the recent new theory-based studies on the determinants of corporate venture capital investments and adoption of corporate venture capital programs (for example, Basu et al., 2006; Gaba and Meyer, 2006; Li and Mahoney, 2006), the research on when and why corporations invest in corporate venture capital is far from saturated. Limitations in current empirical data and methods as well as various competing explanations suggest that more research is still needed to develop a full understanding of the drivers a corporate venture capital programs and investments. How do companies invest in corporate venture capital? From the corporate perspective, corporate venture capital is one important tool in the corporate venturing toolbox used to develop new business (Roberts, 1980; Rind, 1981; Roberts and Berry, 1985; Venkataraman and MacMillan, 1997; Keil, 2002; Maula et al., 2006b). Other tools in this ‘toolbox’ include activities like internal corporate ventures, acquisitions, joint ventures, alliances, research collaboration, and spin-oﬀs as outlined earlier in Figure 15.1. As shown in the same figure, there are several ways in which corporations can engage in corporate venture capital. Many companies start by making arm’s-length investments in independent funds to learn the venture capital game; move on to co-investments with their venture capital partners; and once they have suﬃcient experience, establish their own corporate venture capital fund. At each stage, the strategic and financial upside potential increases. Finally, some corporate investors like Intel Capital and Nokia Venture Partners have established new funds co-financed with external partners. These independent investors give the fund financial autonomy, which helps insulate the corporate venture capital program from abrupt changes in the parent company’s fortunes. They also make the corporate venture capital operation more sustainable by providing strategic benefits at lower cost. Importantly, this structure allows the corporate venture capital operation to oﬀer competitive compensation schemes to help retain a successful investment team. In corporate venture capital programs, there are also a number of design parameters that corporations can adjust depending on the objectives of the program (Birkinshaw et al., 2002; Keil et al., 2004). In a recent conceptual paper, Keil et al. (2004) presented a model of organizational learning in corporate venture capital. Adopting a program-level perspective and applying the organizational learning theory, their paper suggests that corporate venture capital investments can result in both explorative and exploitative learning. The relationship between corporate venture capital and organizational learning is moderated by the investment portfolio and the organization of the corporate venture capital program. Concerning the corporate venture capital program portfolio, the paper highlights the moderating roles of relatedness, dispersion, and the development stage of the ventures. Concerning the program, the paper highlights the roles of structural autonomy, knowledge integration and absorptive capacity. In terms of empirical research, the organizational design of corporate venture capital programs has received relatively little attention, which is probably due to the diﬃculty of

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getting information concerning the organization of the programs. Most of our knowledge of corporate venture capital has been based on anecdotes and industry reports such as the report by Corporate Executive Board (2000) which provides very interesting examples on how companies such as Intel, Novell, Motorola, HP and United Parcel Service have organized some aspects of their corporate venture capital programs. For example, Intel included investment professionals in strategy development of business units to help them identify strategic investment targets; Novell aligned investments and strategy by requiring the venture group to collaborate with senior managers; UPS required board observation rights for senior business unit managers; Motorola improved knowledge transfer by employing a knowledge transfer team with the responsibility of transferring knowledge between portfolio companies and parent firm; and HP tracked investments against strategic objectives to make informed portfolio-management decisions. However, there is relatively little empirical research that explains why corporations organize their corporate venture capital activities in a certain manner and what the performance implications of the organization are. In particular, there is very little quantitative research on the way corporations organize their corporate venture capital activities. The survey of 95 corporate venturing programs (both corporate venture capital and other types of venturing programs) by Birkinshaw et al. (2002) is one of the rare exceptions. The report provides a wealth of descriptive statistics of the organization of diﬀerent types of program showing for instance that most of the employees and the funding of the programs tend to come from the parent corporation, deal flow comes quite evenly from inside and from collaborating venture capital, and that most common compensation is still straight salary although many programs also have other types of incentives including carried interest. Similarly, EVCA (European Private Equity and Venture Capital Association) (EVCA, 2001) has surveyed European corporate venture capital investors and has reported various descriptive statistics showing that more than one third of their deals were syndicated, three quarters of the corporate venture capital programs were organized as a subsidiary, the average corporate venture capital unit consists of 7 employees responsible for about a €50 million portfolio, and that interest in using carried interest as a compensation method was increasing, with more than a third of the corporate venture capital programs already using it. Another recent empirical study examining the structure of corporate venture capital programs is the case study by Henderson and Leleux (2002) in which they carry out an in-depth analysis of six corporate venture capital programs highlighting the arrangements concerning research transfers between ventures and parent organizations of the corporate venture capital program. In addition to design characteristics, some scholars have recently started to examine the required capabilities and their development. Based on two longitudinal case studies of large corporations operating in the information and communication technology sector in Europe, Keil (2004) developed a model emphasizing the learning processes that enable firms to build up an external corporate venturing capability, by utilizing learning strategies both within and outside venturing relationships. To build this new capability, firms engage in acquisitive learning, and the capability is deepened by adapting all knowledge to the firm-specific context through experiential learning mechanisms. Keil also highlights the importance of initial conditions and knowledge management practices influencing the direction and eﬀectiveness of learning processes that lead to an external corporate venturing capability.

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Demonstrating some of the tensions related to the design of corporate venture capital programs, Dushnitsky (2004) showed that some design choices such as tight integration to the parent firm that would aid the corporation in assessing and benefiting from corporate venture capital activity inhibit an investment relationship with many such ventures that would be most relevant from the learning point as a result of self selection by entrepreneurs. Taken together, despite the acknowledged diﬃculties of organizing a performing and sustainable corporate venture capital program, there are perhaps surprisingly few published articles on how corporations actually implement corporate venture capital programs. There is still quite a limited literature on the actual choices companies make and the design and management of corporate venture capital programs. Most of the existing knowledge is based on anecdotes and examples. However, theory-based and/or representative quantitative research is largely missing, perhaps given the obvious large diﬃculties in accessing such rich internal company data that would be needed for studies analyzing the organization of corporate venture capital programs, the determinants of the ways these programs are organized, and the performance of the organizational choices. Therefore, the organization and management of corporate venture capital is clearly an area of research that has still a lot of room to expand. How has corporate venture capital performed? One of the most discussed areas of corporate venture capital is the performance of corporate venture capital activities. Following increased interest and mixed perceptions, diﬀerent dimensions of performance have received increased attention in research during the past few years. In the following two subsections the studies examining performance and the determinants of performance are reviewed. Performance of corporate venture capital The performance of corporate venture capital and its determinants have become important research topics in corporate venture capital during recent years (Gompers and Lerner, 1998; Maula and Murray, 2002; Dushnitsky and Lenox, 2005b; Dushnitsky and Lenox, 2006; Wadhwa and Kotha, 2006). In contrast to earlier dominant perception of corporate venture capital being ‘dumb money’ and leading to poor results, most of the newer academic studies have analyzed the outcomes of corporate venture capital and venture capital-backed companies and found that corporate venture capital investments had a higher likelihood of initial public oﬀerings and higher IPO market valuations when controlling for various other factors (Gompers and Lerner, 1998; Maula and Murray, 2002). These studies are summarized in Table 15.3. Dushnitsky and Lenox (2005b) analyzed a large panel of public firms over a 20-year period and found that increases in corporate venture capital investments are associated with subsequent increases in firm patenting. They also found that these programs are especially eﬀective in weak intellectual property regimes and when the firm has suﬃcient absorptive capacity. In another paper Dushnitsky and Lenox (2006) examined the value creation by corporations from corporate venture capital programs by examining the impact of corporate venture capital on Tobin’s q (market value of a firm divided by total assets). Using a panel of corporate venture capital investments they found evidence that corporate venture capital investment will create greater firm value

Corporate venture capital as a strategic tool Table 15.3

383

Performance of corporate venture capital programs

Study

Sample

Finding

Gompers and Lerner (1998)

32364 venture capital and corporate venture capital investments in the United States A panel of 110 largest US ICT companies 1990–2000 A panel of 110 largest US ICT companies 1990–2000 A panel of 36 corporations between 1989–1999 in the telecommunications equipment industry A panel of US public firms during the period 1969–1999 A panel of US public firms during the period 1969–1999 A panel of 110 largest US ICT companies 1990–2000

Higher share of IPOs in corporate venture capital investments than in traditional VC

Maula et al. (2003b) Keil et al. (2003) Wadhwa and Kotha (2006)

Dushnitsky and Lenox (2006) Dushnitsky and Lenox (2005b) Schildt et al. (2005)

Positive impact on recognizing technological discontinuities Positive impact on patenting An inverted U-shaped relationship between CVC investments and patenting Positive impact on Tobin’s q from the founding of a CVC program Positive impact on patenting Positive impact on explorative learning from target companies

when firms explicitly pursue corporate venture capital to harness novel technology compared to other goals. Maula et al. (2003b) examined the impact of corporate venture capital on recognizing technological discontinuities early. Based on a longitudinal study of information and communications technology firms, established companies’ position in venture capital networks is related to the early recognition of technological discontinuities. Incumbents’ absorptive capacity moderates this relationship. In another study, Keil et al. (2003) investigated the impact of diﬀerent governance modes for external corporate ventures and venture relatedness on innovative performance of the firm. Building on studies that have suggested that external corporate ventures enhance the innovative performance of the firm, the paper argued that governance modes and venture relatedness interact in their eﬀect on innovative performance. In their empirical analysis of a panel of the largest firms in the information and communication technology sector during 1990–2000, they found that corporate venture capital investments had a positive impact on patenting and that the impact was moderated by the relatedness of the ventures. Finally, Schildt et al. (2005) examined the antecedents of explorative and exploitative learning of technological knowledge from external corporate ventures. They compared diﬀerent forms of external corporate venturing, namely corporate venture capital investments, alliances, joint ventures, and acquisitions, as alternative avenues for interorganizational learning, and tested the eﬀects of multiple relational characteristics on the type of learning outcomes using citations in patents filed by a sample of 110 largest US public information and communications technology companies during the years 1992–2000. They found that corporate venturing mode and technological relatedness have significant eﬀects on the likelihood of explorative learning.

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Taken together, the studies on the performance of corporate venture capital have shown primarily positive eﬀects although it has been shown that there may be diminishing returns to corporate venture capital (Wadhwa and Kotha, 2006). However, further research on the longer time horizons is warranted. Furthermore, the research contrasting the costs and benefits of corporate venture capital under diﬀerent circumstances is still quite limited. Overall, the measurement of performance measurement of corporate venture capital is quite challenging. The majority of the performance studies have inferred the eﬀects from quantitative analyses of diﬀerent dimensions of corporate performance controlling for other performance determinants. However, future research could also attempt to develop more direct measures of performance for corporate venture capital (see Allen and Hevert, 2006, and Bassen et al., 2006, as two recent examples). Performance determinants in corporate venture capital The research on corporate venture capital has increasingly examined the determinants of the performance of corporate venture capital programs. A brief summary of the research is provided in Table 15.4. In one of the earliest widely cited studies on corporate venture capital, Siegel et al. (1988) received survey responses from 52 corporate venture capitalists and, based on their analyses, concluded that performance is influenced by the autonomy of the program, skills (that is venture capital expertise/background of employees), compensation and incentives, primary focus on financial returns so that potential strategic goals do not interfere with the investment activity. In another survey, Sykes (1990) received responses from 31 corporate venture capital programs and found that the choice of primary strategic objective, type and Table 15.4

Determinants of performance in corporate venture capital investments

Determinant

Examples

Long term focus Suﬃcient autonomy

(Ernst et al., 2005) (Siegel et al., 1988; Birkinshaw and Hill, 2005; Hill et al., 2005) (Maula et al., 2003b; Dushnitsky and Lenox, 2005b) (Maula et al., 2003b; Birkinshaw and Hill, 2005; Hill et al., 2005) (Block and Ornati, 1987; Siegel et al., 1988; Birkinshaw and Hill, 2005) (Sykes, 1990; Dushnitsky and Lenox, 2006)

Suﬃcient absorptive capacity Strong ties to venture capital community Appropriate compensation systems Strategic objectives that enable aligned objectives with portfolio companies Active involvement and frequent communications with portfolio companies Team members with venture capitalist background Relatedness of portfolio companies

Industry sectors with weak IP regime

(Sykes, 1990; Henderson and Leleux, 2002; Wadhwa and Kotha, 2006) (Siegel et al., 1988; Birkinshaw and Hill, 2005) Positive relationship: (Gompers and Lerner, 1998) Inverted-U-shaped relationship: (Keil et al., 2003; Keil et al., 2004; Hill et al., 2005) (Dushnitsky and Lenox, 2005b)

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frequency of communications with the ventures or limited partners, return on portfolio investment, and the mode of investment (direct investments or indirect investments via independent venture capital fund) influenced the performance of the programs. In a stream of newer studies employing longitudinal analyses employing corporate venture capital investment data and patent data, Keil et al. (2003) analyzed the impact of diﬀerent types of external corporate venturing activities on the patenting rates of firms. In their longitudinal analysis of the 110 largest companies in four information and communications sectors, they found that corporate venture capital has a positive eﬀect and that the relatedness of the corporate investor and the portfolio company had an inverted U-shaped relationship. Dushnitsky and Lenox (2005b) tested the impact of corporate venture capital on patenting and found that weak IP regime in the industry as well as high absorptive capacity increased returns to corporate venture capital investment. Finally, Wadhwa and Kotha (2006) analyzed the impact of corporate venture capital on patenting. In their analysis of 36 telecommunications equipment companies over time, they found that the number of corporate venture capital investments had an inverted U-shaped relationship with patenting. They also found that this relationship was moderated positively by corporate involvement with portfolio companies (board seats and alliances with corporate venture capital portfolio companies). Based on a recent global survey of corporate venture capital investors, Birkinshaw and Hill (2005) analyzed 95 corporate venturing programs including a large number of corporate venture capital programs and found that three key success factors hold across multiple sub-types of corporate venture units: giving venture units substantial autonomy, creating strong ties to the venture capital community, and structuring appropriate compensation systems. In another paper Hill et al. (2005) analyzed separately the drivers of strategic and financial performance of the corporate venture capital programs in the sample and found that financial performance had an inverted U-shaped relationship with the relatedness of the ventures and positive relationship with vertical autonomy (that is autonomous structural position). Strategic performance similarly had an inverted U-shaped relationship with relatedness. In addition, strategic performance was positively related to communications with venture capital community, negatively related to vertical autonomy and positively with horizontal autonomy (that is how extensively other business units within the parent company were involved in corporate venture capital unit decision-making). The authors concluded that the financial and strategic outcomes of corporate venture capital programs need to be understood in terms of distinctive sets of investment and organizational antecedents. Finally, in a recent German study, Ernst et al. (2005) analyzed 21 corporate venture capital programs in Germany and came to the conclusion that a short-term focus on financial objectives of these corporate venture capital programs prohibits the achievement of long-term strategic benefits from external innovation. Taken together, studies on the performance determinants of corporate venture capital have relatively strong convergence concerning the importance of certain design characteristics on the performance of corporate venture capital programs. For instance, most of the studies have raised strategic relatedness or complementarity of the portfolio companies, close interaction with the ventures and/or venture capital community as well as a suﬃcient autonomy of the corporate venture capital operation as success factors. However, there are many other factors that only some studies have included and found significant. Overall, there is still lack of convergence in the understanding of the circumstances under which

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corporate venture capital can provide financial or strategic benefits. In addition to further testing of suggested determinants, there are further challenges that should be taken into account when trying to improve the understanding of performance determinants. First, it is important to take into account the potential contingencies that influence the optimal organizational configurations. Depending on the goals and organizational and environmental circumstances, the optimal organizational structure and management of corporate venture capital programs is likely to diﬀer between companies and even within companies over time. Furthermore, when examining the performance implications of strategic choices, the endogeneity of the choices should be accounted for (Hamilton and Nickerson, 2003). Finally, while some studies find determinants that improve performance, the studies should also take into account the costs and risks associated with the strategic or operational choices to give a balanced picture of the eﬀects of the choices. Given all these challenges, the analysis of performance determinants of corporate venture capital programs continues to be an important and developing research stream. Theoretical perspectives applied in research on corporate venture capital Until recent years, the limited research on corporate venture capital was primarily descriptive. However, following the most recent wave of corporate venture capital activity, the research on corporate venture capital has both increased in volume and has become more deeply rooted in various theoretical perspectives. The theoretical perspectives that have so far been applied in research on corporate venture capital have been summarized in Table 15.5. Analysis of the literature suggests that so far diﬀerent strands of learning theories have been the most commonly applied perspectives in the analysis of corporate venture capital from a corporate perspective. This is well in line with learning being the most common strategic goal for corporations in corporate venture capital. In terms of learning literature, interorganizational learning and particularly absorptive capacity (Cohen and Levinthal, 1990) are commonly invoked concepts. Recently the dynamic capabilities view has also received attention in the analysis of corporate venture capital. Another theoretical base that has been used, but significantly less often, is the theories of economics of information including adverse selection, moral hazard and signaling. In Table 15.5

Theoretical perspectives applied in research on corporate venture capital

Theoretical base

Examples

Learning theories

(Keil et al., 2003; Keil et al., 2004; Schildt et al., 2005; Gaba and Meyer, 2006; Wadhwa and Kotha, 2006) (Maula et al., 2003b; Keil et al., 2004; Dushnitsky and Lenox, 2005b; Lim and Lee, 2006; Schildt et al., 2006) (Keil, 2004) (Dushnitsky, 2004)

Absorptive capacity Dynamic capabilities Economics of information (adverse selection, moral hazard, signaling) Network theories Real options Institutional theory

(Maula et al., 2003b) (Basu et al., 2006; Li and Mahoney, 2006) (Gaba and Meyer, 2006)

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addition, network theories have so far received very little attention. The same is also the case with real options as well as with institutional theory. Taken together, it appears that the literature on corporate venture capital is still very young and underdeveloped when it comes to its theoretical underpinnings. Following the development path common in many other areas of management research, the early literature was primarily descriptive. Only recently has the research on corporate venture capital become more connected to theoretical literature. Although it appears that most of the major theoretical lenses of management theory have been recently applied at least once in research of corporate venture capital, there is clearly more work to do in rooting the understanding of corporate venture capital better in management theory. Research designs and methods applied in research on corporate venture capital As with research on many other phenomena, early research on corporate venture capital was largely descriptive, attempting to chart what kind of companies engage in corporate venture capital and how they do it. The research methods were typically surveys or case studies. The research settings were frequently cross-sectional. As the field has started to mature during recent years, the research settings have more frequently become longitudinal, allowing for a better control for unobserved heterogeneity and measurement of change over time (for example, Dushnitsky and Lenox, 2005a; 2005b; Keil et al., 2005; Schildt et al., 2005; Dushnitsky and Lenox, 2006; Schildt et al., 2006; Wadhwa and Kotha, 2006). Improved data availability has allowed large scale panel datasets combined with other databases. In the future, it can be expected that research designs will become increasingly longitudinal. Controls for the endogeneity of investment decisions are likely to become increasingly standard features of quantitative research designs. The realization of the fact that one size does not fit all means that future research will increasingly focus on contextual determinants that influence the design of programs and their eﬀects on the performance (see for example, Keil et al., 2004; Wadhwa and Kotha, 2006). Although most of corporate venture capital research focused on US companies, some recent studies have also examined it in other regions, for example, Germany (Weber and Weber, 2005; Reichardt and Weber, 2006), Korea (Lim and Lee, 2006) or taking a more global perspective (Birkinshaw et al., 2002). Although longitudinal quantitative research designs are going to have an important role in theory testing, it is also expected that in-depth qualitative research can deepen our understanding of the choices and solutions in the design and management of corporate venture capital programs (see for example, Keil, 2002; 2004). As noted above in sections reviewing literature on diﬀerent facets of the corporate venture capital phenomenon, there are many areas where we still have very limited knowledge of the practices of corporations and the determinants of those practices. Furthermore, the limitations in the available large scale datasets will continue to provide many research opportunities for those researchers who gather in-depth primary data from corporations active in corporate venture capital. Conclusions and avenues for future research Although corporate venture capital has a cyclical history with mixed success in companies, corporate venture capital remains an important tool in the corporate venturing toolbox of corporations. While some corporations have engaged in corporate venture

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capital opportunistically following good returns from the venture capital markets during boom periods, many other corporations have taken a much more strategic approach and use corporate venture capital as an important tool to support their strategy independent of fluctuations in financial markets. However, as research has shown, there is often a long and sometimes costly learning curve to climb before becoming a successful private equity investor. While there are strategies that may be more eﬀective for certain corporations than others, even they may not necessarily be feasible from day one. However, the research and practices of corporate venture capital have become increasingly sophisticated, and many corporations have learned how to use corporate venture capital properly as a tool to support the corporate strategy and innovation while also gaining financial returns. When assessing the existing body of literature on corporate venture capital, it appears that there is a relatively convergent stream of literature answering why corporations invest in corporate venture capital. Corporations often have multiple goals for corporate venture capital, but most often it is more for strategic than financial reasons that corporations engage in corporate venture capital. The research on when corporations engage in corporate venture capital is newer, but it has started to develop and test multiple determinants on industry and firm levels based on several theoretical lenses including learning theories, institutional theory and real options. The research on how corporate venture capital should and has been organized is still relatively underdeveloped, and provides currently primarily descriptive insights and examples. Research on how corporate venture capital has performed has developed rapidly and has become increasingly sophisticated. This stream of literature has found corporate venture capital to have positive eﬀects on several tested performance measures including patenting and firm value creation. Also the research on the performance determinants of corporate venture capital has produced several commonly agreed performance determinants, but there are also many areas where future research is needed. Theoretical understanding of corporate venture capital has developed significantly and the studies have developed from descriptive analyses to testing the applicability of broader theoretical frameworks from economics, sociology and management theory as well as to develop specific theory on corporate venture capital, or even to contribute to the development of broader management theories based on insights made in the analysis of corporate venture capital. Similarly, methodologically the literature on corporate venture capital has evolved like many streams of research that focus on a certain phenomenon. From the early pioneering that qualitatively describes the phenomenon, the research has subsequently advanced through wider cross-sectional surveys and in-depth case studies to increasingly longitudinal research settings frequently testing alternative theoretical explanations employing large panel datasets. While recently activated research on corporate venture capital has answered many previously puzzling questions, there remain many avenues for future research that can help companies use corporate venture capital more successfully to create value in collaboration with entrepreneurs and the venture capital community. Some of the areas for future research on corporate venture capital include the analysis of benefits over costs under diﬀerent circumstances including various firm and industry level determinants and diﬀerent corporate venture capital strategies. Overall, prior research suggests that there are many alternative models of corporate venture capital that

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can be feasible, but the research on the circumstances under which each model is optimal is still underdeveloped. Furthermore, the performance measurement is in general an area that requires additional research. There is still relatively little research examining the impact of corporate venture capital on the performance of corporations. Even more so, the cost side, including the indirect costs from leveraging corporate resources, has been largely neglected. Furthermore, the long run eﬀects of corporate venture capital for the performance of corporations are still an under-researched area. Another area of development is how corporations manage and should manage their corporate venture capital operations including investment processes, the use of corporate resources to facilitate corporate venture capital activity, knowledge integration from corporate venture capital investments, as well as internal performance measurement. There are many tensions concerning various choices inherent in corporate venture capital. For instance, if a corporation wants to learn from corporate venture capital, how should it arrange the activity to get to see the most interesting deals (Dushnitsky, 2004)? While there is already some theoretical research examining the organizational choices related to diﬀerent learning goals (Keil et al., 2004), there is a need to understand more broadly how corporate venture capital should be organized depending on diﬀerent goals and circumstances. Furthermore, empirical research in this area is still nearly non-existent. Also the role of corporate venture capital in the broader toolbox of corporations and the pros and cons of diﬀerent external venturing modes and their interactions are still relatively unexplored areas of research (Dushnitsky and Lavie, 2006; Keil, 2002; Keil et al., 2003; Schildt et al., 2005). Overall, although the research on corporate venture capital, both from corporate and entrepreneurs’ perspectives, has developed rapidly during the past few years, there are still many important areas warranting further research. I believe that corporate venture capital continues to be an interesting research area given the economic importance for many major corporations as well as the complexities and practical challenges in managing it successfully. Note 1. For another parallel review of literature on corporate venture capital, see Dushnitsky (2006).

References Allen, S.A. and K.T. Hevert (2007), ‘Venture capital investing by information technology companies: Did it pay?’, Journal of Business Venturing, 22(2), 262–82. Alter, M. and L. Buchsbaum (2000), ‘Corporate venturing: goals, compensation and taxes’, in D. Barr (ed.), The Corporate Venturing Directory and Yearbook, Wellesley, MA: Asset Alternatives, Inc., pp. 25–9. Bannock Consulting Ltd (1999), ‘Corporate venturing in Europe’, study for the European Commission DGXIII EIMS 98/176, Final Report. Bassen, A., D. Blasel, U. Faisst and M. Hagenmuller (2006), ‘Performance measurement of corporate venture capital – balanced scorecard in theory and practice’, International Journal of Technology Management, 33(4), 420–37. Basu, S., C. Phelps and S.B. Kotha (2006), ‘Corporate venture capital: a real options perspective on who does it and why’, paper presented at the 2006 Academy of Management Meetings, Atlanta, GA. Benson, D. and R. Ziedonis (2004), ‘Try before they buy: corporate venture capital and the acquisition of technology start-ups’, Working Paper, Ann Arbor, MI: University of Michigan. Birkinshaw, J. and S.A. Hill (2005), ‘Corporate venturing units: vehicles for strategic success in the New Europe’, Organizational Dynamics, 34(3), 247–57. Birkinshaw, J., R. van Basten Batenburg and G.C. Murray (2002), Corporate Venturing: The State of the Art and the Prospects for the Future, London: London Business School.

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Bleicher, K. and H. Paul (1987), ‘The external corporate venture capital fund – a valuable vehicle for growth’, Long Range Planning, 20(6), 64–70. Block, Z. and O.A. Ornati (1987), ‘Compensating corporate venture managers’, Journal of Business Venturing, 2(1), 41–51. Brown, S.L. and K.M. Eisenhardt (1997), ‘The art of continuous change: linking complexity theory and timepaced evolution in relentlessly shifting organizations’, Administrative Science Quarterly, 42(1), 1–34. Burgelman, R.A. and L.R. Sayles (1986), Inside Corporate Innovation, New York: The Free Press. Chesbrough, H. (2000), ‘Designing corporate ventures in the shadow of private venture capital’, California Management Review, 42(3), 31–49. Chesbrough, H.W. (2002), ‘Making sense of corporate venture capital’, Harvard Business Review, 80(3), 90–99. Chesbrough, H. and C. Tucci (2004), ‘Corporate venture capital in the context of corporate innovation’, paper presented at the DRUID Summer Conference 2004 on Industrial Dynamics, Innovation and Development, Elsinore, Denmark. Christopher, A. (2000), ‘Corporate venture capital: moving to the head of the class’, Venture Capital Journal, November, pp. 43–6. Cohen, W.M. and D.A. Levinthal (1990), ‘Absorptive capacity: a new perspective on learning and innovation’, Administrative Science Quarterly, 35(1), 128–52. Corporate Executive Board (2000), ‘Corporate venture capital: managing for strategic and financial returns’, Working Council for Chief Financial Oﬃcers, Executive Inquiry Brief, Washington, DC: Corporate Executive Board. Dushnitsky, G. (2004), ‘Limitations to inter-organizational knowledge acquisition: the paradox of corporate venture capital’, doctoral thesis, New York, NY: Stern School of Business. Dushnitsky, G. (2006), ‘Corporate venture capital: past evidence and future directions’, in M. Casson, B. Yeung, A. Basu and N. Wadeson (eds), The Oxford Handbook of Entrepreneurship, London, UK: Oxford University Press. Dushnitsky, G. and D. Lavie (2006), ‘Strategic alliances vs. corporate venture capital: substitutes or complements in the software industry?’, paper presented at the 2006 Academy of Management Meetings, Atlanta, GA. Dushnitsky, G. and M.J. Lenox (2005a), ‘When do firms undertake R&D by investing in new ventures?’, Strategic Management Journal, 26(10), 947–65. Dushnitsky, G. and M.J. Lenox (2005b), ‘When do incumbents learn from entrepreneurial ventures? Corporate venture capital and investing firm innovation rates’, Research Policy, 34(5), 615–39. Dushnitsky, G. and M.J. Lenox (2006), ‘When does corporate venture capital investment create firm value?’, Journal of Business Venturing, 21(6), 753–72. Eisenhardt, K.M. and S.L. Brown (1998), Competing on the Edge: Strategy as Structured Chaos, Cambridge, Massachusetts: Harvard Business School Press. Ernst, H., P. Witt and G. Brachtendorf (2005), ‘Corporate venture capital as a strategy for external innovation: an exploratory empirical study’, R&D Management, 35(3), 233–42. European Private Equity & Venture Capital Association (EVCA) (2001), Corporate Venturing European Activity Report 2000, Zaventem, Belgium: European Private Equity & Venture Capital Association (EVCA). Fast, N.D. (1978), The Rise and Fall of Corporate New Venture Divisions, Ann Arbor, MI: UMI Research Press. Gaba, V. and A.D. Meyer (2006), ‘Learning from peers or other populations? The adoption of corporate venture capital programs’, paper presented at the Academy of Management Meeting, Atlanta, Georgia, 11–16 August. Gawer, A. and M.A. Cusumano (2002), Platform Leadership: How Intel, Microsoft, and Cisco Drive Industry Innovation, Boston, MA: Harvard Business School Press. Ginsberg, A. and M. Hay (1994), ‘Confronting the challenges of corporate entrepreneurship: Guidelines for venture managers’, European Management Journal, 12(4), 382–9. Gompers, P.A. and J. Lerner (1998), ‘The determinants of corporate venture capital success: organizational structure, incentives, and complementarities’, NBER Working Paper, No. W6725, Cambridge, MA: National Bureau of Economic Research. Hamilton, B.H. and J.A. Nickerson (2003), ‘Correcting for endogeneity in strategic management research’, Strategic Organization, 1(1), 53–80. Hardymon, G.F., M.J. Denino and M.S. Salter (1983), ‘When corporate venture capital doesn’t work’, Harvard Business Review, 61(3), 114–20. Hellmann, T. (2002), ‘A theory of strategic venture investing’, Journal of Financial Economics, 64(2), 285–314. Henderson, J. and B. Leleux (2002), ‘Corporate venture capital: eﬀecting resource combinations and transfers’, Babson Entrepreneurial Review, October, pp. 31–46. Hill, S., M.V.J. Maula and G.C. Murray (2005), ‘Corporate venture capital: towards an integration of organization, investment and performance’, paper presented at the Babson College Entrepreneurship Research Conference, Babson College, MA.

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Kann, A. (2000), Strategic Venture Capital Investing by Corporations: A Framework for Structuring and Valuing Corporate Venture Capital Programs, unpublished doctoral dissertation, Stanford University. Keil, T. (2000), ‘External corporate venturing: Cognition, speed, and capability development’, doctoral dissertation, Espoo, Finland: Helsinki University of Technology. Keil, T. (2002), External Corporate Venturing: Strategic Renewal in Rapidly Changing Industries, Westport, CT: Quorum Books. Keil, T. (2004), ‘Building external corporate venturing capability’, Journal of Management Studies, 41(5), 799–825. Keil, T., M. Maula and H. Schildt (2003), ‘Corporate venturing modes and their impact on corporate learning’, in W.D. Bygrave, C.G. Brush, P. Davidsson, J.O. Fiet, P.G. Greene, R.T. Harrison, M. Lerner, G.D. Meyer, J. Sohl and A. Zacharakis (eds), Frontiers of Entrepreneurship Research 2003, Babson Park, MA: Babson College, pp. 471–85. Keil, T., M.V.J. Maula and S.A. Zahra (2004), ‘Explorative and exploitative learning from corporate venture capital: model of program level factors’, best paper proceedings of the Academy of Management Meetings, New Orleans, LA, USA. Keil, T., M. Maula, H. Schildt and S.A. Zahra (2005), ‘Corporate venturing modes and their impact on corporate learning’, Working Paper, Espoo, Finland: Institute of Strategy and International Business, Helsinki University of Technology. Kelley, D. and S. Spinelli (2001), ‘The role of corporate investor relationships in the formation of alliances for corporate venture capital funded start-ups’, paper presented at the Babson College–Kauﬀman Foundation Entrepreneurship Research Conference 2001, Jönköping, Sweden. Li, Y. and J.T. Mahoney (2006), ‘Corporate venture capital investment decisions: real options and absorptive capacity’, paper presented at the Academy of Management Meetings, Atlanta, USA. Lim, S.-J. and J.-D. Lee (2006), ‘The eﬀects of absorptive capacity and complementarities on corporate venture capital’, paper presented at the DRUID Summer Conference, Copenhagen, Denmark, 18–20 June. Mast, R. (1991), ‘The changing nature of corporate venture capital programs’, European Venture Capital Journal, March/April, pp. 26–33. Mathews, R.D. (2006), ‘Strategic alliances, equity stakes, and entry deterrence’, Journal of Financial Economics, 80(1), 35–79. Maula, M.V.J. (2001), ‘Corporate venture capital and the value-added for technology-based new firms’, doctoral dissertation, electronic copy available at http://lib.hut.fi/Diss/2001/isbn9512260816/, Espoo, Finland: Helsinki University of Technology, Institute of Strategy and International Business. Maula, M. and G. Murray (2000), ‘Corporate venture capital and the exercise of the options to acquire’, proceedings of the R&D Management Conference, Manchester, UK, 10–12 July. Maula, M.V.J. and G.C. Murray (2002), ‘Corporate venture capital and the creation of US public companies: the impact of sources of venture capital on the performance of portfolio companies’, in M.A. Hitt, R. Amit, C. Lucier and R.D. Nixon (eds), Creating Value: Winners in the New Business Environment, Oxford, UK: Blackwell Publishers. Maula, M.V.J., E. Autio and G.C. Murray (2003a), ‘Prerequisites for the creation of social capital and subsequent knowledge acquisition in corporate venture capital’, Venture Capital, 5(2), 117–34. Maula, M.V.J., E. Autio and G.C. Murray (2005), ‘Corporate venture capitalists and independent venture capitalists: what do they know, who do they know, and should entrepreneurs care?’, Venture Capital, 7(1), 3–21. Maula, M.V.J., E. Autio and G.C. Murray (2006a), ‘How corporate venture capitalists add value to entrepreneurial young firms’, in J. Wiklund, D. Dimov, J.A. Katz and D.A. Shepherd (eds), Advances in Entrepreneurship, Firm Emergence and Growth, Oxford, UK: JAI, pp. 267–309. Maula, M.V.J., T. Keil and J.-P. Salmenkaita (2006b), ‘Open innovation in systemic innovation contexts’, in H. Chesbrough, W. Vanhaverbeke and J. West (eds), Open Innovation: Researching a New Paradigm, Oxford: Oxford University Press, pp. 241–57. Maula, M.V.J., T. Keil and S.A. Zahra (2003b), ‘Corporate venture capital and recognition of technological discontinuities’, paper presented at the Academy of Management Meeting, Seattle, WA, 1–6 August. McKinsey & Co. (1998), ‘US venture capital-industry overview and economics’, Summary report, New York: McKinsey and Company. McNally, K. (1997), Corporate Venture Capital: Bridging the Gap in the Small Business Sector, London: Routledge. Miles, M.P. and J.G. Covin (2002), ‘Exploring the practice of corporate venturing: some common forms and their organizational implications’, Entrepreneurship: Theory & Practice, 26(1), 21–40. Mitchell, W. and K. Singh (1992), ‘Incumbents use of pre-entry alliances before expansion into new technical subfields of an industry’, Journal of Economic Behavior & Organization, 18(3), 347–72. Reichardt, B. and C. Weber (2006), ‘Corporate venture capital in Germany: a comparative analysis of 2000 and 2003’, Technological Forecasting and Social Change, 73(7), 813–34.

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Rind, K.W. (1981), ‘The role of venture capital in corporate development’, Strategic Management Journal, 2(2), 169–80. Riyanto, Y.E. and A. Schwienbacher (2006), ‘The strategic use of corporate venture financing for securing demand’, Journal of Banking & Finance, 30(10), October, 2809–33. Roberts, E.B. (1980), ‘New ventures for corporate growth’, Harvard Business Review, 58, July/August, 134–42. Roberts, E.B. and C.A. Berry (1985), ‘Entering new businesses: selecting strategies for success’, Sloan Management Review, 26(3), 3–17. Rosenberger, J., R. Katila and K.M. Eisenhardt (2005), ‘The flip side of the coin: nascent technology ventures and corporate venture funding’, Working Paper, Stanford, CA: Stanford University. Schildt, H.A., T. Keil and M.V.J. Maula (2006), ‘The timing of knowledge flows in interorganizational relationships’, the Best Paper Proceedings of the Academy of Management Meetings, Atlanta, USA. Schildt, H.A., M.V.J. Maula and T. Keil (2005), ‘Explorative and exploitative learning from external corporate ventures’, Entrepreneurship: Theory & Practice, 29(4), 493–515. Sharma, P. and J.J. Chrisman (1999), ‘Toward a reconciliation of the definitional issues in the field of corporate entrepreneurship’, Entrepreneurship: Theory & Practice, Spring, pp. 11–27. Siegel, R., E. Siegel and I.C. Macmillan (1988), ‘Corporate venture capitalists: autonomy, obstacles, and performance’, Journal of Business Venturing, 3(3), 233–47. Silver, D.A. (1993), Strategic Partnering, New York, NY: McGraw-Hill. Sykes, H.B. (1986), ‘Anatomy of a corporate venturing program: factors influencing success’, Journal of Business Venturing, 1(3), 275–94. Sykes, H.B. (1990), ‘Corporate venture capital: strategies for success’, Journal of Business Venturing, 5(1), 37–47. Venkataraman, S. and I.C. MacMillan (1997), ‘Choice of organizational mode in new business development: theory and propositions’, in D.L. Sexton and R.W. Smilor (eds), Entrepreneurship 2000, Chicago, IL: Upstart Publishing. Wadhwa, A. and S. Kotha (2006), ‘Knowledge creation through external venturing: evidence from the telecommunications equipment manufacturing industry’, Academy of Management Journal, 49(4), 819–35. Weber, C. and B. Weber (2005), ‘Corporate venture capital organizations in Germany’, Venture Capital, 7(1), 51–73. Winters, T.E. and D.L. Murfin (1988), ‘Venture capital investing for corporate development objectives’, Journal of Business Venturing, 3(3), 207–22. Young, R. and W.G. Rohm (1999), Under the Radar: How Red Hat Changed the Software Business – and Took Microsoft by Surprise, Scottsdale, AZ: The Coriolis Group.

16 Entrepreneurs’ perspective on corporate venture capital (CVC): A relational capital perspective Shaker A. Zahra and Stephen A. Allen

Introduction The relationship between industry incumbents and new ventures has been a subject of much interest in the literature (Zahra et al., 1995; Gompers and Lerner, 1999; 2001; Zahra, 2006a; 2006b). Traditional analyses have emphasized the potential role of new ventures in displacing industry incumbents as a natural part of the process of Schumpeterian creative destruction (Christensen, 1997). More recent analyses highlight a ‘co-specialization’ dynamic, where new ventures excel in discovery and invention and incumbents are better equipped to successfully exploit and commercialize these discoveries. Research applying the co-specialization dynamic recognizes the rivalrous nature of the relationship that might exist between incumbents and new ventures but also highlights opportunities for fruitful collaboration (Chesbrough, 2002). Corporate venture capital (CVC) is one approach some incumbents have used to connect with new ventures in and outside their industries (Keil, 2002; Dushnitsky, 2004; Keil et al., 2005; Maula et al., 2005; Rosenberger et al., 2005). Maula (see Chapter 15) has comprehensively reviewed and summarized the relationship between CVC and other activities that companies undertake to venture into new fields, internally or externally. Maula’s review suggests that companies use CVC for multiple reasons, giving these transations distinctiveness. As Maula indicates, CVC refers to equity-linked investments that incumbents make in young, privately held companies – where the investor is a financial intermediary of a non-financial corporation. While CVC programs can generate substantial direct financial gains or losses (Allen and Hevert, 2007), incumbents may also use these programs to gain access to the knowledge and innovative technologies that new ventures create. Researchers examining CVC often frame their analyses within the ‘co-specialization perspective’, positing that these transactions could evolve into ‘win–win’ outcomes for both incumbents and new ventures (McNally, 1997; Maula, 2001; Keil, 2002). Still, incumbents can use their CVC investments to delay or even thwart new ventures’ eﬀorts to develop and introduce new technologies that are viewed as threats to their market positions or as changing the rules of competition (Gompers and Lerner, 1998; 1999). Objectives, focus and contribution Dushnitsky (2006) and Maula in Chapter 15 provide comprehensive and informative reviews of the literature on CVC. Most prior research stresses the role and eﬀective management of CVC in established corporations (Rind, 1981; Winters, 1988; Sykes, 1990; McNally, 1995; 1997; Dushnitsky and Lenox, 2005; 2006). Even though some CVC deals are purely financial investments, researchers have given special attention to the conditions under which established companies learn from CVC investments. Prior analyses, however, 393

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have given far less systematic attention to clarifying the consequences of CVC for the success of new ventures (McNally, 1995; Ivanov and Xie, 2005; Maula et al., 2006). As a result, theoretical and empirical research on these issues has been sparse and fragmented, making it diﬃcult to guide future intellectual inquiry and eﬀective managerial practice. This is problematic because new ventures need to assemble resources quickly and use these resources to develop capabilities which can create and protect a competitive advantage (Zahra, 2006a; 2006b). Most new ventures usually have one or a few capabilities that should be kept current while assembling other skills and capabilities through the infusion of new knowledge and other resources from external sources or internal development. CVC enables new ventures to obtain the financial resources and business contacts needed to assemble and use these skills, deploy them in a timely fashion, and build a strong market presence. McNally (1997), Rosenberger et al. (2005), Dushnitsky (2006), Dushnitsky and Lenox (2006) and Maula et al. (2006) oﬀer detailed discussions of the various financial, operational and strategic benefits that new ventures can gain from their CVC relationships. Concern persists that CVC investments also open the door for opportunism by established companies that could appropriate much of the value of these ventures’ intellectual property or stifle their growth. In this chapter, we hope to fill a gap in the young but growing literature on CVC. Specifically, we adopt the perspective of entrepreneurs to: (1) examine potential financial and non-financial benefits new ventures can gain from CVC investments; (2) discuss factors that can mitigate or limit these potential gains; and (3) consider eﬀective strategies that entrepreneurs can use to maximize gains from CVC while curbing possibilities for incumbent partner opportunism. To accomplish these three objectives, we ground our arguments in the knowledge-based (Grant, 1996) and relational capital (Dyer and Singh, 1998) perspectives. Invoking the knowledge-based view, we propose that a key source of potential value creation for new ventures that engage in CVC relationships is the creation of unique and inimitable knowledge that becomes embedded in their operations. Exploiting this knowledge creatively can give new ventures competitive advantages over their rivals (Zahra, 2006a). Knowledge creation per se may not enhance the firm’s value or owners’ wealth. Instead, this knowledge has to be used in developing and introducing new products, goods or services. New ventures can also ‘sell’ their knowledge through licensing or other means. We invoke the relational perspective to suggest that contracts have limits in curbing opportunism. When a relationship develops between two or more social actors, it becomes possible for them to share what they know, collaborate, and reveal the ‘hidden code’ in the information being transferred. This makes the information accessible to the recipient, promoting mutual understanding and co-operation. It also makes it easier to use this knowledge, which is important for those new ventures that gain access to their partners’ knowledge through relationships. Still, CVC relationships are susceptible to opportunism because incumbents and new ventures have diﬀerent goals and control diﬀerent resources and knowledge. Therefore, we propose that entrepreneurs can reduce this risk using a variety of contractual, structural and behavioral mechanisms. Relationships develop over time, giving participants an opportunity to learn about and from each other, decipher their mental models, and appreciate their intentions and goals. Information gleaned from these relationships, however, is imperfect because actors have strong incentives not to reveal fully what they know or do, limiting others’ ability to comprehend what they are doing.

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The fact that information could be gained from these relationships makes it imperative for new ventures to develop their absorptive capacity to spot, capture, assimilate and exploit relevant and useful knowledge from incumbents (Zahra and George, 2002). We make three contributions to the literature in this chapter. The first is examining CVC within a relational (rather than a merely transactional) framework, making it possible to articulate the benefits that entrepreneurs can gain from collaboration with incumbents. Other researchers have recognized the merits of this approach and have used it in their analyses (Maula et al., 2006; see also Chapter 15). In contrast, transaction-based analyses often consider formal means of reducing opportunism, taking into account the costs and benefits involved. These analyses often overlook the dynamics of the relationships that develop among companies or parties to exchange over time. Transaction-based analyses also highlight the financial costs of opportunism, ignoring the social implications of such behavior. We argue that a transactional perspective by either party can be short-sighted, undermining the potentially more valuable, longer term collaborations. When there is suﬀicient goal congruence, a relational perspective provides a better means for analyzing new ventures and incumbents’ interactions. These relationships are complex and require considerable investments in time, energy and resources for the development and payoﬀ for the parties involved. Our analyses suggest a number of ways in which new ventures could balance transaction and trust-based governance, protecting their intellectual property. Our second contribution lies in recognizing that diﬀerences in the goals between and within new ventures and incumbents create unique dynamics that influence the outcomes of CVC relationships. Neither incumbents nor new ventures are homogeneous groups, though prior analyses have often erred in treating them as such. By recognizing the diversity of motives of various types of CVC-supported ventures, we set the stage for thoughtful theorizing about the potential vs. realized gains from CVC. This issue has been widely ignored in the CVC literature, creating a serious gap in our understanding of eﬀective ways that companies can organize and cultivate their relationships and create value. Our third contribution in this chapter is to explore the limits of the relational capital perspective in the context of the CVC relationship. Increasingly, some researchers (for example Maula et al., 2006) have used this perspective in lieu of the transactional costs perspective (Williamson, 1985) in theorizing about the dynamics of the relationship between established and new firms. While relational capital can enhance trust and reduce partner opportunism, some recent analyses ignore unique and idiosyncratic qualities of the relationship between new ventures and incumbents that make opportunism likely (and perhaps inevitable) in some situations. By considering the limits of the relational perspective, we provide a more realistic picture of its usefulness especially among new ventures. Excessive trust could be as damaging as lack of trust to business and value creation (Zahra et al., 2006b). The remainder of the chapter progresses as follows. First, we briefly review the growing importance of CVC, especially in emerging high technology industries. Once we have discussed the importance of CVC, we analyze entrepreneurs’ objectives related to these activities. Specifically, we distinguish between exploratory and exploitative objectives (March, 1991). We use the knowledge based (Grant, 1996) and relational capital perspectives (Dyer and Singh, 1998) to argue that one of the key benefits of CVC for entrepreneurs is gaining and developing new knowledge that can accelerate their firms’ development. While we highlight the relational aspect of CVC investments, we underscore

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the conflicting goals of incumbents and new ventures. Our discussion will show how these conflicting motives may come to bear on new ventures’ potential benefits from CVC-based relationships. Our discussion recognizes that entrepreneurs can fail to gain the full range of potential benefits in their CVC relationships. Next, we identify several factors that can contribute to the gap between potential and realized CVC benefits. We examine diﬀerential power, reputations and status as possible sources of this gap. We also examine how partner opportunism and organizational process (and cultural) dissimilarities can contribute to this gap. To achieve our objective, we turn to transaction cost theories (Williamson, 1985). We also highlight how diﬀerences across industries in the strength of intellectual property protection regimes can contribute to the gap between potential and realized benefits of CVC. Finally, we discuss key strategies that entrepreneurs can use to reduce the potentially dysfunctional side of CVC relationships. We cover the importance of due diligence in partner selection, syndicated investment with independent venture capitalists, governance mechanisms (such as board composition and voting rights), use of proactive relationships with a CVC program’s parent organization, and terms of licensing agreements. We conclude the chapter by summarizing the implications of our arguments for entrepreneurs and future research. Importance and growth of CVC CVC investments grew dramatically during the past decade (see for example Dushnitsky, 2006; see also Chapter 15), receiving increased attention from researchers in the fields of strategy, innovation and entrepreneurship (Keil, 2002; Chesbrough, 2003; Christensen and Raynor, 2003; Dess et al., 2003; Keil et al., 2005). This interest relates to wider research agendas on organizational learning and renewal (Cohen and Levinthal, 1990; March, 1991) and on the diﬀerent roles incumbent and young firms play in industry ecosystems (Hagedoorn, 1993; Zahra and Chaples, 1993; Iansiti and Levien, 2004). Evidence on the broad patterns of CVC investments during the past decade has several implications for new ventures considering funding and for the strategic relationships they might form with established companies.1 CVC investments were a significant source of funding for young companies, primarily in emerging high technology industries. An estimated worldwide population of 447 programs made some $44 billion of investments during 1994–2003, rising from $120 million in 1994 to a peak of $17 billion in 2000, and falling to a still substantial $2 billion in 2003 (Birkinshaw et al., 2002; National Venture Capital Association, 2004).2 US companies accounted for nearly 84 per cent of investments, representing 12 per cent of formal US venture capital activity during the 1994–2003 period. While these figures suggest a broad but temporally variable CVC investor opportunity space for new ventures, the eﬀective space was narrower because more than 70 per cent of the programs were initiated by companies within two economic sectors – information technology-telecom and biotech-pharmaceuticals-chemicals. These programs focused their investments within their respective sectors (Kann, 2000; Birkinshaw et al., 2002). Programs in these two sectors accounted for as much as 90 per cent of US CVC investments (Dushnitsky and Lenox, 2006). New ventures seeking attractive CVC investors should be aware of the diversity among programs with respect to scale, experience, longevity and parent funding. Half of the existing CVC programs were small by US venture capital industry standards (for example

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cumulative investment was less than $95 million). However, as many as 25 programs invested more than $500 million (Allen and Hevert, 2007). Most programs were initiated after 1992, roughly half had five or less years of investing experience through 2003, and many were discontinued after a few years of activity. For example, of the 447 programs identified by Birkinshaw et al. (2002), 31 per cent were inactive or closed by early 2002. While some programs, like independent venture capital funds, received long-term commitments from their investors, many did not (Gompers, 2002). These programs were likely to be more vulnerable to funding volatility or eventual closure (Birkinshaw et al., 2002; Gompers, 2002). CVC programs that fail to achieve material and sustained funding are less likely to assist new ventures in establishing alliance activities with parent organizations or to participate in multiple financing rounds. Even though the relative youth of many CVC programs makes the identification of most attractive partners a challenge, some due diligence can reduce prospects for adverse selection. Other things being equal, the most attractive CVC investors are likely to have longer experience, substantial scale (for example $100–500 million in cumulative investment over several years), and committed parent funding. Another factor for new ventures to consider is the track record of the CVC program in co-investing with well-regarded venture capital funds (Maula and Murray, 2000). In this case, venture capitalists may be signaling their implied endorsement of a CVC program’s staying power, potential reputational benefits, or record of productively working with younger companies and their other investors (Breyer, 2000). Strategic motives for CVC-based relationships Established companies generally cite both strategic and financial goals in initiating CVC programs (Siegel et al., 1988; Birkinshaw et al., 2002). Similarly, new ventures have both financial and strategic motives for seeking CVC investments (see Chapter 15). In this section we set aside the issue of direct financial objectives of corporate investors,3 focusing instead on the strategic benefits each party might seek from a CVC investment; situations in which there may be congruence or conflict between the goals of these parties; and how goal congruence–conflict may diﬀer across developmental stages of young companies, investment rounds and economic sectors. Consequently, we first consider the objectives of corporate investors and then the goals of new ventures seeking funding through CVC programs. Corporate investor perspectives The literature highlights diﬀerent reasons that lead established companies to use CVC (for a detailed discussion see Keil, 2002; Maula et al., 2003; Keil et al., 2005; Maula et al., 2005; see also Chapter 15). It suggests that rapid technological change has encouraged incumbents to search beyond their existing capabilities for innovation. Rapid technological obsolescence has made it essential to obtain new and diverse knowledge from external sources to augment the firm’s internal operations and discoveries. New ventures are a key source of new knowledge that can be brought into the organization and combined with existing skills to create new products and services. As noted, the knowledge-based theory of the firm highlights the importance of exploiting knowledge for creating value (Grant, 1996). Combinative knowledge, in particular, can be an important source of value creation (Kogut and Zander, 1992). Some established companies have turned to CVC investments because their internal R&D activities have failed to recognize serious technological

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discontinuities. Even when they did recognize pending technological change, their development process was sometimes too slow to pre-empt smaller or more flexible rivals (Foster, 1986; Gompers and Lerner, 1999; 2001). Several surveys provide rankings of the strategic objectives cited by companies in initiating CVC programs (Siegel et al., 1988; Corporate Strategy Board, 2000; Kann, 2000; Birkinshaw et al., 2002). Findings from these surveys converge around three clusters of highly rated objectives. The first and most highly ranked goal is exposure and access to emerging technologies, including both complementary and disruptive technologies. Incumbents frequently use their CVC investments to canvass a wide range of technological fields and learn more quickly about forthcoming technological discontinuities (Maula et al., 2003). The second goal cited by CVC programs is to expose incumbents to new markets and gain access to resources and relationships which can accelerate these firms’ ability to enter new markets. CVC relationships give incumbents opportunities to learn about diﬀerent new ventures, their strengths and weaknesses and their potential to change the dynamics of industry structure. This information can help incumbents reshape their technological portfolios, enter new markets, and identify attractive acquisition targets. The third goal centers on enhancing the demand for current products or services of the investor. One version of this is ecosystem investing in the information technology sector, in which the primary goal is to support a network of suppliers, complementors, customers and investors that can help create or defend de facto technology standards for the investing firm (Chesbrough, 2003). Some research shows that incumbents attach diﬀerent priorities to diﬀerent CVC goals. Kann (2000) found that the importance of these strategic objectives diﬀered significantly across industries. For example, gaining timely exposure and access to emerging technologies was the main objective for pharmaceutical and chemical companies, while enhancing demand was the dominant theme among software firms. These diﬀerences reflect industry dynamics and the powerful forces that govern competition. A key limitation of past research findings is its failure to address the potential for goal congruence or conflict between incumbents and new ventures. Conflict in goals can undermine this relationship and lower the potential gains of the corporate investor and new venture. Goals underlying these investments also change over time. Unfortunately, it is not clear from the literature how this congruence (or conflict) may change over development cycles and funding rounds. To explore these issues more fully, in Table 16.1 we depict the perspective of a CVC investor as a function of: (1) strategic investment objectives; (2) potential impact of the investees (new ventures) on strategy of the CVC program’s parent; and (3) preferred timing of investment. Even though Table 16.1 focuses on established corporate investors, we believe that understanding what these investors seek and how they make their strategic decisions can help new ventures and their managers refine their strategies for collaboration with established companies. Inexperienced new ventures often fail to consider the consequences of the strategic imperatives CVC investors have on the decisions these investors make to ensure the flow of funds, resources and knowledge to the companies in their portfolios. Focusing on strategic investment objectives (Table 16.1), we distinguish between exploration and exploitation (March, 1991). Exploratory investments can be viewed as equity funded intelligence gathering with the possibilities for follow-up actions and investments within the investor’s parent company and through alliance activity with the new ventures

Entrepreneurs’ perspective on corporate venture capital Table 16.1

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Perspectives of corporate venture capital investors

Potential impact of entrepreneurial firm on strategy of CVC program’s parents

(1) Strategic investment objectives Explores Early stage

Exploits Later stage

Early stage

Later stage

Threatens Unclear or mixed Supports

in their portfolio. This type of investment gives incumbents a window on emerging business models as well as technological, marketing and business process innovations that could alter industry dynamics and boundaries. Incumbents may also learn about their rivals’ emerging technologies and how they might evolve over time. Exploratory investments can lead to (or occur simultaneously with) exploitative actions. For example, Henderson and Leleux (2003) found that 56 per cent of telecom CVC investors announced collaboration agreements with new ventures in their portfolios. Alternatively, exploratory investments need not result in alliances between incumbents and new ventures because incumbents may decide to limit the application of any learning they obtain to internal projects. Exploitative CVC investments do not have to precede exploratory investments (Rothaermel, 2001). In fact, incumbents may elect to wait to invest until later funding rounds or to seek only licensing agreements. If the objective is other than gaining early exposure or obtaining rights to new technologies, later direct exploitation moves may be preferred. In this vein, Henderson and Leleux (2003) found that decisions to initiate investment in later rounds were a significant predictor of the likelihood of collaboration agreements in the telecom sector.4 The second factor we highlight in Table 16.1 is the perceived impact of the entrepreneurial firm on the strategy of the CVC program’s parent. Hellmann (2002) observes that non-contractible activities between CVC investors and new ventures may be complementary or competing. We assume that incumbents’ key decision makers develop perceptions of the degree to which the new venture is supportive or threatening to their firms’ strategy. This perception may result from search and screening processes for initial investments or may emerge over time. Thus, perceived strategic fit can change over time.5 It is also possible that a CVC program or diﬀerent business units may have conflicting views on goal congruence. For instance, the new venture might be seen as an ally of internal units pursuing a disruptive technology but as a threat to others supporting alternative technologies or defending current technology bases within incumbent organizations. Therefore, in Table 16.1, we provide a third category of potential impact reflecting unclear or conflicting perceptions and the possibility of a mixed threat–support situation. The final factor we highlight in Table 16.1 is the preferred timing of the initial investments. If the initial strategic objective is to gain exposure to new technologies, then the incumbent is likely to invest in early, pre-revenue rounds. Evidence suggests that up to 40 per cent of transactions (not value) by CVC investors are in seed money through development

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rounds, reinforcing an inference of importance for exploratory activities (Gompers and Lerner, 1998; Kann, 2000). Overall, Table 16.1 highlights six diﬀerent scenarios of CVC investors with diﬀerent implications for preferred timing of initial investments. New venture managers should be aware that the exploration–exploitation dimension may or may not involve path dependency, depending on the preferences of incumbents’ senior managers. Each of the six scenarios suggested in Table 16.1 implies a diﬀerent foundation of common interests and information upon which to build productive collaborations between incumbents and new ventures. The entrepreneurial firm’s perspective As noted, limited research exists on the objectives and priorities that new ventures pursue when they seek CVC investors. New ventures are heterogeneous in their ownership, strategic focuses, resources, skills and experiences. Owners and managers may also diﬀer significantly in their goals; some may want to develop the venture just enough to make it a candidate for acquisition. For others, the goal may be to become a leading player in their industries (Zahra, 2006b). These variations can lead to major diﬀerences in new ventures’ motivations to pursue CVC relationships. The paucity of empirical research on these variations leads us to rely on anecdotal evidence plus studies that address the broader topic of strategic alliances between incumbents and young companies. Specifically, we explore the factors highlighted in Table 16.1 from the new ventures’ perspective and add financing and endorsement needs, which we believe to be unique to this side of the CVC relationship. It is important to recognize that some subset of CVC relationships may be viewed by both parties as serving short-term financial and strategic objectives. Long-term learning and collaboration would be viewed as secondary considerations. These investments would be likely to mirror the logic of transaction-cost analysis (Williamson, 1985). Eﬀort and resources would be committed to making the transaction eﬃcient and profitable over a short time horizon but little attention would be given to developing mechanisms for building a basis for multiple future collaborations. We would expect this type of CVC relationship to make extensive use of traditional contracting safeguards. It may also be more prone to opportunistic behavior. Whether either of these predictions is true remains an empirical question which has yet to be fully explained by the literature.6 New ventures are needy creatures on several counts. An immediate need is often to avoid running out of cash before suﬃciently resolving uncertainties surrounding planned oﬀerings (Kaplan, 1994). This can limit new ventures’ discretion and bargaining power in their selection of and negotiations with potential investors (Smith, 2001). Lerner and Merges (1998) show this to be a common issue for young biotech firms seeking development funding from larger companies. Kann (2000, p. iv) also observes that CVC investing involves ‘collaborative agreements with unequal partners centered on a one-directional equity investment’. Under these circumstances, CVC investors may have the upper hand in shaping the course of negotiations with new ventures, determining the amount of intellectual property disclosure, and setting terms for sharing the benefits from collaboration. Reflecting on Table 16.1, we first consider the various exploitation objectives of new ventures in higher goal congruence situations. One key motive is to obtain access to CVC investors’ resources and networks. In this case, the preferred timing for seeking investors is usually at the later development or go-to-market stages. A related goal is often to secure

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incumbents’ endorsement of the ventures’ emerging technologies or products (Stuart, 2000) and reduce liabilities of newness (Schoonhoven, 2005). These endorsements can significantly improve the new firm’s name recognition, encourage buyers and suppliers to collaborate, and increase overall market standing. In this vein, Leibelein and Reuer (2004) provide evidence of small US semiconductor firms initiating equity alliances with larger partners with a primary goal of increasing foreign sales. Early-stage, exploratory CVC investments can also oﬀer new ventures prospects for credible endorsements and access to diverse strategic resources. Still, they may carry higher risks of opportunistic and harmful behavior by well established partners. Consider, for example, the information technology sector which is characterized by system-level design rules and horizontal networks of developers of sub-systems and components (Baldwin and Clark, 2000). In this sector, CVC relationships can provide an avenue for gaining access to technology roadmaps of leading firms, access to their promotional activities at trade shows, and improved prospects for design-in of young companies’ products. In contrast, for young biotech firms, the goal of early stage CVC deals may be gaining access to larger companies’ capabilities in conducting clinical trials and pilot production for trials. In both these early-stage situations, the words explore and exploit will be likely to raise few eyebrows in larger companies. Yet, they often raise the pulses of entrepreneurs who are concerned that larger company exploration can translate into the appropriation of intellectual property. Another concern for entrepreneurs is that larger partners, by intent or because of internal conflicts, may fail to deliver access to capabilities. These are classic agency issues of adverse selection, moral hazard, and hold-up (Jensen and Meckling, 1976; Kaplan and Stromberg, 2002) but treating new ventures as the principals. Concerns about harmful behavior by larger, powerful and established partners should be greater when they see new ventures as a threat to their market leadership or growth goals. When new ventures control innovative and proprietary technologies that can displace incumbents, they are likely to be viewed as credible threats. Under these conditions, one would expect new ventures to avoid those prospective investors; but this is not always the case. There is evidence that low or mixed goal congruence situations are common in the biotech industry (Pisano, 1991; Lerner and Merges, 1998; Rothaermel, 2001). This seems to reflect new ventures’ need to gain access to larger pharmaceutical companies’ capabilities as well as long development cycles which often cannot be fully funded from venture capital and public market sources. In both the information technology and biotech sectors, gaining access to established companies’ marketing, distribution and manufacturing capabilities, as well as the need for cash, may often trump concerns about large partner behavior (Kaplan, 1994; Smith, 2001).7 If the new venture has suﬃcient financing and can choose among diﬀerent investors, it can employ multiple criteria in searching and screening for attractive CVC partners or in deciding to avoid potentially opportunistic partners. Yet, Alvarez and Barney (2001) found that it was not unusual for new ventures to devote as little as half a day to conducting due diligence on a potential alliance partner. While this may reflect limited management time and cash, it can set the stage for a failed relationship between the venture and its CVC investors. Eﬀective due diligence by new ventures should go beyond the most tangible issues (for example financial resources and investment windows) when evaluating potential CVC investors. It should probe CVC providers’ track records in working with portfolio firms, transferring knowledge and skills, connecting these companies to potential suppliers and

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customers, and contributing to the quality of their management. The quality as well as the durability of the potential relationship should also be investigated to establish CVC providers’ claims and credibility. Do entrepreneurial firms capture CVCs’ strategic benefits? Evidence on the strategic benefits that new ventures gain from CVC-based relationships reveals considerable diversity with respect to the particular benefits gained and to the positive and negative outcomes.8 This supports our portrayal of the diversity of interests of the parties to CVC relationships and reflects diﬀerences in how new technologies and products are developed and commercialized across industries (Davidson, 1990; Hagedoorn, 1993). Three studies suggest positive eﬀects of CVC investors in information technology and telecom industries. Maula and Murray (2000) found higher post-IPO valuations for companies financed by multiple CVC investors and by CVC investors and venture capital funds than for those funded only by venture capital funds. Henderson and Leleux (2003) found higher IPO rates for new ventures that also announced collaboration agreements with their CVC investors. Stuart (2000) also found that young semiconductor companies that developed technology alliances with large, technically well-endowed partners benefited in terms of augmented sales growth and patent activity. Recently, Maula et al. (2005) sought to identify the sources of new venture satisfaction with CVC investors in relationships that remained active. Two major benefits were found: (1) technological knowledge and social capital in (2) seeking access to additional funding and (3) to foreign customers. However, market knowledge and social capital in gaining access to partners or to domestic markets were not significant in explaining satisfaction. Even though these results attest to key strategic benefits from ongoing alliances, they do not address survival rates. In contrast, a study by Alvarez and Barney (2001) of 128 alliances in the biotech, information technology and oil and gas industries reported that 80 per cent of new ventures felt unfairly exploited by their large partners. In some cases, this involved actions detrimental to the long-term success of alliances and, in others, the disproportionate appropriation of value created in these alliances. Two linked studies of 200 R&D alliances of young biotech firms provide evidence of how the bargaining power of larger partners can negatively impact performance (Lerner and Merges, 1998; Lerner et al., 2003). Large, corporate partners often extracted substantial control rights and received the bulk of these rights when smaller firms had limited cash reserves and lacked immediate access to public financing. The studies revealed that alliances that assigned greater control rights to larger partners underperformed in terms of meeting subsequent development milestones. Equally important, underperformance was substantial when agreements had been signed in poor capital market environments. Discussion of the findings with industry executives supported the interpretation of the negative impacts of large firm bargaining power on new ventures. Interesting observations also surfaced regarding agency problems within large companies’ business development groups. Some executives noted that given long time horizons of alliances and frequent job changes of new business development managers, one of the few proxies for success of their activities was the toughness of the deals they negotiated. As a result, some business development oﬃcials extracted as many control rights as possible, regardless of how the allocation of these rights might influence the joint welfare of the alliance. These findings suggest that career dynamics within CVC units can have significant implications for the

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structure of deals, the evolution of mutually beneficial relationships with new ventures, and the outcomes of these relationships. Some research also suggests that conflicting interests and incentives within many industry-leading companies may influence failures in the development and commercialization of new technologies (Christensen, 1997; Leifer et al., 2000; Hill and Rothaermal, 2003). This is likely to be an important influence on the track records of smaller partners in realizing strategic benefits from CVC relationships (Hellmann, 1998). Capturing these benefits often requires significant eﬀorts in navigating the complex structures and organizations of larger partners which may not act with unified intent. This suggests a need for researchers to study management of CVC-based relationships at a process level, an area which has received little attention to date. An important variable that can determine new ventures’ capacity to capture value from CVC relationships is ‘absorptive capacity’ (Zahra and George, 2002). New ventures are usually lopsided in their skills and knowledge bases, having only limited knowledge in one or two areas. New ventures need to develop and sustain a capacity to identify potentially valuable knowledge from their CVC collaborations, capture that knowledge, assimilate it and use it strategically by building new capabilities and upgrading existing ones (Lim and Lee, 2006). Building and honing absorptive capacity can be a costly and time consuming process. In turn, this requires entrepreneurs to stay focused on the knowledge flows emanating from their CVC partnerships and on identifying the most salient types of knowledge. Doing so demands managerial foresight as well as an understanding of the potential trajectory of an industry’s evolution. It also necessitates ensuring the rapid and eﬀective flow of knowledge throughout the firm’s operations, either through internal R&D activities or the use of licensing, alliances or similar means. Building an eﬀective absorptive capacity does not ensure the creation of value, however. Zahra and George (2002) emphasize the need for having appropriate systems and processes that transform knowledge into products and goods. Zahra et al. (2006a) argue that new ventures have to develop a ‘knowledge conversion capability’ (KCC) for this purpose. KCC denotes a new venture’s capacity to transform research and scientific discoveries into successful products that are quickly and eﬃciently commercialized. It centers on envisioning, conceiving and articulating ways in which knowledge inflows can be creatively used and then integrating and embedding this knowledge into innovative products, goods and services that create value. Having and using KCC, therefore, can enable new ventures to exploit knowledge inflows from their CVC relationships. Another important task for entrepreneurs is to integrate knowledge inflows from CVC relationships with the knowledge their new ventures have. Integration is more than a simple addition or combination of diﬀerent types of knowledge. Oftentimes integration requires rethinking the nature, content, structure and potential uses of knowledge. Performing each of these activities takes time and entails risks for entrepreneurs and their companies. Integration also requires attention to organizational political issues, dealing with diverse views of knowledge, and diﬀerent cognitive models that new ventures’ employees and managers have. As a result, eﬀorts at integrating internal and external knowledge might slow new ventures’ quest for successful commercialization and may even backfire as the distinctive quality of internal knowledge is lost. Still, integration can yield new and radically innovative knowledge that could be used to leapfrog existing products and the technological paradigms that underlie them.

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Achieving productive collaborations with CVC investors What can entrepreneurs and new venture managers do to extract the strategic benefits from CVC relationships while mitigating the risks of harmful behavior by larger partners? Even when trust exists between parties, the threat of opportunism cannot be totally eliminated. Therefore, we focus our attention on those situations where perceptions of prospects for joint gains are suﬃcient to motivate both parties to expend the energy necessary to develop and sustain collaborations.9 We explore the merits of four approaches: contracting, unbundling of alliance activity, board membership, and proactive relationship management. We also provide some evidence of new ventures using these approaches to reduce the gap between the potential and realized gains from CVC relationships. Contracting The venture capital literature provides extensive treatment of how investors use financial contracting to mitigate agency concerns about new ventures (Sahlman, 1990; Kaplan and Stromberg, 2002). Contract negotiations can also provide new ventures with opportunities to mitigate agency concerns about CVC investors and to test the prospects for cooperative behavior (Cable and Shane, 1997). Lerner and Merges (1998) identify several areas where new ventures generally maintain control rights: process development, alliance expansion, termination of other than focal projects, sub-licensing, ownership of patents and core technology, and board seats. New ventures often cede control of management of clinical trials, final product manufacture, marketing and decisions to shelve focal projects. Clearly, contracting can provide some protection to new ventures. These firms can also succeed in renegotiating contracts, which may reflect uncertainty reduction about alliance value and growing trust between parties (Lerner et al., 2003). Yet, it is important to recognize the costs and limits of contracting. Complex agreements and protracted negotiations can drain cash and managerial resources of new ventures. Defense of negotiated rights can prove costly, and prospects of success will diﬀer across intellectual property protection regimes (Cohen et al., 2001). Katis and Young (2004) interviewed eight veterans of CVC investments, half from each side of these relationships. Responding managers were unanimous in their views that the burden for capturing value from potential strategic benefits lay with new ventures and that they should recognize the need to invest time and travel expenses to accomplish this. They also noted that it was vital to proactively cultivate relations with multiple supporters at business unit levels and that this should begin during the search for potential CVC investors. One executive said, ‘Don’t assume that just because the CVC program invested in you that the rest of the company understands your business. You have to articulate and communicate your value proposition to particular business units.’ Another manager cited a young company which assigned a relationship manager to work with CVC oﬃcials and business units. He talked weekly with them to exchange information on product and customer activity. These findings reinforce the growing belief in the literature that new ventures have to work hard at keeping an on-going dialog with multiple key managers in CVC investor companies. Unbundling of alliance activity into multiple projects This approach can mitigate the risks of appropriation of intellectual property. It also oﬀers a basis for moving from a one-time contracting approach to a broader relationship

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mindset. This mindset develops as partners collaborate, work through their perceived and real diﬀerences and achieve a greater understanding of mutual interests. This process can reduce information asymmetries while building collaboration and mutual trust (Cable and Shane, 1997; Dyer and Singh, 1998).10 One executive of a new venture put it this way: ‘An alliance is a broad-based agreement that we will collaborate over a very broad set of issues. So it is more than just one project, more than one program, more than just one technology where we have similar interest areas’ (Alvarez and Barney, 2001, p. 147). Board membership Board membership or observer status can expose CVC investors to discussions about the strategy that the new venture will follow. It may also give CVC investors valuable insights into technology and market developments, barriers to the firm’s attempts to commercialize the technology, and conflicts within the top management team. This first-hand exposure can be important for recognizing and interpreting tacit knowledge. However, Gompers and Lerner (2001) identify several drawbacks to board membership by established companies. Membership exposes the investor company to potential legal liabilities. Entrepreneurs are often uncomfortable with corporate representatives on their boards. Entrepreneurs also fear the appropriation of proprietary technology and competitive information or misuse of this information, for example to pre-empt the younger firms’ plans or subsequent merger negotiations. While non-disclosure agreements can address some of these concerns, they seldom eliminate them. The more potent antidotes for moral hazards are common interests and mutual trust. Proactive relationship management Trust develops over time, based on frequent and mutually beneficial exchanges. Trust requires credible commitments as well as a mindset that encourages collaborative and supportive behavior. A new venture seeking long-term, profitable relationships with a CVC investor should therefore demonstrate a willingness to build this relationship. Two types of trust are recognized in the literature. The first is calculative and is based on a party’s assessment of the potential risks and returns of collaboration. New ventures can induce this type of calculative trust through careful contracting and negotiation, as we have suggested earlier. The second type of trust is relational in nature. It rests on lateral communication, frequent and honest disclosure, and mutual sharing of information and other resources. In developing and sustaining relational trust, calculations are slowly augmented by a belief that one party will not take advantage of the other’s vulnerabilities and will not exercise its powers to coerce the other into acquiescence or compliance. Rather, emphasis is on developing mutual understanding that fosters joint problem solving and information sharing. Relational trust generates social capital between the entrepreneurial firm and CVC partner (Maula et al., 2005). To be eﬀective in building relational trust, a new venture has to be skilled in identifying relevant groups and actors within the incumbent’s organization and in its communicating with them. Frequently, these actors are placed in the CVC unit and interact with business unit managers and others in the corporation (Gompers and Lerner, 2001). Members of the CVC unit have a vested interest in keeping track of what the ventures in their portfolio are doing and how well they are progressing in serving their goals. This can set the stage for frequent communication between new ventures and CVC providers’ staﬀ.

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Developing relational-based trust is a time consuming process that is fraught with uncertainties. First, the risk of opportunism might decline but it certainly persists. Opportunism is likely as long as actors have access to diﬀerent types of information, hold diﬀerent perceptions of process or outcomes, or pursue diﬀerent goals. Second, members of the incumbent’s CVC unit are under significant pressures to share their findings with those in their strategic business units, possibly compromising their positions with their portfolio ventures. Information about what new ventures plan to do with their technology or in markets could be of great value to incumbents as they explore ways to protect their established positions. Sharing that information could compromise the position of the CVC unit (or staﬀ) in their communications or other interactions with new ventures. Third, the membership and objectives of the CVC unit are subject to major and sometimes frequent changes (Gompers and Lerner, 2001). Companies may change objectives about what they want to achieve through their CVC program and the metrics used in evaluating that unit. These changes introduce uncertainty into the communications process, making relational trust more diﬃcult to sustain over time. Fourth, young companies have obvious limits on how much time and how many resources they can devote to relationship management. To summarize, our discussion makes clear that entrepreneurs should ‘trust but verify’ the intent and actions of their CVC providers. Transactional cost analysis would favor formalized, strict monitoring which is diﬃcult to conduct especially where there are considerable power, information and resource asymmetries among parties. New ventures may not be well staﬀed or have the resources to monitor CVC providers on a consistent basis. These ventures cannot rely solely on trust, especially when a powerful partner can capture their knowledge and intellectual property and use it to advantage. However, excessive trust can blind venture managers to the potential opportunism of CVC providers. This absolute trust can have dysfunctional eﬀects that can undermine the very existence of the new venture itself. The astute entrepreneur has to balance trust with some of the formal mechanisms we have just discussed to ensure the protection of the venture’s intellectual property, realizing that the best protection lies in causal ambiguity where the CVC provider cannot decipher what the new venture is doing (Zahra and Chaples, 1993). Embedding innovations and intellectual property into the new ventures’ systems, internal processes and organization is another important means to achieving this goal. Overall, our discussion shows that both trust and transaction-based monitoring are necessary when uncertainty is high and outcomes of the relationship are subject to interpretation and change. Transaction and relational governance therefore could be eﬀective complements, not substitutes. Discussion CVC investments oﬀer opportunities for incumbents and new ventures to collaborate and acquire new skills and capabilities. Adopting the perspective of the entrepreneur and her/his new venture, we have highlighted the importance of CVC for gaining access to financial resources, complementary assets and market information. CVC investments also provide an important signal of a new venture’s legitimacy and viability. We have argued that the congruence of goals of new ventures and incumbents are a crucial requirement for a ‘win–win’ partnership between these parties (Table 16.1). Yet, the stakes are too high for both parties to assume that good intentions will lead to satisfactory and sustainable results. New ventures have to work to curb incumbent partners’ potential opportunism through

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contracting, patenting, licensing, legally binding non-disclosure agreements, selective board membership decisions, syndicated investments, and making credible investments in building and sustaining their relationships with their CVC partners. Our discussion suggests several implications for entrepreneurs and new ventures, as discussed next. Implications for managerial practice Our discussion highlights the importance of several managerial actions that can improve new ventures’ gains from CVC. Notably, there is a need for due diligence in selecting CVC partners. We have outlined several criteria that entrepreneurs can apply in this process but it is worth reiterating the need to go beyond numbers. It is important for entrepreneurs to probe CVC investors’ motives, goals, track records, personnel and overall credibility. Entrepreneurs are busy people who often err by favoring speed over gaining insights into their partners. Clouded by the ‘illusion of control’, some entrepreneurs may come to believe that they can ‘fix’ problems as they arise. This is not always possible, especially when valuable information about a company’s proprietary technologies, skills, trade secrets, weaknesses and strategies leaks to outsiders. Entrepreneurs also need to communicate the goals of their new ventures clearly to potential CVC providers. It is equally important to seek clarifications about their CVCs’ partners’ goals related to investing in their new ventures. Even though these goals are likely to change over time, understanding them initially sets the stage for a clearer and more congruent alignment of goals. Entrepreneurs therefore need frequently to reassess their goals and those of their partners to ensure an eﬀective fit. Future research directions We believe that research opportunities on the various benefits of CVC for new ventures abound. Yet, as we reviewed the literature, we could only find a few studies on the topic – highlighting the need for better theory development and testing in this fertile area. Clearly, we need to move beyond anecdotal evidence and case-based research and apply a more systematic and theory-grounded approach (Maula, 2001). Thousands of CVC deals have been completed in the US and elsewhere, oﬀering a broad basis to theorize about conditions under which they can create value for investors and new ventures. Agency, strategic contingency, institutional and knowledge based theories could oﬀer a foundation for examining these conditions and delineating the eﬀect of CVC on new ventures and investors. Theory building and testing could substitute individual case studies to begin to provide reliable generalizations that can guide eﬀective managerial practice. Fortunately, recent published research on the topic shows a great deal of attention to careful theory building and empirical testing (Dushnitsky and Lenox, 2005; 2006). Future researchers would also benefit from examining how new ventures select their CVC partners. As stated throughout this chapter, there are multiple criteria for new venture managers to consider as they evaluate potential CVC investors and it is useful to determine the relative importance of these criteria across industries, diﬀerent stages of the ventures’ evolution, and time periods. How do venture managers rank the tangible and intangible attributes of potential CVC investors? How do these rankings relate to industry and strategic variables and the preferences and skills of entrepreneurs? Answering these questions can improve our understanding of how entrepreneurs choose CVC providers and how they begin to build their relationship with them.

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Throughout this chapter, we have discussed several legal and relational ways that new ventures can curb the opportunism of their CVC partners. It would be useful to develop theories that allow us to predict the viability of these approaches under diﬀerent industry and competitive conditions. Empirical studies that identify and clarify these conditions would also enrich the literature. Are these approaches complementary? Do they substitute for each other? If so, when and how does this influence the relationship between new ventures and incumbents? What are the types of social capital that determine this substitutability? Maula et al. (2005) highlight diﬀerent roles for social capital in the context of CVC, and future researchers would benefit from exploring these roles. Recent analyses also suggest that the capabilities of CVC partners have important implications for new ventures’ knowledge acquisition and learning (Zahra, 2006a). For instance, ventures that obtain funding from well established technological leaders are more apt to learn a great deal more about technology commercialization than those ventures that have technologically weaker partners. These preliminary findings indicate a need to delve more deeply into CVC partners’ knowledge and capabilities and how they might influence new ventures’ learning. These results extend and revise the prevailing wisdom by showing that these ventures also learn from their relationships with established companies. This learning, in turn, depends greatly on the social capital and absorptive capacity of new ventures and entrepreneurs’ willingness to build trusting relationships with their CVC partners (Zahra, 2006a). Understanding potential partners’ skills and knowledge requires due diligence by new venture managers who have to analyze the capabilities of CVC providers. Therefore, managers might seek the feedback of other ventures that received CVC support from a given provider, inquire about the ease by which knowledge and skills were transferred, any barriers that limited such transfers, and the quality of skills and information transferred. Partners’ reliability in keeping their promises regarding skill and resource transfers should be a central issue. New venture managers can also use formal and informal competitive analysis techniques to gather and assess information about partners’ reliability in sharing their knowledge. New ventures often need help with strategic planning, marketing and manufacturing capabilities and established companies typically possess competent staﬀ who perform these activities. New venture managers should openly discuss with potential CVC providers the extent to which they are willing to share their knowledge and the appropriate forum in which this sharing is likely to occur. Finally, future research would benefit from applying and testing the relationships suggested in Table 16.1 and the applicability of the relational approach we discussed throughout this chapter. Complementarities vs. competition between CVC providers and new ventures could influence the potential payoﬀ from exploratory vs. exploitative investments that incumbents make. Several research questions arise from considering Table 16.1 and deserve attention. For instance, does the timing of investment (late vs. early) influence the payoﬀ from exploratory vs. exploitative CVC funding? How do new ventures ensure complementarity when making CVC decisions? When does complementarity give way to competition between the CVC provider and the venture receiving funding? Conversely, when does the relationship between these two groups change from competition to complementarity? Empirical studies along these lines can enrich our understanding of the payoﬀ from CVC for providers and new ventures.

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Conclusion Entrepreneurs and their ventures stand to gain a great deal from CVC relationships. Even though some CVC relationships provide a setting in which opportunistic behavior could flourish, others serve as an important means of legitimization and an eﬀective conduit for knowledge sharing and organizational learning. As we have presented throughout this chapter, opportunities for collaboration and learning increase significantly with new ventures’ use of legal and trust-based mechanisms to protect their intellectual property and curb their partners’ potential opportunism. Using the approaches we have outlined in this chapter, CVC investments could evolve into ‘win–win’ relationships for new ventures and their established corporate partners. Acknowledgements We acknowledge with appreciation the comments of Hans Landström, Markku Maula, Don Neubaum, Harry Sapienza and Patricia H. Zahra on earlier drafts of this chapter. The first author also expresses his gratitude for financial support of The Research Programme for Advanced Technology Policy (ProACT) of the Ministry of Trade and Industry and the National Technology Agency, Tekes (Finland) and the Glavin Center for Global Management at Babson College. The second author expresses his appreciation for financial support as holder of the Paul and Phyllis Fireman Charitable Foundation Chair at Babson College. Notes 1. 2. 3. 4.

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7.

8.

While CVC activity dates from the 1960s (Rind, 1981), we focus on the previous decade because investment levels, sectoral focuses of activity, and program characteristics diﬀer significantly from prior periods (Gompers, 2002; Dushnitsky and Lenox, 2005). Estimates of investment are derived from analyses of the Thomson Venture Economics database and exclude indirect and certain direct activity. They may also understate substantial activity by Asian firms (Haemmig, 2003). Allen and Hevert (2007) provide evidence on direct performance of CVC programs. Some observers view the possibilities we describe as real options (McGrath, 1997). While option logics are broadly consistent with our treatment, their underlying assumption of a right but not obligation to take subsequent actions is not fully representative. In many instances, exploratory investment does not convey a contingent claim to pursue additional strategic benefits. This is often subject to negotiation among the parties. Also, there are numerous examples of renegotiation of alliance agreements by investees (Lerner et al., 2003). This assumes bounded rationality of investors in establishing and applying criteria for strategic relevance of targets. A Corporate Strategy Board (2000) study indicates that this may be the case for a subset of best practice companies. However, it also cites misaligned criteria and inconsistency and lack of rigor in screening and monitoring processes as major challenges for the wider population of CVC programs. Opportunism discourages the flow of information between new ventures and incumbents, thus depriving established companies of a vital source of information about pending technological and other competitive changes. When the threat of opportunism is high, new ventures may withhold information or share it selectively with their CVC investors. New ventures can also induce causal ambiguity by omitting key details about their technologies. When their technologies are vastly diﬀerent from those of the incumbents, ambiguity becomes real and incumbents cannot ascertain cause–eﬀect relationships. There are serious implications for new ventures’ eﬀorts aimed at reducing incumbents’ potential opportunism. While diﬀerences in strength of intellectual property protection regimes (Cohen et al., 2001; Dushnitsky & Lenox, 2005) may influence young firm attitudes in low goal congruence situations, limited evidence is available. Kann (2000) finds that industries with stronger intellectual property protection have more CVC programs with early-stage investment missions; however, his data do not extend to views of investees or to characteristics of deals. The broader alliance literature provides evidence of value creation: positive average wealth eﬀects around announcement dates, heterogeneity of results across samples, and wealth creating learning eﬀects for firms which make repeated use of R&D joint ventures (Chan et al., 1997; Anand and Khanna, 2000). Whether

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10.

Handbook of research on venture capital these results extend to CVC-based alliances and the issues of division of gains among partners remain empirical questions. CVC investments in low goal congruence situations often may not meet this condition. This is an issue of adverse selection, which we treat earlier in the chapter. Syndicated investment with venture capitalists or other CVC programs may mitigate risks of hold up or appropriation of intellectual property by a single corporate investor (Maula and Murray, 2000), but this does not address how to generate positive strategic benefits from a relationship. This relates to the role of relational capital in obtaining productive outcomes from alliances. In a survey of 212 managers who had been involved in alliances in technology intensive industries, Kale et al. (2000) found positive relationships among relational capital, integrative conflict management behavior, organizational learning, and protection of proprietary assets. They did not address CVC-based alliances per se or economic significance of outcomes for partners.

References Allen, S.A. and K.T. Hevert (2007), ‘Venture capital investing by information technology companies: did it pay’, Journal of Business Venturing, 22, 262–82. Alvarez, S.A. and J.B. Barney (2001), ‘How entrepreneurial firms can benefit from alliances with large partners’, Academy of Management Executive, 15(1), 139–48. Anand, B.T. and T. Khanna (2000), ‘Do firms learn to create value? The case of alliances’, Strategic Management Journal, 21, 295–315. Baldwin, C.W. and K.B. Clark (2000), Design Rules: the Power of Modularity, Cambridge, MA: MIT Press. Birkinshaw, J., R. van Basten Batenburg and G. Murray (2002), ‘Corporate venturing: the state of the art and prospects for the future’, Working Paper, London Business School. Breyer, J. (2000), ‘Accel partners’, reprinted in U. Gupta (ed.), Done deals: Venture Capitalists tell their Stories, Boston, MA: Harvard Business School Press, pp. 331–47. Cable, D.M. and S. Shane (1997), ‘A prisoner’s dilemma approach to entrepreneur–venture capitalist relationships’, Academy of Management Review, 22(1), 142–76. Chan, S.H., J.W. Kensinger, A.J. Keown and J.D. Martin (1997), ‘Do strategic alliances create value?’, Journal of Financial Economics, 46, 199–221. Chesbrough, H.W. (2002), ‘Making sense of corporate venture capital’, Harvard Business Review, 80(3), 90–97. Chesbrough, H.W. (2003), Open Innovation, Boston, MA: Harvard Business School Press. Christensen, C. (1997), Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, Boston, MA: Harvard Business School Press. Christensen, C.M. and M.E. Raynor (2003), The Innovator’s Solution, Boston, MA: Harvard Business School Press. Cohen, W.M. and D.A. Levinthal (1990), ‘Absorptive capacity; a new perspective on learning and innovation’, Administrative Science Quarterly, 35, 128–52. Cohen, W., R. Nelson and J. Walsh (2001), ‘Protecting their intellectual assets: appropriability conditions and why US manufacturing firms patent (or not)’, Working Paper 7552, National Bureau of Economics Research. Corporate Strategy Board (2000), ‘Corporate venture capital: managing equity investments for strategic returns’, Working Paper 071-241-955, Washington DC. Davidson, W. (1990), ‘Technology environments and organizational choice’, Journal of High Technology Research, 1(1), 15–38. Dess, G.G., R.D. Ireland, S.A. Zahra, S.W. Floyd, J.J. Janney and P.J. Lane (2003), ‘Emerging issues in corporate entrepreneurship’, Journal of Management, 29(3), 351–78. Dushnitsky, G. (2004), ‘Limitations to inter-organizational knowledge acquisition: The paradox of corporate venture capital’, doctoral thesis, New York, NY: Stern School of Business. Dushnitsky, G. (2006), ‘Corporate venture capital: past evidence and future directions’, in M. Casson et al. (eds), Oxford Handbook of Entrepreneurship, Oxford: Oxford University Press. Dushnitsky, G. and M.J. Lenox (2005), ‘Corporate venture capital and incumbent firm innovation rate’, Research Policy, 34(5), 615–39. Dushnitsky, G. and M.J. Lenox (2006), ‘When does corporate venture capital create firm value?’, Journal of Business Venturing, 21(4), 753–72. Dyer, J.H. and H. Singh (1998), ‘The relational view: cooperative strategy and sources of inter-organizational competitive advantage’, Academy of Management Review, 23(4), 660–79. Foster, R.N. (1986), Innovation: The attacker’s advantage, New York, NY: Summit Books. Gompers, P.A. (2002), ‘Corporations and the financing of innovation: the corporate venturing experience’, Federal Reserve Bank of Atlanta Economic Review, 87(4), 1–18. Gompers, P.A. and J. Lerner (1998), ‘The determinants of corporate venture capital success: organizational structure, incentives, and complementarities’, Working Paper 6725, National Bureau of Economic Research, Washington, DC.

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Gompers, P.A. and J. Lerner (1999), The Venture Capital Cycle, Cambridge, MA: MIT Press. Gompers, P.A. and J. Lerner (2001), The Money of Invention: How Venture Capital Creates New Wealth, Boston, MA: Harvard University Press. Grant, R.M. (1996), ‘Toward a knowledge-based theory of the firm’, Strategic Management Journal, 17, 109–22. Haemmig, M. (2003), ‘The globalization of venture capital’, doctoral thesis, California School of International Management, USA. Hagedoorn, J. (1993), ‘Understanding the rationale of strategic technology partnering: interorganizational modes of cooperation and sectoral diﬀerences’, Strategic Management Journal, 14, 371–85. Hellmann, T. (1998), ‘Some thoughts on the theory of corporate venture investing’, Corporate Governance Today, Columbia University Law School, May, pp. 37–43. Hellmann, T. (2002), ‘A theory of strategic venture investing’, Journal of Financial Economics, 64, 285–314. Henderson, J. and B. Leleux (2003), ‘Learning to eﬀect resource combinations and transfer in corporate venture capital programs: an empirical appraisal’, Working Paper, Babson College, MA. Hill, C.W. and F.T. Rothaermel (2003), ‘Performance of incumbent firms in the face of radical technological innovation’, Academy of Management Review, 28(2), 257–74. Iansiti, M. and R. Levien (2004), ‘Strategy as ecology’, Harvard Business Review, 84(30), 68–78. Ivanov, V.I. and F. Xie (2005), ‘Do corporate venture capitalists add value to startup firms? Evidence from venture-backed IPOs’, Working Paper, Vanderbilt University. Jensen, M. and W.M. Meckling (1976), ‘Theory of the firm: managerial behavior, agency costs, and ownership systems’, Journal of Financial Economics, 3, 305–60. Kale, P., H. Singh and H. Perlmutter (2000), ‘Learning and protection of proprietary assets in strategic alliances: building relational capital’, Strategic Management Journal, 21(3), 217–32. Kann, A. (2000), ‘Strategic venture capital investing by corporations’, doctoral thesis, Stanford University, USA. Kaplan, J. (1994), Startup: a Silicon Valley Adventure, Boston, MA: Houghton Miﬄin. Kaplan, S.N. and P. Stromberg (2002), ‘Financial contracting theory meets the real world: an empirical analysis of venture capital contracts’, Review of Economic Studies, 70(243), 281–315. Katis, N. and S. Young (2004), ‘Top ten ways to get the most value out of corporate venture capital’, Babson College student research report. Keil, T. (2002), External Corporate Venturing: Strategic Renewal in Rapidly Changing Industries, Westport, CT: Quorum. Keil, T., S. Zahra and M. Maula (2005), ‘Corporate venture capital and organizational learning from a portfolio of relationships’, unpublished paper, Toronto: York University. Kogut, B. and U. Zander (1992), ‘Knowledge of the firm, combinative capabilities, and the replication of technology’, Organization Science, 3(3), 383–97. Leiblein, M.J. and J.J. Reuer (2004), ‘Building a foreign sales base: the roles of capabilities and alliances of entrepreneurial firms’, Journal of Business Venturing, 19, 285–307. Leifer, R., C.M. McDermott, G.C. O’Connor, M. Rice and R.W. Veryzer (2000), Radical Innovation: how Mature Companies can Beat Upstarts, Boston, MA: Harvard Business School Press. Lerner, J. and R.P. Merges (1998), ‘The control of technology alliances: an empirical analysis of the biotechnology industry’, Journal of Industrial Economics, 46(2), 125–55. Lerner, J., H. Shane and A. Tsai (2003), ‘Do equity financing cycles matter? Evidence from biotechnology alliances’, Journal of Financial Economics, 67, 411–46. Lim, S.-J. and J.-D. Lee (2006), ‘The eﬀects of absorptive capacity and complementarities on corporate venture capital’, Working Paper, Seoul National University, Korea. March, J.G. (1991), ‘Exploration and exploitation in organizational learning’, Organization Science, 2, 71–87. Maula, M.V.J. (2001), Corporate Venture Capital and the Value-added for Technology-based New Firms, Espoo, Finland: Helsinki University of Technology, Institute of Strategy and International Business. Maula, M., E. Autio and G. Murray (2005), ‘Corporate venture capitalists and independent venture capitalists: who do they know and should entrepreneurs care?’, Venture Capital, 7(1), 3–21. Maula, M.V.J., E. Autio and G.C. Murray (2006), ‘How corporate venture capitalists add value to entrepreneurial young firms’, in J. Wiklund, D. Dimov, J.A. Katz and D.A. Shepherd (eds), Advances in Entrepreneurship, Firm Emergence and Growth, Vol. 9, Greenwich, Connecticut: JAI Press, pp. 267–309. Maula, M. and G. Murray (2000), ‘Corporate venture capital and the creation of US public companies: the impact of venture capital on the performance of portfolio companies’, in M.A. Hitt, R. Amit, C. Lucier and R.D. Nixon (eds), Creating Value: Winners In The New Business Environment, Oxford: Blackwell Publishers, pp. 164–87. Maula, M.J.V., T. Keil and S.A. Zahra (2003), ‘Corporate venture capital and recognition of technological discontinuities’, paper presented at the annual meeting of the Academy of Management, Seattle, Washington. McGrath, R.G. (1997), ‘A real options logic for initiating technology positioning investments’, Academy of Management Review, 22(4), 974–96. McNally, K. (1995), ‘Corporate venture capital: the financing of technology businesses’, International Journal of Entrepreneurial Behaviour & Research, 1(3), 9–43.

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McNally, K. (1997), Corporate Venture Capital: Bridging the Gap in the Small Business Sector, London: Routledge. National Venture Capital Association (2004), Yearbook, Newark, NJ: Venture Economics Information Services. Pisano, G.P. (1991), ‘The governance of innovation: vertical integration and collaborative arrangements in the biotechnology industry’, Research Policy, 20, 237–49. Rind, K.W. (1981), ‘The role of venture capital in corporate development’, Strategic Management Journal, 2, 169–80. Rosenberger, J., R. Katila and K.M. Eisenhardt (2005), ‘The flip side of the coin: nascent technology ventures and corporate venture funding’, Working Paper, Stanford University. Rothaermel, F.T. (2001), ‘Incumbent’s advantage through exploiting complementary assets via interfirm cooperation’, Strategic Management Journal, 22, 687–99. Sahlman, W. (1990), ‘The structure and governance of venture capital organizations’, Journal of Financial Economics, 27, 473–521. Schoonhoven, C.B. (2005), ‘Liability of newness’, in M.A. Hitt and R.D. Ireland (eds), Blackwell Encyclopedia of Management, Vol. 3, Oxford: Blackwell Publishing, pp. 171–5. Siegel, R., E. Siegel and I.C. MacMillan (1988), ‘Corporate venture capitalists: autonomy, obstacles, and performance’, Journal of Business Venturing, 3, 233–47. Smith, G. (2001), ‘How early stage entrepreneurs evaluate venture capitalists’, Journal of Private Equity, 4(2), 33–46. Stuart, T.E. (2000), ‘Interorganizational alliances and the performance of firms: a study of growth and innovation in high technology industry’, Strategic Management Journal, 21, 791–811. Sykes, H.B. (1990), ‘Corporate venture capital: strategies for success’, Journal of Business Venturing, 5(1), 37–47. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York, NY: Free Press. Winters, T.E. (1988), ‘Venture capital investing for corporate development objectives’, Journal of Business Venturing, 3(3), 207–23. Zahra, S. (2006a), ‘New venture strategy: transforming caterpillars into butterflies’, in S.C. Parker (ed.), The Life Cycle of the Entrepreneurial Venture, New York: Kluwer, pp. 39–73. Zahra, S. (2006b), ‘When do new ventures learn about technology from well established companies? A relational capital perspective’, unpublished paper, Carlson School of Management, University of Minnesota. Zahra S. and S. Chaples (1993), ‘Blind spots in competitive analysis’, Academy of Management Executive, 7(2), 7–28. Zahra, S. and G. George (2002), ‘Absorptive capacity: a review. Reconceptualization and extension’, Academy of Management Review, 27(2), 185–203. Zahra, S., S. Nash and D. Bickford (1995), ‘Transforming technological pioneering into competitive advantage’, Academy of Management Executive, 9(1), 17–31. Zahra, S., E. van de Velde and B. Larrañeta (2006a), ‘Knowledge conversion capability and the performance of corporate and university spin-oﬀs’, unpublished paper, Carlson School of Management, University of Minnesota. Zahra, S., R.I. Yavuz and D. Ucbasaran (2006b), ‘How much do you trust me? The dark side of relational trust in new business creation in established companies’, Entrepreneurship: Theory & Practice, 30(4), 541–59.

PART V IMPLICATIONS

17 Implications for practice, policy-making and research Hans Landström

In this Handbook of Research on Venture Capital we have tried to show the ‘research front’ of our knowledge on venture capital – what we know about venture capital – but, the chapters also clearly indicate what we do not know. This final chapter is intended to provide some suggestions for researchers, doctoral candidates and masters students on the future direction of our understanding about venture capital as well as trying to answer the question: where are we going in venture capital research? In the previous chapters we have tried to learn from earlier knowledge in the respect that we try to communicate to reflective entrepreneurs, venture capitalists and policymakers what conclusions can be drawn from research on venture capital and how our knowledge can be applicable to their field of activities and the understanding of venture capital. Therefore, in the second section of this chapter we will try to answer the question: what advice can be given to practitioners and policy-makers? Where are we going in venture capital research? Although research on venture capital has been in progress for a quarter of a century and we now have a great deal of knowledge that did not exist 10–15 years ago, many unanswered questions remain. The authors of the chapters in the book have all tried to pinpoint these questions and provide some indications of where venture capital research is going. Venture capital research in general Based on the arguments by Van de Ven and Johnson (2006) on ‘engaged scholarship’ and Ghosal (2005) on ‘positive organizational scholarship’, Harry Sapienza and Jaume Villanueva (Chapter 2) exhort venture capital researchers to immerse themselves in the phenomenon of venture capital and foster increased stakeholder cooperation in order to broaden as well as deepen our theoretical knowledge and the methods used in our studies, in addition to addressing important questions that enrich theory and practice in a meaningful way. Sapienza and Villanueva make the following recommendations for future studies on venture capital: ● ● ● ● ● ●

Stay close to the phenomenon and study ‘big’ issues. Develop learning communities among academics and the venture ecosystem. Study phenomena over time via multiple theories and methods. Seek a balanced, humble view that reaches beyond rational self-interest. Explore the ethical and aﬀective aspects of decision-making. Explore the bright side of entrepreneurship and its value creating correlates.

Focusing on the geographical aspects of venture capital, Colin Mason concludes in Chapter 3 that the geographies of venture capital have been largely ignored by scholars in 415

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entrepreneurship and finance and have only attracted limited attention from economic geographers. Thus, there is a more or less ‘open field’ of research to explore, and Mason prioritizes five topics for future research: ●

● ● ● ●

In business angel research there is a need to ‘put boundaries on our ignorance’, for example, better quality statistical information on the local distribution of business angels, the characteristics of business angels in diﬀerent locations, and so on. Make use of databases that enable researchers to explore a greater range of geographical questions. Move from the macro-scale and quantitative data, to the micro-scale and qualitative data. There is a need to clarify the connection between venture capital and technological clusters. A very great deal of our knowledge reflects what happens in dynamic regions such as Silicon Valley and Boston, but we need to recognize venture capital practices in other regions.

In Chapter 4 Gordon Murray discusses the relationship between policy and research, and the somewhat contradictory link between policy-makers’ wish to know how to change or improve systems in order to achieve tangible and cost eﬀective outcomes, preferably quickly, and the many scholars who feel comfortable taking a purely theoretical interest in venture capital finance. However, we have seen an increase in the interest in ‘policy-oriented research’ and Murray suggests some domains in which we need further knowledge: ● ● ●

● ●

The existence of the equity capital gap. Does an equity capital gap exist and, if so, at what levels of finance, who is aﬀected, and are there adverse material consequences? The eﬃciency of government actions. Which government actions are most eﬀective in stimulating venture capital investments? Business angels are seen as an alternative to institutional venture capital. Is this assumption empirically valid? By what means can business angels succeed in earlystage market conditions? How can business angels and venture capitalists most eﬀectively work together to support potential ventures? ‘Hybrid’ venture capital programs. By what means should public/private ‘hybrid’ venture capital programs be evaluated? Internationalization of venture capital. The venture capital industry has become globalized, and more comparative studies are needed. How can emerging economies learn from current venture capital experience?

In addition, Murray addresses and follows up on the discussion introduced by Sapienza and Villanueva in Chapter 2 and encourages collaboration between policy-makers and scholars in the field of venture capital. But this is not an easy task – policy-makers frequently prefer inter-disciplinary teams that address big issues with strong evaluative and executive recommendations and it is not easy for academic researchers to meet these needs while still being able to undertake studies capable of scholarly validation via peer

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review – which requires a high level of trust building and mutual understanding between academics and policy-makers, something that is still largely in its infancy. Institutional venture capital In Part II of the handbook several authors elaborated on institutional venture capital. In Chapter 5 Douglas Cumming, Grant Fleming and Armin Schwienbacher examined the structure and governance of diﬀerent types of venture capital organizations. Regarding future research themes they oﬀered the following suggestions: ●

●

●

Internationalization of venture capital – the internationalization of the industry raises a number of new research questions, such as, how will venture capital markets evolve around the world, how does internationalization impact on venture capital firm structure and management, and will the growth of new markets with diﬀerent legal systems lead to diﬀerent styles of venture capital investing? Business culture and venture capital fund structure. The venture capital model is mainly based on an Anglo-Saxon (especially US) business tradition. As the venture capital industry becomes more international, venture capital must merge with other business cultures, which may question existing models and constitute a dynamic basis for interesting research in the future. Emerging fund structures. The professionalization of the venture capital industry has led to new structures, for example, the venture capital fund-of-funds and listed venture capital funds, but we still need more research on these emerging structures – their development, characteristics and performance.

In Chapter 6, which deals with venture capitalists’ pre-investment process, Andrew Zacharakis and Dean Shepherd call for more research on: (1) decision heuristics – heuristics can be eﬃcient for time constrained venture capitalists, but we need to know more about how and when to use it, and (2) biases in venture capitalists’ decision-making – we need to gain further insights in order to minimize the potentially negative impact of decision-biases. In addition, despite the fact that the research on venture capitalists’ investment activities has been more and more theoretically based – mainly relying on strategy research – there is a need to move beyond theories of strategy and explore other theoretical frameworks, for example, in psychology and sociology, as well as investigating how decision-making criteria might diﬀer across both the venture capital process and the venture’s development stage. Dirk De Clercq and Sophie Manigart in Chapter 7 reviewed and synthesized our knowledge of venture capitalists’ activities after the investment has been made. Regarding the post-investment phase they suggest that future research should further elaborate on how the heterogeneity of venture capitalists’ monitoring and value-adding activities depends on the combination of (1) venture capitalist characteristics, (2) characteristics of the entrepreneur and the venture, and (3) the institutional and social environment in which both parties are embedded. In addition, research should build further on the literature pertaining to how value is added in the venture capitalist–entrepreneur relationship, and in particular, how the exchanges of specific knowledge and the process of such exchanges aﬀect investment performance. Finally, our knowledge would benefit from comparing how the context and process-related issues of monitoring and value-adding

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activities may diﬀer across diﬀerent investor types, for example, institutional venture capitalists, business angels and corporate venture capitalists. Chapter 8 follows up on this discussion, and Lowell Busenitz argues that research on venture capitalists’ value-adding has addressed rather broad questions and the studies have produced mixed results. According to Busenitz, we need to move beyond these broad questions and he suggests further research into several areas. First, we need to know more about (1) the internal governance structures that venture capitalists bring to the ventures – not least the activities on the board of directors in the venture capital context, (2) the provision of compensation to founders and top management teams and its consequences, and (3) the role of venture capitalists’ reputation and certification in the subsequent rounds of financing and in the IPO process. Second, research has only started to probe the question of the relationship between venture capital and the emergence of new industries – more work needs to be done – for example, we need to know more about questions such as: does venture capital investment lead to more innovations in society? What role does venture capital play in the emergence of new industries? A similar argument is oﬀered by Benoit Leleux in Chapter 9, who states that, despite several studies on venture capitalists’ value-adding activities, it is diﬃcult to find consensus in the results, and one important issue in this respect is the problem of measuring financial returns on venture capital investments in early stage, privately held ventures. Leleux concludes that we need a great deal more research on measuring venture capital performance. In her review of our knowledge on early stage venture capital, Annaleena Parhankangas concludes in Chapter 10 that after decades of research we still have limited knowledge about venture capital investments in early stage ventures. Parhankangas makes the following suggestions for future studies: ●

●

●

●

There is a declining trend worldwide in venture capital investments in early stage ventures, but we don’t know the reasons behind it. Therefore, we need studies to identify changes in the incentive systems and governance structures within the venture capital industry that may explain the relative decline in investments in early stage ventures. It could be argued that the financial needs of early stage ventures can be best addressed by a combination of diﬀerent financial sources – public funding, informal investors and early stage venture capitalists – and we need research that addresses the complementarities and synergies between diﬀerent sources of early stage financing. There seem to be regional diﬀerences and diﬀerent traditions between countries in the finance of early stage ventures, and we need to explore how venture capital could appear in diﬀerent contexts. The greatest challenges for venture capitalists investing in early stage ventures are cognitive in nature – the perception of risks and trying to make sense of the chaotic environment surrounding new ventures. Therefore, research on early stage venture capital benefits from borrowing from research fields such as human cognition and information processing mechanisms.

The private equity and management buy-out market is discussed by Mike Wright in Chapter 11, where he identifies some gaps in earlier knowledge related to (1) the development of private equity and buy-out markets, and (2) the life-cycle of buy-outs:

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The development of private equity and buy-out markets: ● ●

●

Changes in deal characteristics over time, for example, comparative analyses of diﬀerent time periods. International aspects of private equity and MBOs, for example, the influence of contextual factors in the growth of the market as well as focus on the internationalization of private equity firms. Source of MBOs – in this respect neglected areas of research are the linkage between early stage venture capital funds and buy-out funds as well as buy-out investments and the succession problems facing many family firms.

The buy-out life cycle: ●

● ●

Organizational forms of financiers – private equity firms can take several organizational forms, and we need more knowledge on how diﬀerent organizational forms impact on the buy-out life-cycle. The added value brought about by MBOs. Exiting MBOs, that is issues concerning the ability of private equity firms to realize the gains from their investments.

Informal venture capital Looking more closely at informal venture capital in Part III of the Handbook, Peter Kelly highlights in Chapter 12 a number of issues that need to be tackled in business angel research. According to Kelly, we need to know more about: ●

● ● ●

The early funding gap, that is the gap between the funding achieved by the three Fs (founder, family and friends) and business angel finance as well as the role and impact of public sector funding instruments in this context. Following the Global Entrepreneurship Monitor research initiative, we need to undertake business angel demographic studies beyond developed economies. The complementary nature of business angels and venture capital funds – are they complementary, and if so, in what way? Latent angels – individuals who have not yet made their first investment – seem to be an immense untapped potential in the informal venture capital market, and we need to know how to encourage them into the market.

Kelly argues that researchers on the informal venture capital market need to broaden their theoretical frameworks and include fields such as psychology and sociology, and highlights some methodological issues for future research. In Chapter 13, Allan Riding, Judith Madill and George Haines provide a review and synthesis of our knowledge regarding the decision-making process employed by business angels when making investments in new proposals – a central and long-standing theme of interest for researchers on informal venture capital. The authors suggest that: ●

We still do not possess a comprehensive model of how business angels make their investments – the investment process.

420 ● ●

●

Handbook of research on venture capital We need to know more about how decision criteria used by business angels can change as the investment process unwinds. Business angels are actively involved in the firms in which they invest, and we need to know more about the relationship between the investment process and postinvestment involvement. Business angels are usually not the only financier of a new venture – it is a mix of business angels, founders, banks, government money and even institutional venture capitalists – and we need to know more about how diﬀerent financiers of new ventures interact.

Riding, Madill and Haines also address some methodological issues of research on informal venture capital, and they argue that we need: (1) more theoretically based studies (not least when it comes to modelling the investment decision process); (2) more demand side research (seen from the entrepreneur’s perspective); and (3) in order to sort out the definitional problems that exist in informal venture capital research, we need to decompose the informal venture capital market into relevant segments, and by elaborating on these segments contribute to the understanding of how diﬀerent types of informal investors diﬀer in significant ways, including how they make their investment decisions. Jeﬀrey Sohl focused his chapter (Chapter 14) on a special feature of the business angel investment process – business angel portals – that are introduced in order to enhance the eﬃciency of quality deal flow and increase the availability of capital. Business angel portals have received considerable attention in previous research, but Sohl argues that many facets of angel portals remain misunderstood and thus require further research, for which he makes the following suggestions: ●

●

It is important to understand why some angel portals may be appropriate for certain regions and not for others as well as the role of angel portals in regional economic development. The relationship between angel portals and institutional venture capitalists – are there market complementarities or not?

In common with Riding, Madill and Haines in the previous chapter, Sohl suggests longitudinal methodological approaches in order to track changes in various portals over time. As seems to be the case for business angel research in general, Sohl advocates more theoretically based research on business angel portals and suggests that theories such as the eﬀectiveness of group structures, the interplay of group dynamics, social capital and social networks could provide an interesting basis for such theoretical development. Corporate venture capital Part IV of the book concerns the corporate venture capital market, and in Chapter 15 Markku Maula demonstrates that both the research and the practice of corporate venture capital have become increasingly sophisticated and that earlier research has answered many previously puzzling questions. However, several avenues for further research remain, and Maula emphasizes that the following issues need to be addressed:

Implications for practice, policy-making and research ● ● ●

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Analysis of benefits over costs under diﬀerent circumstances, such as various firm and industry level determinants and diﬀerent corporate venture capital strategies. The impact of corporate venture capital on the performance of corporations. The management of corporate venture capital operations, including investment processes, the use of corporate resources to facilitate corporate venture capital activity, knowledge integration from corporate venture capital investments, and internal performance measurement.

However, as shown by Shaker Zahra and Stephen Allen in Chapter 16, research on corporate venture capital that adopts the entrepreneur’s perspective has been sparse and fragmented, and the authors highlight the need for better theory development and testing within the area, that is theory building and testing could substitute for individual case studies in order to provide reliable generalizations that can guide eﬀective managerial practice. Furthermore, the authors suggest the following topics for future research: ●

● ● ●

New ventures’ selection of corporate venture capital partners and due diligence by new venture managers in order to gather and assess information about potential corporate venture capital partners. Legal and relational ways in which new ventures can curb the opportunities of their corporate venture capital partners. The influence of corporate venture capital partners’ knowledge and capabilities on the new ventures’ learning. The relationship between corporate venture capital investors and new ventures.

What advice can be given to practitioners and policy-makers? Implications for policy-makers Venture capital has been regarded as an influential factor in the creation of new firms and dynamics in the economy. This positive view has prompted governments around the world to see venture capital as an essential ingredient in their policies to facilitate entrepreneurship, innovation, employment and economic growth. This interest in venture capital has not least been shown in lagging regions where venture capital has been seen as a measure to change the prevailing situation into something positive – increasing growth and wealth in the region. However, as argued by Mason in Chapter 3, the mere availability of venture capital is not the solution, more needs to be done, for example: ● ●

●

Venture capital must be combined with talented individuals and role models. Providing capital is not the only role of venture capitalists, and thus creating venture capital funds staﬀed by managers who lack the value-added skills of venture capitalists will be ineﬀective. Trying to artificially create a regional pool of venture capital is likely to be unsuccessful – venture capital is only attracted to places with novel ideas and talented individuals – thus policy-makers should concentrate on developing their region’s technology base, encourage venture creation and growth and enhance the business support infrastructure.

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Murray devotes the whole of Chapter 4 to venture capital policy issues, and policymakers can learn a great deal from it. In order to conclude the chapter, Murray argues that despite the enormous growth in the amount of venture capital in many countries in recent decades, we cannot find the same level of success in public involvement in new venture financing. However, we have to remind ourselves that governments do not face an easy or unambiguous task: governments have to determine if they wish to intervene in order to correct market imperfections or realign incentives in a manner congruent with their policy goals; and government is usually involved in the least attractive areas of a financial market – the public becomes involved due to the absence of private investors. In addition, we still lack knowledge as to the appropriate role of government in venture capital activity, both in terms of theoretical understanding and the diversity of exemplar programs from which to benchmark progress. However, there seems to be growing academic consensus that sanctioning government intervention is a decision that should be taken with considerable caution and perhaps only when private venture capital markets are obviously failing. Murray provides some guidelines that policymakers may consider: ● ●

● ●

●

● ●

Institutional or informal venture capital programs should harness private investors’ interests and experience as agents of government program goals. There are trade-oﬀs between venture capital and business angel program outcomes. Policy makers should be explicit as to the ‘value’ of diﬀerent objectives when both launching and evaluating programs. There are major economies of scale and scope in venture capital fund activities. The level of unmanageable uncertainty in the very early stages of venture development may be such that it may not be sensible to allocate resources by market alone – venture capital should be seen as only one of a range of financing options. The premium for managerial and investor experience is high – program designers need to reflect on how such tacit knowledge may be best harnessed to address the challenges of early-stage investments. All new venture capital programs involving public funds should have a formal evaluation model built into the program at the design stage. The US provides a role model for venture capital worldwide. Much of the stock of knowledge in the US may be valid and relevant outside North America, although certain aspects will not be usable in other contexts. It is implausible that a global venture capital industry will, over time, be dependent on one absolute and exclusive model of success.

Elaborating on Murray’s comment about the US venture capital market as a role model, Leleux showed in Chapter 9 that the European venture capital market experienced a serious decrease in the rate of returns in the mid-2000s – the average 10-year investment horizon returns for early stage investments became negative on a per annum basis, and the performance of all venture capital classes was an unimpressive 5.3 per cent. A comparison with US venture capital market data revealed that the diﬀerences between European and US performance figures in terms of early-stage deals were the largest reported in the last 20 years, indicating that the US and European venture capital markets are at very diﬀerent stages of development.

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423

It is often assumed that institutional venture capital is an important contributor to the advancement of innovation and the emergence of new industries. The assumption is that venture capital is intimately involved in the development of entirely new industries – without venture capital investments these industries would not have been developed. However, in Chapter 8 Busenitz states that we still know very little about the impact of institutional venture capital in this respect, and he argues that, although there is evidence that venture capitalists invest in technology-based ventures that pursue an innovative strategy, it does not mean that they prefer to back the exploration of new technologies. On the contrary, most venture capitalists tend to become involved in later stages of development where capital requirements are larger and the distance to exit and pay-oﬀ is shorter. Especially, venture capitalists seem to be particularly helpful in the transition from the exploration of new technologies to their commercialization on the market. Thus, evidence suggests that venture capitalists seem to be reluctant to become involved in funding new ventures that are not part of an industry that is perceived to be developing, and in that respect, one can question the view of venture capitalists as drivers, or creators, of entirely new industries – indeed, this rarely seems to be the case. It would be more accurate to say that venture capitalists help to finance newer industries that are on the rise and show some growth rate. In Part III (Chapters 12 to 14) we discussed the informal venture capital market. From the survey it was evident that the informal venture capital market is fraught with ineﬃciencies, causing two kinds of capital gaps (Sohl, 2003): (1) primary seed gap, that is the diﬃculty in finding business angels and the lack of ‘investor ready’ quality deals in very early stages of development; and (2) secondary post-seed gap, that is due to the fact that the institutional venture capital industry migrates to later stage and larger sized deals, there is a gap between business angels and the institutional venture industry for ventures in the early stages of growth. However, Sohl (ibid.) indicates that business angels are increasing their investments in this secondary post-seed gap, redistributing the risk capital that exacerbates the primary seed capital. Sohl argues in Chapter 14 that policy can play a role in enhancing the flow of early stage equity capital and contribute to establishing a more eﬃcient market. In particular, Sohl oﬀers the following recommendations for policy-makers in the field of informal venture capital: 1. 2. 3. 4.

Public policy can play a role in fostering and nurturing the links between innovators, entrepreneurs and business angels. Support research in order to increase understanding of the informal venture capital market. Develop educational programmes targeting the supply (latent and existing business angels) as well as the demand (entrepreneurs) side. Public policy monetary incentives should focus on enhancing the flow of early stage equity capital to entrepreneurial ventures.

More specifically, looking at the lack of eﬃciency in the informal venture capital market, diﬀerent kinds of business angel portals have been established since the mid1980s. A business angel portal is ‘an organization that provides a structure and approach for bringing together entrepreneurs seeking capital and business angels searching for investment opportunities. The primary goal of angel portals is to increase the eﬃciency

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in the early stage market’ (Sohl, Chapter 14, p. 348). Lessons that can be learned from early attempts to develop business angel portals are that they have been important in increasing the awareness of angel investing and the role played by business angels in the early stage financing of entrepreneurial ventures. But, on the other hand, in many cases early business angel portals have experienced diﬃculties in (1) finding a suﬃcient number of investors to join the networks; (2) identifying high quality deals (‘investment ready’ deals); (3) finding funding for the operation for the portal; and (4) an inability to create suﬃcient awareness of the existence and value of the networks. Adapting to changing market conditions and experiences from earlier attempts to increase the eﬃciency of the market have led the informal venture capital market to assume several organizational structures, and in his chapter Sohl examined six types of business angel portal: matching networks, facilitators, informal angel groups, formal angel alliances, electronic networks and individual angels. According to Sohl, these angel portals should adopt some basic features: ●

●

●

Angel portals should maintain an informal structure, be based on a regional model, provide a face-to-face interaction between business angels and entrepreneurs and strive to provide a quality deal flow for their members. The three portal types ‘informal angel groups’, ‘individual angels’, and ‘matching networks’ are best suited to investing in the primary seed gap, whereas the ‘formal angel alliances’ and to some extent the ‘matching network’, are best positioned for investment in the secondary post-seed gap. Portals must remember that they are collections of business angels who make an individual investment decision and not institutional venture capitalists who manage a pool of capital.

Implications for venture capitalists and entrepreneurs Several chapters in the handbook focus on the relationship between the entrepreneur and institutional venture capitalist. In particular, there is an interest in understanding how value-adding is created in the relationship. In Chapter 7 for example, De Clercq and Manigart try to open the ‘black box’ in order to understand the creation of value-added in the entrepreneur–venture capitalist relationship. In their chapter they emphasize the role of knowledge and learning, and their conclusions are: ● ●

●

Venture capitalists’ specialization in terms of the industry and development stage has a positive eﬀect on the performance of portfolio firms. Knowledge exchange between venture capitalists plays an important role in generating positive investment outcomes, including (1) the aggregated knowledge held by the individual venture capitalists in one and the same venture capital firm as well as (2) the knowledge exchange that takes place within venture capital investment syndicates. Knowledge exchange between the venture capitalist and entrepreneur indicates that the potential outcomes from this relationship may be highest when the two parties hold complementary knowledge that enhances each other’s expertise and skills. However, it is necessary for the two parties to establish eﬀective knowledge sharing routines – both in the form of formal (for example board of directors) and informal (for example by means of the telephone and personal meetings) communication.

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425

In addition, value-adding is a process-related issue, and De Clercq and Manigart recognize the importance of establishing strong social relationships between the venture capitalist and entrepreneur: ●

●

●

There seems to be a positive relationship between venture capitalists’ trust in their portfolio firms and their perception of the firms’ performance, but too much trust may potentially have a negative eﬀect on performance. In addition, the level of goal congruence between the partners is an important aspect of the value-adding process, while the commitment of venture capitalist and entrepreneur to their mutual relationship may increase the value that is created. Research suggests that process-related issues, such as trust and commitment, may facilitate venture capitalists’ ability to add value to their portfolio firms, that is good relationships may lead to more specific insights into how an investment can be optimized and therefore enhance the potential to add value.

Over the years a great deal of research has investigated the key drivers of performance in venture capital-backed deals. The results are mixed and it is diﬃcult to find consensus regarding venture capitalists’ value-adding activities and their eﬀect on venture performance. However, both Leleux in Chapter 9 and Parhankangas in Chapter 10 review earlier findings of factors that seem to influence venture performance, and following the reasoning of Leleux we can divide the key drivers of performance into three categories: (1) venture capital-controlled investment factors; (2) environmental factors; and (3) decision-making processes (see Figure 17.1). In Part IV of the handbook we turn our attention to corporate venture capital. In Chapter 16 Zahra and Allen argue that entrepreneurs and their new ventures could gain Venture capital-controlled investment factors – larger funds (up to a point) – high quality deal flow and syndication deals – control mechanisms – specialization strategy – earlier performance of venture capital fund – timing and duration of investment – reputation of fund and general partners – value-added services – multistage investment

PERFORMANCE

Environmental factors – availability and status of public markets for IPOs – overall economic cycle – tax, regulatory and legal environment – availability of investors Venture capitalist decision-making processes – the screening, evaluation and selection of new venture investments

Figure 17.1

Key drivers of performance in venture capital-backed ventures

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a great deal from an investment by a corporate venture capital provider. Such an investment oﬀers opportunities for the new venture to collaborate and acquire new skills and capabilities. Corporate venture capital partners seem to have important implications for new ventures’ knowledge acquisition and learning, but in order to achieve a ‘win–win’ partnership the authors highlight the fact that the congruence of new ventures’ and incumbents’ goals are of crucial importance. The entrepreneur can take several actions to improve the gain from corporate venture capital, for example: ● ● ●

Due diligence in selecting corporate venture capital partners (and probe their motives, goals, track records, personnel and overall credibility), the entrepreneur also needs to communicate the goals of the ventures clearly to potential corporate venture capital investors, and as goals and motives change over time, the entrepreneurs need to reassess their goals and those of their corporate venture capital partners frequently in order to ensure an eﬀective fit.

References Ghosal, S. (2005), ‘Bad management theories are destroying good management practices’, Academy of Management Learning & Education, 4(1), 75–91. Sohl, J. (2003), ‘The private equity market in the USA: lessons from volatility’, Venture Capital, 5(1), 29–46. Van de Ven, A.H. and P.E. Johnson (2006), ‘Knowledge for theory and practice’, Academy of Management Review, 31(4), 802–21.

Index ABC – study of angels (attitudes, behaviors, characteristics) 52–3, 315, 316 absorptive capacity 403 Access to Capital for Entrepreneurs Act 2006 138 accounting measures of financial performance 230, 232 added value 18, 240 activities heterogeneity 212 early stage venture capital 265–7, 270 innovation and performance implications 219 post-investment phase 193–4 private equity and management buy-outs 300–304, 307–8 service 171–2 adverse selection 196–7 corporate venture capital 386, 401 early stage venture capital 262, 263 innovation and performance implications 221 private equity and management buy-outs 296 Africa 281 agency risks 258, 260 agency theory 72–3, 80, 199, 206–7, 321–2 business angels and investment decision making 333, 337, 340 corporate venture capital 401 early stage venture capital 272 innovation and performance implications 221 performance of investments 239 post-investment phase 209 private equity and management buy-outs 306 Ajzen, I. 335 Allen, S. 62, 393–410, 421 alternative assets portfolio 250 altruistic motivation 318 Alvarez, S.A. 401, 402 Amatucci, F.M. 333, 335 Amazon 188 American Research and Development 11, 34, 71, 156 Amess, K. 302 Amit, R. 119, 257–8, 356 angel portals 139–40, 353–61 electronic networks 355, 360–61

facilitators 355, 357–8 formal angel alliance 355, 359–60 individual angels 355, 361 informal angel groups 355, 358–9 matching networks 355–7 Apple Computer 47, 71, 167 Archimedes Fund 364–5 Argentina 323 Arthurs, J.D. 80 Asia 14–15, 16 early stage venture capital 254, 270 government policy 139, 144 informal venture capital market 352 post-investment phase 197, 201 private equity and management buy-outs 281 structure of venture capital funds 160 see also Asia-Pacific Asia-Pacific 157, 158, 159, 172, 173 Asquith, P. 295, 302 asset-based financing 298 attribution bias 264 Audretsch, D.B. 120 Auerswald, P.E. 115, 121 Australia 14, 352–3 Aussie Opportunities 360 business angels 316, 318 Business Angels Party 356 early stage venture capital 261 Enterprise Angels 352–3 Founders Forum 352, 358 government policy 130, 132 Industry Research and Development Board 167 Innovation Investment Fund Programme 133, 166, 167–8 Pre-seed Fund 134 Private Equity and Entrepreneur Exchange 360 Austria 226, 261, 290, 293 Avdeitchikova, S. 91 Balkin, D.B. 223 Banatao, D.P. 98 bank venture capital funds 164–5 Bannock Consulting Ltd 374 Barney, J. 188, 401, 402 Baron, R. 185, 188 Barr, P. 184

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Belgium 13, 16, 137, 261, 290, 293 Benjamin, G. 318 Berg, A. 307 Bhide, A. 80 biases 185, 186–8, 189 attribution 264 mental model 186 BIC economies 116 biotech industry 396, 400, 401, 402 Birch, D.J. 3 Birkinshaw, J. 237, 381, 385 Birley, S. 263, 267 birth of venture capital 10–11 Black, B. 14, 166, 172, 241 board of directors 18, 197, 221–2, 405 Bottazzi, L. 259–60 bounded rationality 221 Branscomb, L.M. 115, 121 Brazil 114, 323, 371 Bruining, H. 301 Bruno, A. 15, 21–3, 27, 177, 179, 253–4 Bruton, G. 304 Bürgel, O. 114–15, 120 Busenitz, L. 60, 73, 80, 185, 188, 219–34, 267, 418, 423 business angels 9, 52, 55–8, 59, 71, 315–29 agency theory 321–2 attitudes, behaviours and characteristics 317–19 conceptual and theoretical reflections 73, 74, 77, 80, 82 decision-making process 319 demographic research 323 early stage venture capital 256, 257 experience 325–6 FFFs (family, friends and fools) 323 funds 360 geographical perspective 86, 89, 90–91, 92, 104, 106 government policy 135, 144 individual 355, 361, 362, 424 informal venture capital market 347, 353–4 location 87–8 market scale 317 methodological approaches 327–8 networks 54, 125, 141, 317, 336 post-investment phase 214 public financiers 324 public policy 320 signaling theory 322–3 social capital 322 venture capital funds 67, 324–5 see also angel portals; formal angel alliance; informal venture capital; investment decision making; ‘virgin angels’

business associate referrals 336 business culture 174, 417 Business Development Bank 103 business introduction services 54 business volume measures 230–31 buy-back options 132 buy-in/management buy-outs (BIMBOs) 283 buy-ins 290, 291, 299–301 buy-outs: worldwide 292 see also leveraged buy-outs; management buy-outs Bygrave, W. 6–7, 15, 31–6, 78, 121, 135, 323, 332 early stage venture capital 254, 264 innovation and performance implications 226, 227 Cable, D. 69, 79, 81, 198 Canada: business angels 316, 318, 319, 327, 333, 337, 338 early stage venture capital 261 geographical perspective 87, 88, 90, 91, 93, 95, 96 government policy 137 informal venture capital market 349 Labor-Sponsored Venture Capital Corporation (LSVCC) 93, 130, 168 Opportunities Investment Network (COIN) 349 structure of venture capital funds 165 Venture Capital Association 103 see also Ottawa Capital Alliances 103 capital gains tax 12, 36 government policy 137 performance of investments 242 structure of venture capital funds 166 capped return for public investors 133 capped returns to the state 132 captive venture capitalists 6, 7, 92, 161, 164–5, 169 Celtic House 97, 103, 104 Center for Research in Securities Prices 19, 315 Center for Venture Research 348 Central and Eastern Europe 144, 281, 284–6 certification 136, 224–5 Chandler, G.N. 230, 233 chemicals industry 396, 398 chief executive officers 201, 221–2, 295, 301, 303 Chile: CORFU 133 China 14, 114, 174, 261 corporate venture capital 371 pre-investment process 182–3

Index private equity and management buy-outs 281 Cisco Systems 102 classical venture capital funds 6, 7, 254 see also institutional venture capital Cochrane, J. 245 cognitive dimensions 207, 322 cognitive processes 272, 273–4 co-investing 18 Compaq 377 compensation 222–3, 265 complementarity 325 complementary technologies 398 Compton, C. 11 computer industry 43 conceptual and theoretical reflections 66–84 dominant focuses 72–3 early contributions 68–9 ‘engaged scholar’ view 75–8 entrepreneurship literature 66, 73–5 expansion along several dimensions 69–72 conflict 267, 398 conjoint analysis 71, 178–9, 180–81, 183, 187, 243 consummation 334, 339–41, 343 content-related issues 181–3, 193–4, 203–6, 213 contingent pay 222–3 contingent valuation techniques 248–9 contract repudiation 259 contracting 18, 404 contractual covenants 265 control mechanisms 238–9 convertible securities 197 Cook, D.O. 295 Cornelius, B. 19–20 Corporate Executive Board 381 corporate governance 303 corporate law variations 270 corporate venture capital 6, 7–8, 9–10, 43–51, 67, 165 external 7, 372, 373 fund 159 history and research 43–4 internal 7, 372 Rind, K. 44–51 see also corporate venture capital from entrepreneurs’ perspective; corporate venture capital as strategic tool corporate venture capital from entrepreneurs’ perspective 393–410 board membership 405 contracting 404 corporate investor perspectives 397–400

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entrepreneurial firms’ perspective 400–402 importance and growth 396–7 objectives, focus and contribution 393–6 proactive relationship management 405–6 strategic benefits 402–3 corporate venture capital as strategic tool 371–89 cyclical history 378 definition 372–3 industry and firm level drivers of investment 378–80 learning motives 375–6 option building motives 376–7 performance 382–6 resource leveraging motives 377–8 co-specialization perspective 393 Cotter, J.F. 298 covenants: contractual 265 governing venture capital limited partnerships 163–4 negotiation 162 Coveney, P. 88, 318 cross-national variations 260, 262 cultural factors 269 Cumming, D. 60, 155–74, 267, 303, 417 DalCin, P. 333, 335, 336, 340, 341 De Clercq, D. 60, 193–214, 233, 240, 268, 417–18, 424–5 De Noble, A.F. 336 deal/deals: appraisal 262–4 characteristics, changes in over time 305 evaluation 98–9, 177 flows 98, 177, 237–8, 353 generation 262, 269, 292–6 -makers 325 opportunities 284 origination 177, 336 resurgence 289 screening 177, 269 sourcing 335–6 structure 177, 339–41 DeAngelo, L. 295, 298 decision: accuracy 189 aids 244, 264 criteria 181, 183 -making: criteria 24–5 expert 184 process 127, 243–4, 319, 425 see also investment decision-making

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-policies see pre-investment process: decision policies definition of venture capital 5–10 corporate venture capital 7–8, 9–10 informal venture capital 8–10 institutional venture capital 5–7, 9–10 Dell 377 Deltaray Corporation 34 demand 256 enhanced 374, 398 for private equity 285 -side factors 100, 127, 284, 341 demographic research 323 Denmark 261, 290, 293, 350–51 Business Development Finance 129 Business Innovation Center 351 Business Introduction Service 351 Loan Guarantee Scheme 134 National Agency of Industry and Trade 351 Department of Labor 12 Desbrierers, P. 301 development of industries 19 DeVol, R.C. 102 Dibben, M. 338 Digital Equipment Company 11 Diller, C. 268 Dimov, D.P. 122, 141, 233, 260, 268 direct public involvement 129–30 disruptive technologies 398 Dolvin, S. 224 Doriot, G. 11, 34, 179 dot.com boom and bust 15, 114, 186, 188, 289, 360, 443 downside protection 133–4 Draper, Gaither and Andersen 11 due diligence 177–8 business angels and investment decision making 336–7, 339 corporate venture capital 401 early stage venture capital 263 informal venture capital market 366 DuPont 43 Dushnitsky, G. 378–9, 382, 385, 393 Duxbury, L. 333, 339 early stage venture capital 253–74 characteristics 258–60 classification based on development stage 255–7 deals, appraisal of 262–4 exit strategies and performance 267–8 fund raising 260–62 institutional context and management 269–71

major risks 257–8 monitoring and adding value 265–7 recent trends 258 structuring of investments and investment portfolios 264–5 theoretical and methodological considerations 272–3 EASDAQ 13 economic cycle, overall 242 educational capability 182 educational programs 364 educational seminars 356–7 Einhorn, H. 189 Eisenhardt, K. 185 electronic networks 355, 360–61 electronic sector 43 Elitzur, R. 340 emerging fund structures 417 emerging technologies 398 Employee Share Ownership Plans 302 Employers’ Retirement Investment Security Act (ERISA) 12 ‘Prudent Man Rule’ 12 endowments 160, 268 ‘engaged scholar’ view 68, 75–8, 82 ‘positive organizational scholarship’ view 78–81 Engel, D. 238, 239 entrepreneur 179, 212 as agent 196–8 early stage venture capital 262, 264, 267 innovation and performance implications 221 perceived impact 399 practice, policy-making and research implications 424–6 /venture capital evaluations 231 entrepreneurial activity, growing status of 126–7 entrepreneurial knowledge sharing 326 entrepreneurial team quality 263 entrepreneurship 66 conceptual and theoretical reflections 74–5 literature 73–5 scholars 272–3 environmental factors 241–3, 425 equity 298 enhancement schemes 131, 133–4 gap 86, 117–18, 140 programs 125 ratchets 300–301 see also private equity Ernst, H. 385 Ettenson, R. 69–70

Index Europe 6, 7, 10–11, 13–14, 15, 16, 25, 40 Angel Academies 364 business angels 315, 324 corporate venture capital 372, 374, 381 early stage venture capital 254, 258, 259–60, 267, 269 geographical perspective 93–4 government policy 114, 116, 121–2, 126–8, 133, 135, 139, 141, 144 informal venture capital market 357 performance of investments 238–9, 240, 242, 243, 245, 246 post-investment phase 197, 198, 201 private equity and management buy-outs 281, 282, 287, 289–92, 298, 300 Seed Capital Scheme 134 structure of venture capital funds 157, 158, 159, 160, 166, 172, 173 Young Innovative Company Scheme 138 see also Central and Eastern Europe European Investment Bank 134 European Investment Fund 133, 135 European Private Equity and Venture Capital Association (EVCA) 248, 250, 381 evaluation: business angels and investment decision making 339 criteria 269–70 early stage venture capital 262 of proposal 334, 343 strategy (mental model) 184–5 exit 334, 343 events 342 private equity and management buy-outs 304, 308 routes 284 strategies 267–8, 270 timing of 270 expected rates of return 342 experience 179, 182, 189, 203–4, 262, 268, 325–6 expert decision-making model 184 exploitation 225–7, 398–9, 400 exploration 225–7, 398–9 exposure 162, 398 facilitators 355, 357–8 Fair Market Value 248 Farrell, A.E. 342 Federal Express 167 Federal Reserve 51 Bank of Boston 11 Feeney, L. 339 female entrepreneurs 322, 323

431

FFFs (family, friends and fools) 9, 52, 53, 257, 306, 323, 328, 329, 342 Fiet, J. 74, 264, 321, 339 financial considerations 179 financial goals 374 financial institutions and investment 14 financial intermediator, venture capital as 19 financial motivation 318 financial objectives 375 financial returns (direct and indirect) 172–3 Finland 91, 261, 290, 293, 351 business angels 316, 318, 324 INTRO Venture Forums 351 Investment Industry program 129 Matching-Palvelu 351, 353, 354 Sitra PreSeed Finance 351 first resort investors 135 first stage financing 255, 256, 257 Fishbein, M. 335 fixed management fee 162 Flanders, R. 11 Fleming, G. 60, 155–74, 268, 417 Florida, R. 97, 101, 108 flow of venture capital 19 Flynn, D.M. 266 Fong, K.A. 98 Ford, H. 315 formal angel alliance 355, 359–60, 362, 424 formal networks 264 formal venture capital 87, 325 see also institutional venture capital France 13 early stage venture capital 261, 270 Fund for the Promotion of Venture Capital (FPCR) 134 geographical perspective 94 government policy 137 Jeune Entreprise Innovante 138 Nouveau Marché 13, 289 post-investment phase 201 private equity and management buy-outs 290, 291, 292, 293, 301 Second Marché 289 SOFARIS 133–4 Freear, J. 77, 91, 318 Fried, V.H. 273 front end incentives 137 Fulghieri, P. 170 fund: -level perspective 236, 244–5 -of-funds 173 operating costs 134 performance 270–71

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raising 260–62 reputation 240 returns 232 size 123–4, 260, 268 ‘funds of funds’ 134–5 gains, realization of 286 game theory 207 Gaston, R. 88, 318 ‘gatekeepers’ see investment advisors Gavious, A. 340 Genentech 71 General Electric 43 General Motors 43, 47 general partners 92, 169, 170 experience 239 reputation 240 geographical perspective 23, 86–109, 265, 268 informal venture capital market 87–92 policy implications 108–9 see also institutional venture capital: geographical analysis; internationalization George, G. 403 Germany 13, 14, 353 BTU program 138 Business Angel Network Deutschland (BAND) 353 business angels 316, 318, 338 corporate venture capital 385, 387 early stage venture capital 261 Euregional Business Angel Network 356 geographical perspective 87, 94, 96, 97, 101 government policy 114–15, 120, 130 innovation and performance implications 226 Neuer Markt 13 private equity and management buy-outs 284–6, 289, 290, 291, 292, 293 structure of venture capital funds 160, 162, 171 Ghoshal, S. 68, 75, 78–80, 415 Gifford, S. 69, 139, 211 Gilson, R.J. 14, 121, 139, 142, 166, 172, 241 Gladwell, M. 328 Global Entrepreneurship Monitor 9, 135, 323 globalization 23 Glofson, C. 16 goal 256 congruence 207, 209–10, 401 financial 374 incongruence 196, 214 strategic 374

Gompers, P. 121, 189, 332, 342, 405 performance of investments 238, 239, 241, 242, 243 structure of venture capital funds 160, 162, 163, 170, 171, 172 Google 23, 188 Gorman, M. 39, 177, 254 Gottschalg, O. 239, 242, 245 governance 18, 220–22 government: investment schemes 166 sponsored fund 161 venture capital funds 165–9 venture capital organizations 6 see also government policy government policy 113–46 ‘equity gap’, longevity of 117–18 fund size, insufficient 123–4 information asymmetries 119–20 market failure 116–17, 118 minimum fund scale 121–3 performance of investments 243 public involvement in private venture capital 141–3 R&D spillovers 120 United States exemplar, influence of 121 see also informal investors (business angels); institutional venture capital grandstanding 170, 172, 189, 199, 239 Greece 261 Grilichese, Z. 120 growth markets, high 263 guaranteed underwriting of investment losses incurred by limited partners 132 Gulliford, J. 91 gut feeling (intuition) 180, 189, 264, 337 Haines, G. Jr 61, 332–45, 419–20 Hall, J. 179 Halpern, P. 295 Hand, J. 244 hands-on investors 200 Hanks, S. 230, 233 Harris, R. 302 Harrison, R. 5–6, 8–9, 16, 54, 89, 91–2, 136 business angels 317, 319, 320, 322 investment decisions by business angels 336, 337–8, 339, 340, 341, 342 Hatch, J.E. 340 Hatherly, D. 301 Hatton, L. 243 Hauser, H. 97 Hay, M. 318, 321, 340–41 hedge funds 307 Hege, U. 172, 238, 240, 270

Index Hellmann, T. 172, 399 Henderson, J. 381, 399, 402 herding phenomenon 186 heuristics 185–6, 188, 189, 190 representative 186, 264 satisficing 186, 190, 264 Hewlett Packard 381 hidden action 257 hidden information 257 Higashide, H. 267 High Voltage Engineering Corporation 11, 34 highly innovative technological ventures 31, 33 Hill, C. 302–3 Hill, S. 237, 385 Hisrich, R.D. 273 Hitt, M. 307 Hochberg, Y. 237 Hofer, C. 179 Holthausen, D. 304 Hong Kong 14 Houghton, S. 189 Hsu, D.H. 200 Hunt, S. 332 Hurry, D. 204 Hussayni, H.Y. 16 hybrid venture capital 144 IBM (International Business Machines) 11, 38, 47, 377 importance of venture capital 3 inactive investors 200 independent funds 159 independent limited partnership 6 independent venture capital firm 161 India 14, 269, 371 indirect intervention 128–31 industry: diversity 265 level evidence 245–6 performance and correlation with other asset classes 250 infant industry argument 131 informal angel groups 355, 358–9, 362, 424 informal investors (business angels) 9, 135–41 business angels as policy focus 136 early stage venture capital 257 first resort investors 135 institutional investors, complement to 135–6 networks, portals, match-makers and information asymmetries 139–40 targeting business angels as co-investors 138–9 targeting business angels as individuals 136–8

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informal networks 264 informal venture capital 8–10, 51–62, 325 ABC of angels 52–3 geographical perspective 86–7 market scale 52 policies and information networks 53–4 Wetzel, W. 54–9 see also informal venture capital market informal venture capital market 87–92, 347–67 Australia 352–3 business angels, location of 87–8 Canada 349 Denmark 350–51 early business angel network 353–4 Finland 351 Germany 353 location, role of in investment decision 89 locational preferences 88–9 locations of actual investments 89–92 policy implications 363–5 Singapore 352 Sweden 350 United Kingdom 349–50 United States 348–9 see also angel portals information: asymmetry 119–20, 139–40, 195–200 business angels and investment decision making 341 early stage venture capital 257, 260, 262, 264, 265, 269, 272 innovation and performance implications 221 performance of investments 242 post-investment phase 199, 209 private equity and management buy-outs 296–7, 306 networks 53–4 processing 183–5, 273–4 technology 396, 401, 402 infrastructure to complete deals 284, 285–6 initial market development 288 initial public offerings 13, 14, 40, 43, 50 corporate venture capital 402 early stage venture capital 270 geographical perspective 104 innovation and performance implications 224, 233 performance of investments 249 post-investment phase 199 private equity and management buy-outs 304, 306 public markets 241 structure of venture capital funds 166, 172

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innovation and performance implications 219–34 accounting measures of performance 230 compensation 222–3 exploration and exploitation 225–7 governance 220–22 new industries 227–9 reputation and certification 224–5 subjective measures of performance 230, 233 venture outcomes as measure of performance 233 institutional venture capital 5–7, 9–10, 16–42, 212, 214, 272 Bygrave, W. on 31–6 conceptual and theoretical reflections 74 early contributions 16–17 early stage venture capital 269–71 geographical analysis 92–105 definitions 92–3 demand-side factors 100 geographical concentration of investments 95–9 location factor, venture capital as 99–100 location of investments 93–5 long distance investing 100–101 geographical perspective 86 government policy 124–35 direct public involvement 129–30 entrepreneurial activity, growing status of 126–7 ‘equity enhancement’ schemes 133–4 ‘funds of funds’ 134–5 indirect or ‘hybrid’ public/private models 130–31 intervention typologies 128–9 public-funded incentives in hybrid funds 131–4 Intel 167, 377, 381 Capital 371, 376, 380 internal rate of return 122, 132, 249–50, 263 internationalization 173, 305–6, 417 Internet investing 97 intuition see gut feeling investment: advisors 12 ‘bubble’ 95 decision-making by business angels 332–45 deal sourcing and initial screening 335–6 decision criteria 337–9 due diligence 336–7

negotiation, consummation and deal structure 339–41 post-investment involvement 341–3 decisions 170 durations 239–40 portfolios 265–6 readiness arguments 140 regulations 125 risks in new technology-based firms 119 strategies 18 types 171–2 investment factors, venture capital-controlled 237–41, 425 investor: availability 243 -led buy-outs (IBOs) 283 membership 353 tax benefits 137 Ireland 137, 261, 290, 293 Israel 44, 48 early stage venture capital 269 Nitzanim-AVX/Kyocera Venture Fund 48 structure of venture capital funds 160, 171 Yozma program 132, 133, 166 Italy 174, 261, 290, 291, 292, 293 Japan 14, 44, 48 business angels 316, 318 early stage venture capital 261 International Angel Investors 357 Nippon Angels Forum 359 post-investment phase 204 private equity and management buy-outs 281, 284–6, 292 structure of venture capital funds 160, 162, 171 JDS-Uniphase 102, 104, 105 Jeng, L. 142, 160, 241, 242, 243 Jensen, M.C. 287, 294 Johnson, P.E. 75–8, 415 Johnstone, H. 88 Jungwirth, C. 226 Kandel, G. 170 Kann, A. 374, 398, 400 Kanniainen, V. 170 Kaplan, S. 197, 270 performance of investments 239, 240, 241, 245 private equity and management buy-outs 295, 297, 298, 300, 302, 303 Kaserer, C. 268 Katis, N. 404

Index Keeley, R.H. 177 Keil, T. 80, 372, 374, 381, 383, 385 Keilbach, M. 120 Kelly, P. 61, 135, 136, 315–29, 340–41, 419 Kenney, M. 101, 108, 227 Keuschnigg, C. 170 Kieschnick, R. 295 Kleiner Perkins 35 Knigge, A. 303 knowledge: -based industries and market failure 118 -based view 394 conversion capability 403 economy 118 exchange 204–6 implicit, tacit 239 inflows 403 spillovers 107 Korea 182, 281, 323, 387 Korsgaard, A.M. 267, 270 Kotha, S. 385 Landström, H. 3–62, 91, 335, 341, 342, 415–26 business angels 318, 319, 321, 322 Larcker, D. 304 leadership experience 182 leadership potential 263 learning motives 375–6 learning new markets and technologies 374 least innovative technological ventures 31, 33 legal protections 271 Lehn, K. 295 Lei, D. 307 Leleux, B. 60, 236–51, 381, 399, 402, 418, 422, 425 Lengyel, Z. 91 Lenox, M.J. 378–9, 382, 385 Lerner, J. 8, 54, 332, 342 corporate venture capital 400, 404, 405 government policy 113, 140, 142 performance of investments 238, 239, 241, 242, 243, 245 structure of venture capital funds 160, 162, 163, 164, 166–7, 170, 172, 173 leveraged build-ups 283–4 Leveraged Buy-Out Associations 300 leveraged buy-outs 239–40, 282–3, 287–8, 295, 297–8, 301–3, 305, 307–8 leveraged recapitalizations 302 leveraging own complementary resources 377–8 leveraging own technologies and platforms 377 Lichtenberg, F.R. 301–2 limited liability partnership fund 128 limited liability partnership structure 138

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limited partnerships 92, 160–65, 170, 173 early stage venture capital 269 independent 6 structure of venture capital funds 169 venture capital limited partnerships Linux 377 Lisbon Agenda 116 listed closed-end funds 156 listed venture capital funds 173–4 ‘living dead’ 233 Ljungqvist, A. 242, 245 local area networking 227 localized nature of investing 97–8 location factor, venture capital as 99–100 location of investments 93–5 location, role of in investment decision 89 locational preferences 88–9 locations of actual investments 89–92 long distance investing 91–2, 100–101 longevity in private equity and management buy-outs 304 long-run investment returns 122 love money see FFFs Lowenstein, L. 294–5 Lumme, A. 341 McGrath, R. 30 MacIntosh, J.G. 267 MacLean, J. 340 MacMillan, I.C. 15, 26–31, 179, 254 Macmillan Report 117–18 McNally, K. 7, 372, 373–4 macro perspective (industry level) 236 macroeconomic conditions 242 Madill, J. 61, 104, 332–45, 419–20 Malaysia 14 management 179 buy-ins 283, 296, 302, 303 buy-outs 61, 290, 293, 419 geographical perspective 94, 108 see also private equity and management buy-outs early stage venture capital 269–71 -employee buy-out 283 managerial practice and corporate venture capital 407 ‘managerial-oriented venture capital research’ 17 Manigart, S. 16, 60, 193–214, 240, 268, 340, 417–18, 424–5 Marais, L. 302 Margulis, J. 318 market 262 characteristics 179

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enhancement 374 failure 114, 116–17, 118 growth, rapid 288–9 -level learning 375–6 potential 179 risks 258, 260 scale 52, 317 size hurdles 263 Marriott, R. 122 Martin, R. 97, 100 Mason, C. 5–6, 8–9, 16, 54, 59, 86–109, 136, 415–16, 421 business angels 317, 319, 320, 322 investment decisions by business angels 336, 337–8, 339, 340, 341, 342 Mast, R. 373 match-makers 139–40 matching networks 355–7, 362, 424 Matthews, T. 97, 103 Maula, M. 7, 62, 371–89, 393, 395, 402, 408, 420–21 Mayer, C. 160, 162, 171 Megginson, W. 224, 269 mentoring 341, 343 merchant venture capital funds 6–7, 254 Merges, R.P. 400, 404 metaphorical kaleidoscope 69–70, 72, 73, 81, 82 Mexico 323 Meyer, G. 180, 190 mezzanine finance 300 Microsoft 377 Microsystems International 102 Middle East 371 minimum fund scale 121–3 Mitel Corporation 102, 104 Moesel, D.D. 264 monetary incentives 364–5 monitoring 71 corporate venture capital 374 early stage venture capital 265–7, 270 heterogeneity 212 performance of investments 239 post-investment phase 193–4, 197–8, 199 private equity and management buy-outs 300–304 value-added in venture capitalist-entrepreneur relationships 194–203 information asymmetry 195–200 value adding 200–203 Moog, P. 226 Moore, K. 88, 318 Moorehead, J. 243

moral hazard 196–7 business angels and investment decision making 340, 341, 344 corporate venture capital 386, 401 early stage venture capital 264, 272 innovation and performance implications 221 Motorola 381 multistage investment 241 Murfin, D.L. 373 Murray, G. 59–60, 113–46, 260, 306, 402, 416, 422 Muzyka, D. 181 Nahata, R. 240, 241 NASDAQ 14 National Research Council Laboratories 102 National Science Foundation 34 negotiation 334, 343 business angels 339–41 of covenants 162 pre-investment process 178 private equity and management buy-outs 296–7 Netherlands 201, 261, 289, 290, 293 Netscape 100 networks 139–40 ties 322 new industries development guide 227–9 new techologies 12 New Zealand 113 early stage venture capital 261 government policy 130, 132 Mentor Investor Network Events for Business Angels 359 Seed Co-investment Fund 138–9 Venture Investment Fund 133, 166 Newbridge Affiliates Programme 103 Newbridge Networks 102, 103, 104, 105 Nikoskelainen, E. 303 Nokia 102 Venture Partners 380 non-serial angels 338 Nortel 104, 105 Networks 102 North America 144 see also Canada; United States Northern Telecom 102 Norway 261, 290, 293, 316, 318, 322 Novell 377, 381 Nye, D. 269 operational role 201 operational skills 263 Opler, T.C. 295, 302 Oppenheimer 47, 48

Index opportunism 199 option: building motives 376–7 reasoning 30 to acquire companies 376 to enter new markets 376–7 to expand 374 Oracle 377 Organisation for Economic Co-operation and Development (OECD) 130, 137 organizational forms of financiers 302, 306–7 Orser, B. 344 Ottawa 89, 98, 102–5, 107, 109 Venture Capital Fair 103, 105 overconfidence 187–8, 244, 264 Pareto improvements 166 Parhankangas, A. 61, 253–74, 418, 425 pari passu funding 131 partnership agreement 162 Peck, S.W. 298 pensions funds 12, 14, 36, 160, 162 early stage venture capital 269 performance of investments 243 performance 18 corporate venture capital as strategic tool 382–4 determinants 384–6 early stage venture capital 268 fee 162 gap 238–9 implications see innovation and performance implications of investments 236–51 fund level perspective – return performance 244–5 generic issues with industry performance measurement 246–50 industry level evidence 245–6 see also value drivers persistence 239–40 prior 262 subjective measures 230, 233 Perry, S.E. 298 Persson, O. 19–20 Peters, H. 333, 338 Phan, P. 302–3 pharmaceuticals industry 396, 398 pioneers in venture capital research 3–62 birth of venture capital 10–11 definition of venture capital 5–10 Europe 13–14 importance of venture capital 3 state-of-the art venture capital research 59–62

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United States 11–13 worldwide venture capital 14–15 see also corporate; informal; institutional planned behaviour theory 335, 344 policy: capturing 180–81, 182 implications in informal venture capital market 363–5 -oriented venture capital research 19 Politis, D. 322 population ecology literatures 182 Porter, M. 307 portfolio: companies 212, 268, 270 size 171 theory 162 Portugal 290, 293 ‘positive organizational scholarship’ view 67, 78–81 post-investment 177 activities 18 involvement 334, 341–3 phase 193–214 content-related issues 203–6 process-related issues 206–11 see also monitoring and value-added relationships 99 potential financial distress costs 295 Poulsen, A. 295 Powell, W.W. 97, 101 practice, policy-making and research implications 415–26 corporate venture capital 420–21 entrepreneurs 424–6 general research 415–17 informal venture capital 419–20 institutional venture capital 417–19 policy-makers 421–4 venture capitalists 424–6 Prasad, D. 322, 336–7 Pratt, S. 255 pre-investment process: decision policies 18, 177–90 conjoint analysis and policy capturing 180–81 espoused decisions of venture capitalists 179 theory development and content tested using experiments 181–3 theory development in process and experiments 183–9 verbal protocol analysis 179–80 preferred convertible stock 265 PriceWaterhouseCoopers 250 primary seed gap 347–8, 362, 363, 423, 424 private equity 5, 128

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early stage venture capital 254, 256 geographical perspective 108 government policy 128 performance of investments 239, 245, 250 see also private equity and management buy-outs private equity and management buy-outs 281–308 adding value 307–8 deal characteristics, changes in over time 305 deal generation and antecedents 292–6 definitions of buy-outs 282–4 Europe 289–92 factors influencing 284–7 international aspects 305–6 life-cycle behaviour and organizational forms of financiers 306–7 monitoring and adding value 300–304 screening and negotiation 296–7 sources 306 structuring 298–300 United Kingdom 288–9 United States 287–8 valuation 297–8 worldwide buy-outs 292 proactive relationship management 405–6 procedural justice theory 73, 207, 272 process-related issues 193–4, 206–11, 213 commitment 210–11 goal congruence 209–10 social interaction 208–9 trust, role of 208 product: attributes 262 feasibility 179 /service characteristics 179 uniqueness 263 proprietary deal flow 240 proprietary products 263 ‘Prudent Man Rule’ 12 public financiers 324 public investor co-investing with private investors 133 public involvement in private venture capital 141–3 public markets, availability and status of 241 public policies 166–7, 320 public to private transactions 288, 291, 294, 295, 296, 297, 306 public-funded incentives in hybrid funds 131–4 quasi-debt 298 quasi-equity 298

rational model 186 regional aspects 19 regional gaps 86 regulatory environment 242–3 relational capital perspective 394–5 relational dimension 207, 322 relationship orientation 270 relation-specific investments 205 Renneboog, L. 296, 297 reputation 202, 224–5, 240, 264 research 364 and development 120, 302, 374 see also practice, policy-making and research implications resource: -based theory 182, 272 dependence theory 194 endowments 194 leveraging motives 377–8 Reynolds, P.D. 114 Richardson, M. 242, 245 Rickards, T. 181 Riding, A. 61, 319, 332–45, 419–20 Rind, K.W. 15, 44–51 Riquelme, H. 181 risk capital, informal 55 risk reduction 265 risks 256, 258, 260 Riyanto, Y. 172–3 Robbie, K. 300 Robinson, R. 265, 317, 319 Rockefeller family 47 Romain, A. 243 Roure, J.B. 177 Ruhnka, J.C. 255, 265 rules of thumb see heuristics Russia 44, 48, 114 S&P 500 245 Sætre, A. 322 Sahlman, W.A. 15, 37–42, 69, 177, 198, 254, 300 Sapienza, H.J. 19, 59, 66–84, 201, 208, 233, 267, 270, 415 Sarbanes-Oxley Act 288 SBA Dun’s Market Identifier data 317 Scandinavia 166, 327 see also Denmark; Finland; Norway; Sweden Schatt, A. 301 Schildt, H.A. 383 Schoar, A. 163, 164, 239, 240, 245 scholarship and roles of researchers 77–8 see also engaged; positive organizational Schulze, W. 306

Index Schwienbacher, A. 60, 155–74, 259–60, 270, 417 screening 237–8 business angels 335–6, 338 early stage venture capital 262, 264 pre-investment process 178, 180 private equity and management buy-outs 296–7 second-tier stock markets 125 secondary post-seed gap 347–8, 362, 363, 423–4 Securities and Exchange Commission 249 seed stage 255, 256, 258, 260, 264 self-interest 79–80, 81 self-oriented motivation 318 semiconductor industries 401, 402 Seppa, T. 200 serial investors 318, 325, 338 Severiens, H. 359 Sevilir, M. 170 Shane, S. 69, 79, 81, 198 shareholder rights 259 Shepherd, D. 60, 69–70, 177–90, 233, 244, 263, 417 short distance investments, dominance of 90–91 Siegel, D. 301–2 Siegel, R. 373, 384 Siemens 47 signaling theory 322–3 business angels 324, 336–7 corporate venture capital 386 early stage venture capital 272 structure of venture capital funds 169–70 Silicon Valley 11, 97, 102, 106, 107 Band of Angels 359 government policy 116, 121 Silver, D.A. 373 Simon, M. 189 Singapore 14, 44, 261, 316, 318, 352 Business Angel Network Southeast Asia (BANSEA) Mentoring Program 352 Singh, H. 295 Small Business Administration 12 Small Business Investment Companies 12, 51, 131, 156 Smart, G. 74, 180, 183 Smith, A. 298, 302 Smith, D.F. Jr 97, 101 Smith, D.G. 264 snowball sampling 317 social capital 322 social environment 212 social interaction 207, 208–9 Söderblom, A. 122

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software companies 398 Sohl, J.E. 61, 347–67, 420, 423–4 business angels 320, 323, 324 government policy 118, 135, 136, 141 investment decisions by business angels 333, 335, 336 Sorenson, O. 101 Sørheim, R. 318 source of funding 256 sourcing of potential deals and first impressions 334, 343 South Africa 261 South America 144 Spain 261, 290, 291, 292, 293 spatial clustering of firms 96–7 staged capital infusions 241, 265 staged investing 197 Stark, M. 339 start-up stage 255, 256, 257 state-of-the art venture capital research 59–62 Stedler, H. 333, 338 Stein, J.C. 298, 303 Stevenson, H. 37–8, 41, 80, 244–5 stewardship theory 80, 199 stock market 14 strategic goals 374 strategic objectives 374, 375 strategic role 201 strip financing arrangement 282 Strömberg, P. 197, 239, 240, 241, 300 structural dimensions 207, 322 structure of venture capital funds 155–74 financial returns (direct and indirect) 172–3 future research directions 173–4 government venture capital funds 165–9 institutional venture capital markets development 156–60 investment types and value-added service 171–2 limited partnerships 160–65 structuring of investments and investment portfolios 264–5 structuring in private equity and management buy-outs 298–300 Stuart, T.E. 101, 402 style drift 164, 171–2 ‘super-angels’ 91 supply of opportunities 285 supply side factors 127, 341, 345 Surlemont, B. 243 Sweden 13, 16, 52, 261, 289, 290, 293, 350 business angels 316, 317, 318, 324 geographical perspective 87–8 Sweeting, R. 208, 266 Switzerland 226, 261, 290, 293

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Sykes, H.B. 373, 384–5 syndication 18, 101, 205, 237–8, 265 business angels 326 early stage venture capital 270 Taiwan 14 tax 125 hypothesis 294 incentives 53–4 law variations 270 technology boom 43 Technology Capital Network 58, 357 technology clusters 102–5, 107 telecommunications industry 396, 399, 402 temporal variations 260, 262 Thompson, S. 302 Thomson Financial: Venture Expert Database 106–7 Thurik, A.R. 126 timing 177, 239–40 of cash flows 134 preferred 399–400 Timmons, J.A. 6–7, 16, 31, 34, 121, 226, 227, 254, 264 Titman, S. 295 Toms, S. 289 transaction cost hypothesis 294 transaction-based analyses 395 trust 207, 208, 322 business angels and investment decision making 338, 339, 340 calculative 405 informal venture capital market 358 relational 405–6 Tyebjee, T.T. 15, 21–6, 27, 177, 179, 253–4 uncertainty 269 under-investment 199 undervaluation hypothesis 295 United Kingdom 13, 14, 16, 53, 54 3i 13, 131 Advantage Business Angels 359 Alternative Investment Market 13 business angels 316, 317, 318, 319, 320, 327, 337, 338, 342 Business Enterprise Scheme see Enterprise Investment Scheme Business Start-Up Scheme see Enterprise Investment Scheme Cambridge 97, 102 corporate venture capital 373–4 Department of Trade and Industry Informal Investment Demonstration Projects 350 early stage venture capital 261, 263, 270 Enterprise Capital Fund 138

Enterprise Investment Scheme 137–8 geographical perspective 87, 88–9, 91, 92, 93–4, 95, 96 government policy 114–15, 117–18, 120, 126–7, 130–32, 135, 137 High Technology Fund 134–5 informal venture capital market 349–50 Local Investment Networking Company 349–50, 354 London Business Angels 139, 359 Macmillan Committee on Finance and Industry 320 post-investment phase 201 private equity and management buy-outs 281, 284–6, 287–90, 292–3, 295–304 regional venture capital funds 134, 135, 136 Scottish Co-Investment Fund 139, 365 Scottish Enterprise Business Growth Fund 365 Small Business Service: Early Growth Fund 139 structure of venture capital funds 160, 162, 166, 171 Venture Capital Trust 93, 168 United Parcel Service 381 United States 3–7, 10–15, 23, 25, 38, 40–41, 43, 46, 50, 52–4 128 Innovation Capital Group 357 Angels Forum 359 BlueTree Allied Angels 359 Boston Chamber of Commerce 11 business angels 315, 317–18, 320, 323–5, 327, 336, 338 Civilian Research and Development Foundation 48 corporate venture capital 372, 383, 387, 396, 401, 407 early stage venture capital 253–4, 258, 260, 261, 267, 269–70 eCoast Angels 358 Funding Match 360 geographical perspective 87–91, 93–7, 99, 101, 103–5, 108 government policy 115, 122, 124, 126, 128, 130–31, 135, 137, 139, 142–3 informal venture capital market 348–9, 357, 358, 361 innovation and performance implications 221, 225 Mid Atlantic Angel Group 360 National Venture Capital Association 245 New England Industrial Development Corporation 11 performance of investments 238–9, 241, 246, 247, 249

Index post-investment phase 197, 198, 201, 212 Power of Angel Investing 364 pre-investment process 182 private equity and management buy-outs 282, 287–8, 295, 297–8, 301–3, 305–6 Robin Hood Ventures 360 SBIC 133, 166 Small Business Administration 131, 167, 316 Small Business Innovation Research Programme 167, 168 structure of venture capital funds 155, 159, 160, 164, 165, 172 Tech Coast Angels 359 Venture Capital Network 350 Walnut Ventures 358 see also Silicon Valley university spin-outs 257 valuation 269, 270, 297–8, 340 early stage companies 247–8 methods 263 processes 263 value drivers 237–44 decision making processes 243–4 environmental factors 241–3 venture capital-controlled investment factors 237–41 value-added see added value Van de Ven, A.H. 75–8, 415 Van Osnabrugge, M. 79, 135 business angels 317, 319, 321 investment decisions by business angels 332, 333, 337, 338, 341 Van Pottelsberghe de la Potterie, B. 243 Venkataraman, S. 108–9 venture capital limited partnerships 156, 158, 161, 168, 169, 171, 172 Venture Capital Network 54, 58 informal venture capital market 348–9, 356 see also Technology Capital Network Venture Economics 18, 31, 33, 35, 250

venture growth 230–31 venture outcomes 231–2, 233 venture team 179 venture-specific learning 376 verbal protocol analysis 178, 179–80, 181 Villanueva, J. 19, 59, 66–84, 415 ‘virgin angels’ 318, 325, 326 von Burg, U. 227 Wadhwa, A. 385 Walz, U. 303 Warga, A. 295 Wassermann, N. 269 wealth transfer from other stakeholders hypothesis 295 Weir, C. 295–6, 297 Weiss, K. 224 Welch, I. 295 Wells, P. 142, 160, 241, 242, 243 Westinghouse 43 Wetzel, W.E. Jr 8, 15, 51–2, 53, 54–9, 90, 315–17, 327, 341, 356 Wiklund, J. 122 Williams, T. 298 Winchester Disk Drive 37–8, 41 Winters, T.E. 373 Wizman, T. 295, 302 Wong, C.F. 266 worldwide buy-outs 292 worldwide venture capital 14–15 Wright, M. 16, 61, 281–308, 418–19 Wrigley, N. 108 Wu, T.W. 295 Xerox Corporation 43, 44, 47 Yahoo! 100 Young, J.E. 255, 265 Young, S. 404 Zacharakis, A. 60, 177–90, 244, 263, 417 Zahra, S. 62, 301, 393–410, 421 Zook, M.A. 97, 99–100, 108

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