Management Decision

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ISSN 0025-1747

Volume 45 Number 5 2007

Management Decision Investor influence on company management Guest Editors: Tahir M. Nisar and Roderick Martin

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Management Decision

ISSN 0025-1747 Volume 45 Number 5 2007

Investor influence on company management Guest Editors Tahir M. Nisar and Roderick Martin

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Editorial advisory board ________________________________

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Guest editorial ___________________________________________

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Activist investment: institutional investor monitoring of portfolio companies Roderick Martin and Tahir M. Nisar ______________________________

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Shaping exit and voice: an account of corporate control in UK sports Lynne Nikolychuk and Brian Sturgess ______________________________

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Intangible economy: how can investors deliver change in businesses? Lessons from nonprofit-business partnerships Maria May Seitanidi____________________________________________

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The governance of going private transactions: the leveraged buyout board of directors as a distinctive source of value Michael R. Braun and Scott F. Latham_____________________________

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CONTENTS

CONTENTS continued

Entrepreneurship and organizational design: investor specialization Peter D. Casson and Tahir M. Nisar_______________________________

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Optimal allocation of decision rights for value-adding in venture capital Derek Eldridge ________________________________________________

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The role of partners in investor firms Peter D. Casson and Roderick Martin ______________________________

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Performance effects of venture capital firm networks Peter Abell and Tahir M. Nisar ___________________________________

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EDITORIAL ADVISORY BOARD

Ali E. Akgu¨n Associate Professor of Science & Technology Studies and Technology Management, School of Business Administration, Gebze Istitute of Technology, Turkey Professor Giles Arnaud Dean of Faculty, Professor of Organizational Behaviour and I/O Psychology, Toulouse Business School, France David Ballantyne Associate Professor of Marketing, University of Otago, New Zealand Dr Mike Berrell Professor of Work Organization, Director Academic, Graduate School of Business, RMIT University, Melbourne, Australia David M. Boje PhD Department of Management, New Mexico State University, USA Mike Bourne Cranfield School of Management, Centre for Business Performance, Cranfield, UK Catherine Cassell Professor of Occupational Psychology, Manchester Business School, UK Professor Jason C.H. Chen, PhD Professor, Graduate School of Business, Gonzaga University, USA Prof. (Dr) Patrick Low Kim Cheng, PhD & Chartered Marketer MD BusinesscrAFT Consultancy (Asia Pacific), Associate, University of South Australia Mark Dodgson Director, Technology and Innovation Management Centre, University of Queensland, Brisbane, Australia Mario Emiliani Professor of Management, Rensselaer at Hartford Lally School of Management and Technology, USA Dr Check Teck Foo Professor & Honorary Chair of Competitive Strategy, School of Management, University of St Andrews, UK Stan Glaser Fred Emery Institute, Melbourne, Australia Christian Gro¨nroos Professor, Swedish School of Economics, Helsinki, Finland John C. Groth Professor of Finance, Texas A&M University, USA Professor Simone Guercini Department of Business Sciences, University of Florence, Italy Professor Angappa Gunasekaran Department of Management, Charlton College of Business, University of Massachusetts, North Dartmouth, USA Kristina L. Guo PhD, MPH Associate Professor, Public Administration/Allied Health Administration, University of Hawaii-West O’ahu, Pearl City, HI, USA William D. Guth Harold Price Professor of Entrepreneurship and Strategic Management, New York University, USA Eric Hansen Professor, Forest Products Marketing, Department of Wood Science and Engineering, Oregon State University, USA Douglas A. Hensler PhD, PE Dean and Sid Craig Endowed Dean’s Chair, Craig School of Business, USA Management Decision Sam Ho Vol. 45 No. 5, 2007 Dean. Hang Seng School of Commerce, Hong Kong p. 824 Jay Kandampully # Emerald Group Publishing Limited Ohio State University, Columbus, USA

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Magda Elsayed Kandil Senior Economist, International Monetary Fund, Washington DC, USA Tauno O. Kekale University of Vaasa, Finland Yoshio Kondo Professor Emeritus, Kyoto University, Japan William S. Lightfoot, PhD Professor of Management, Associate Dean, International University of Monaco Hao Ma PhD Professor of Management & EMBA Director, Peking University, People’s Republic of China Dr Robert K. Perrons Executive Coordinator of R&D, Shell International Exploration & Production, The Netherlands Nigel F. Piercy Professor of Marketing & Strategic Management, Warwick Business School, University of Warwick, UK Erwin Rausch President, Didactic Systems, Inc., and Adjunct Professor, Kean University, USA Michael A. Roberto Assistant Professor, Harvard Business School, Boston, MA, USA Jennifer Rowley School for Business & Regional Development, University of Wales, Bangor, UK Joseph Sarkis Clark University, Worcester, MA, USA William Schulte, PhD Associate Professor, Sam Walton Free Enterprise Fellow, Harry F. Byrd Jr School of Business, Shenandoah University, USA Wang ShouQing Deputy Head, Department of Construction Management, School of Civil Engineering, Tsinghua University, Beijing, China Amrik S. Sohal Department of Management, Monash University, Melbourne, Australia Mary-Beth Stanek General Motors, USA Ian Taplin Department of Sociology and International Studies, Wake Forest University, Winston Salem, USA and Bordeaux Business School, France David Tranfield Professor of Management, Director of Research and Faculty Development, Cranfield School of Management, Cranfield, UK Joao Vieira da Cunha MIT Sloan School of Management, Cambridge, USA Claus von Campenhausen Accenture, Mu¨nchen, Germany Ingo Walter Charles Simon Professor of Applied Financial Economics, New York University, USA Charlie Weir Aberdeen Business School, Robert Gordon University, Aberdeen, UK Ray Wild Principal, Henley Management College, Henley-on-Thames, UK, 1990-2001 Richard Wilding Cranfield School of Management, Cranfield, UK

Guest editorial Investor influence on company management Investors have traditionally shied away from openly participating in company management. The general view held by these investors was that any interference in company business strategy would harm management initiative and accountability. However, during the last two decades a movement has taken hold that favours an activist style of investment. Not only is it acceptable to the proponents of this movement to vote against management at shareholder meetings, but they are also willing to enforce corporate governance standards using overt means of public pressure. Notable activists are CalPERS, the California Public Employees’ Retirement System, and Hermes, a British fund. At any rate, investors now take an interest in how companies are being managed, and what possible actions can be taken to improve the operation of companies in their portfolios. Different types of investors have different institutional interests – private trusts, portfolio equity investors, institutional investors – and may be expected to have different levels and forms of influence upon management practice. In terms of board membership of a portfolio company, institutional investors’ main concern is with fostering board independence rather than directly participating in board decision-making. They will engage with their companies using a variety of methods including discussion behind the scenes, publication of a list of “target companies”, proxy voting, running dissident slates and shareholder derivative suits, and using media pressure. On the other hand, venture capital and private equity firms are not only concerned with board composition but they also seek to directly influence board decisions through their representatives on portfolio company boards. Less directly, they influence employee recruitment, wages and salaries of lower level employees, selection of suppliers and launch customers and, more broadly, commercialization strategies. Against this background, the UK Department of Trade and Industry (DTI) commissioned a research project into the effects of financial institutions and investor behaviour on management practice. The project was carried out by a team from the School of Management at the University of Southampton. The project’s findings have now been published by the DTI and by Oxford University Press in a book entitled Investor Engagement: Investors and Management Practice Under Shareholder Value. This special issue of Management Decision is aimed at exploring further many of the issues and research questions initially raised by the DTI report. Martin and Nisar’s paper examines the way asset managers apply the ISC Principles designed to improve corporate governance standards. Using a survey study of fund managers to evaluate the adherence of managers to the ISC Principles, the authors show that fund managers routinely analyse information concerning those companies in which they invest, and are actively involved in activities to promote standards of corporate governance and corporate accountability. Nikolychuk and Sturgess analyse the interplay between voice and exit strategies and how they influence corporate control in the UK’s sports industry. They provide two cases of football clubs to demonstrate the extent to which socio-cultural and

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market oriented incentives jointly contribute to corporate control outcomes. Seitanidi investigates how investors can protect their assets by prioritising intangible resources. She argues that investors traditionally focus on tangible outcomes (money, land, machinery), and rather less on the intangible economy (trust, human resources, information, reputation). Using the case of Nonprofit-Business Partnerships, she demonstrates how investors can protect their financial assets by facilitating the shift from the tangible to the intangible economy. Braun and Latham explore going-private transactions via leveraged buyouts (LBOs) as a response to deficient governance structures, as well as post-buyout board restructuring. Their study gives credence to the argument that boards represent a unique source of value creation in LBOs. The study complements previous agency-theoretic work by focusing on the monitoring function of the board, and introduces resource dependence theory to suggest the importance of a strategic service and support function. Casson and Nisar examine the role of organizational design in venture capital (VC) firms’ investment strategies. They find that VC firms’ engagement style is strongly related to their organizational focus. VC firms investing in one particular specialized area are significantly more likely to become involved with their companies than general firms. Eldridge develops a conceptual framework to analyse optimal allocation of decision rights in venture capital environments. His particular focus is on how investors and investees search to find a suitable venture capital partner and how investors allocate significant decision rights to portfolio company managers. Casson and Martin’s paper is primarily concerned with the question of what makes VC firms more or less engaged investors. To examine these factors, Casson and Martin use hand-collected data about the venture capital practice in the UK. They find that the skills and experience (the human capital endowments) of VC partner managers are a key fact in investor engagement: VC partners with prior business experience are significantly more involved with the companies they finance. Finally, Abell and Nisar investigate the effects of syndication on VC firm performance. Their evidence suggests that better-networked VC firms are able to create a whole lot of business opportunities for network members. Tahir M. Nisar and Roderick Martin Guest Editors

The current issue and full text archive of this journal is available at www.emeraldinsight.com/0025-1747.htm

Activist investment: institutional investor monitoring of portfolio companies Roderick Martin

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Central European University (CEU), CEU Business School, Frankel Leo´ u´t, Budapest, Hungary, and

Tahir M. Nisar University of Southampton, Southampton, UK Abstract Purpose – The purpose of the paper is to show what Asset managers undertake to operate in accordance with the Statement of Institutional Shareholders’ Committee (ISC) whenever they engage with portfolio companies on behalf of their institutional investor clients. The Statement (2002) states that institutional shareholders have a responsibility to make considered use of their votes, and to enter into a dialogue with companies based on the mutual understanding of objectives. Design/methodology/approach – A survey study of Asset managers was conducted to evaluate their adherence to the ISC Principles. Findings – The findings in the paper show that fund managers routinely analyse information concerning those companies in which they invest, and have meetings with company managers. Managers are also involved in activities to promote standards of corporate governance and corporate accountability. It is also found that managers’ experience in managing deal flows, funds’ specialization and engagement specialists are the key drivers of adherence to the ISC Principles. Originality/value – The paper highlights the importance of specific fund capabilities for monitoring and controlling portfolio companies. Keywords Assets management, Investors, Best practice, Corporate governance Paper type Research paper

Introduction Companies run by managers and directors in the best long term interests of shareholders can be confident of investors’ continuing support. However, the problem of motivating company management to act on behalf of investors is well known in the principal-agent models (Jensen and Meckling, 1976). In recent years, a new literature has emerged that suggests that activist investors will become engaged when situations arise where investor involvement could lead to better company performance (Black, 1992). One such example of activist investment is the launch by the Institutional Shareholders’ Committee (ISC) of its Statement of Principles on the responsibilities of institutional shareholders and agents in late 2002. The aim of ISC principles is to develop a more systematic and transparent engagement by institutional fund managers. Its submission stated that “managers’ commitments on engagement will be set out in client agreements so that their clients, be they pension funds, insurance The authors thank Peter Casson, Maria Cody and John Baker for useful comments on an earlier draft of the paper.

Management Decision Vol. 45 No. 5, 2007 pp. 827-840 q Emerald Group Publishing Limited 0025-1747 DOI 10.1108/00251740710753657

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companies or investment trusts, can require that they are adhered to”. Following this initiative, fund managers routinely take measures, as our survey results show, to oversee the companies in which they invest, for example, almost all Asset managers have clear policy statements on engagement. Despite this apparent commitment to the ISC principles, fund managers take different approaches to meeting the demands of ISC principles. This paper measures Asset managers’ engagement with the companies in which they invest. In managing assets for both retail and institutional investors, Asset managers act as agents for the beneficial owners and are major investors in companies whose securities are traded on the regulated markets. They engage with those companies, enter into an active dialogue, and decide how these shares will be voted on the principles’ behalf. However, a great deal of this engagement is determined by their organizational and staff capabilities that let them monitor and evaluate portfolio company performance. In the present study, we analyse data from a survey of Asset managers that examine these capabilities and their practice of investor engagement. Our empirical study covers engagement in relation to UK investee companies. As at 30 June 2006, the managers’ holding in UK companies ranged from under 250 to just over 1,500 companies. The paper is organized as follows: the first section introduces ISC Statement of Principles and its likely impact upon the behaviour of fund managers. This is followed by our description of the data and various specifications of the variables used in empirical regressions. The next section presents our findings and the final section provides conclusions and corroborates the results by noting the findings of the prior literature on institutional investor activism. Statement of institutional shareholder committee Institutional investors have both a fiduciary responsibility and an economic interest in ensuring that company management goals are fully aligned with their interests (Black and Coffee, 1994). The ISC maintains current and relevant guidelines regarding the process of investor engagement and how to communicate investors’ perspectives on critical issues. Therefore, our benchmark for measuring the extent to which asset managers engage is their adherence to the ISC principles on engagement. The Statement recommends that institutional investors should: . publish a policy statement on engagement; . monitor and maintain a dialogue with companies; . intervene where necessary; . evaluate the impact of their policies; and . report to clients. Under these headings, the Statement sets out a core set of principles of engagement and stewardship that fund managers ought to observe. It means working with boards, management teams and other shareholders to bring about changes in either corporate governance, financial structure, strategy or appetite for certain risks that will in time lead to superior long-term performance by the company. We discuss below the practical implications of these principles for the engagement practice of Asset managers studied.

Corporate governance best practice The overriding objective of a company should be to optimize over time the returns to its shareholders. To achieve this goal, fund managers will need to encourage the companies in which they or their clients invest to comply with internationally recognized corporate governance principles. In this respect, the ISC believes that corporate boards play a critical role in representing owners in the process of key management issues such as remuneration design and oversight. Boards thus need to adhere to best practice in regard to their process, and that they ensure the pertinence and independence of all supporting advisors and guidelines used in monitoring company performance. It should also develop a framework that explains how the company deals with the issues of strategic positions, the ways it maximizes long-term financial returns, and how it manages the risks that it faces. By adopting a standard set of corporate governance principles portfolio companies will be able to garner support from the market while pursuing a right framework for value creation. However, fund managers should also take a pragmatic view in applying the ISC principles, which should be understood as an international benchmark for good corporate governance, and which may at times have to be adapted to the local financial and legal environment and the commercial imperatives within which a particular company operates. It is important to recognize that specific market conditions may influence the way and the extent to which fund managers are able to fulfil their responsibilities. However, they should strive to grow the beneficiaries’ investments as much as possible and to be both advocates and practitioners of good governance.

Understanding the companies The ISC principles set out a number of expectations, which ISC believes should exist between owners and managers. By being explicit about appropriate expectations, it will be possible to get a better framework for communication and dialogue between boards and shareholders. It is likely that the companies with which fund managers engage intensively will tend to have strategic or structural governance issues that have caused the share price of the company to be discounted by the market. Investor engagement is motivated by a belief that companies with active, interested and involved shareholders are more likely to achieve superior long-term returns than those without. To this end, fund managers will need to put considerable effort into understanding the reasons for a company not fulfilling its performance potential and the appropriate course of action for the board and management team to take to turn the situation around. To be effective, managers are likely to have constructive, informed discussions with boards and management teams based on a thorough understanding of the company’s past and potential. Understanding the company’s performance requires an analysis of the degree to which strategic objectives have been met, its historical financial performance and how risks and competition are managed. An important plank of this analysis is evaluating the company’s governance structures and how ISC principles justify any intervention. On the basis of the information collected, a roadmap is prepared for implementing change and how various measures can be targeted at ensuring the company’s long-term development.

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Engagement resources The ISC Principles emphasize disclosure and management of conflicts, transparency, proper expertise and oversight structures as important elements of investor engagement. Another related aspect of this process is the need to put in place mechanisms that collect feedback from the beneficiaries Asset managers serve and to responds to their concerns. In this respect, fund managers should be able to seek third-party sources of advice and research that incorporate corporate governance considerations. Independent outside advice and the delegation of key processes can add substantially to the quality of service provided to beneficiaries. Engagement is most effective if fund managers bring to bear their competence, knowledge and experience on operations at portfolio companies. However, in order to make a useful contribution, managers should also have a good understanding of the company and the business sector and market it operates in. To further such understanding, fund managers should ideally have a formal capability enhancement and skill acquisition process. ISC argues that fund managers should be appropriately resourced and meet relevant standards of experience and skill in investor engagement. Portfolio managers may have their own teams of governance and stewardship professionals with appropriate backgrounds in corporate, investment, legal, financial, strategic management consultancy, and forensic accountancy environments or they can employ independent outside advice, including an audit separate from the audit of the sponsoring body. These skills and competencies are important as engagement with companies, voting decisions and execution does require making informed and expert decisions. In addition, as they would be expected to justify to beneficiaries specific actions taken on their behalf whether by themselves or by those to whom specific services are out-sourced, managers will need mechanisms that engage with their clients. Applying governance codes flexibly and with intelligence The ISC principles aim to replace the damaging finger-pointing which normally characterise the City-Industry debate, with a positive dialogue between managers and owners about the proper purpose of the corporation. Codes of best practice and supplementary guidelines provide the basis for Asset managers to build a dialogue with companies. Managers are encouraged to apply the principles pragmatically and with thought. In particular, the specific circumstances of individual companies play an important role in how fund managers develop their own engagement strategy. This flexible approach is consistent with the overriding objective of investor engagement intended for maximizing long-term returns for their clients. The ISC principles are underpinned by the idea that engagement should be integrated into the investment process. For example, engagement in relation to strategy and performance is handled by fund managers/analysts and, due to the specialist knowledge required, particular individuals are dedicated to certain aspects, such as corporate governance and socially responsible investment. The dedicated specialists do not act in isolation from those involved with the investment process. Very often they sit with the fund managers/analysts and attend the same meetings. In addition, those involved with the investment process are frequently responsible for approving the policy for engagement and voting, and in deciding in a controversial or contentious situation.

Exercising voting rights Voting forms an important part of fund managers’ approach to corporate governance. It is based on the premise that all votes cast on key management issues contribute to a stronger management focus on the interests of shareholders in the case at hand, as well as in general. However, the process of casting voting can be made more meaningful by basing decisions on careful analysis, consistent with a well-considered policy towards improving and upholding the corporate governance of companies and markets. This also implies that automatic voting should be avoided. This process can be strengthened by developing voting guidelines that take due account of already existing international and national standards. The opportunity to vote at shareholder meetings hinges in part on the adequacy of the voting system. Some concrete steps can be taken by companies themselves to ensure higher levels of shareholder participation in the decision making process-support initiatives to expand voting options to include the secure use of telecommunication and other electronic channels. Institutional investors, or Asset managers on their behalf, can engage proactively with intermediaries to remove barriers along the entire voting chain. However, this requires that all intermediaries in the voting chain work together to eliminate them. A case in point is the unnecessary strict voting deadlines, which sometimes fall before markets require the disclosure of basic meeting information. These restrictions often frustrate the exercise of shareholder rights. Empirical tests The first aim of this section is to develop parameters that enable us to empirically investigate fund manager characteristics and the extent to which they influence their propensity to engage with portfolio company management. In the light of our above discussion, we discuss these in terms of: . structure and resources; . ongoing monitoring; . voting; and . evaluation and reporting. We then provide variable definitions and introduce our dataset. Structure and resources The first issue in relation to the implementation of ISC Statement of Principles is the nature and scope of fund resources, structure and approach developed for monitoring and interaction with portfolio companies. Due to the very nature of the engagement process, it is very difficult to isolate precisely the resources deployed as engagement is often integrated with the investment process itself. This is the case, even if, due to the specialist knowledge required, particular individuals take responsibility for certain engagement processes, such as voting and corporate governance or socially responsible investment. On the other hand, engagement resources are also influenced by the engagement strategy itself. When investment strategy guides the engagement processes, firms either use their own proprietary analysis (rather than employing a traditional fund management approach) or they deliberately invest in under-performing companies with the aim of encouraging change and adoption. In the latter case, firms adopt a more rigorous and capability-based engagement approach in

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that they set up a team of dedicated staff to carry out the engagement process, rather than overlaying monitoring and interaction on the investment process. Inevitably, detailed discussions are held by these teams with portfolio company management to influence their policy and practice. To obtain information about these practices, the survey asks whether funds employ engagement specialists.

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Ongoing monitoring Fund managers are encouraged to prefer dialogue and negotiation with company management and avoid taking the public route when seeking change at companies. This is because of the notion that confrontational style will not produce desirable change in management behaviours and will only aggravate the already worsening situation. Fund managers may use the press and other public forums to drive change only as a last resort in situations where no progress is made. In this respect, the Statement of Principles envisages a prominent role for desk-based monitoring as part of the firms’ engagement strategy. Desk-based monitoring ensures regular processing of information about portfolio company performance. However, meetings with investee company management are seen as a critical step in ensuring that fund managers’ concerns are fully transmitted to the investee company management. As our survey finds, some companies meet with a portfolio company’s management at least once a year while others meet at a minimum six times a year. The following factors are likely to affect the frequency of meetings; the firm that deliberately invested in under-performing companies – managing a specialist fund holding companies with long-term underperformance – do so under the assumption that interaction would have a “dramatic” impact on the value of the investment, thus requiring frequent meetings; the management of companies where “core” engagement rules are applied requires meetings on a regular basis but not as frequent as in the first case; engagement with companies where conventional corporate governance issues such as board structure and remuneration are discussed require not-very-frequent meetings (e.g. once a year), and if portfolio companies find the going tough, fund managers may have to intervene on a more urgent basis, even if they do not subscribe to “deliberately investing in under-performing” strategy. Depending on circumstances and local regulations, fund managers may discuss price sensitive information and cease active trading in the affected securities for the relevant period. In these circumstances, managers may conduct either prompt-the-case meetings or regular one to six meetings a year. To investigate these issues, the survey obtains information about the frequency with which meetings are held by fund managers with portfolio companies. Voting Whether firms would vote against portfolio company management and/or consciously abstain (for an abstention to be conscious, there should have been some communication that this was a conscious abstention with management) and if it is the firm’s policy to advise the portfolio company’s management of such intentions in advance is a key question of interest in investor engagement. An interesting aspect of the voting policy relates to the situations where a vote is particularly controversial or contentious that could affect the value of the shares held. Determining what constitutes a contentious situation hinges on individual perceptions of the likely impact of a particular managerial situation. At the organizational level, it may be that a certain amount of

discussion and/or debate between the firm and the portfolio company held beforehand underlines the importance of a particular situation. These discussions can also result in the proposed resolution modified or an undertaking given that the issue would be addressed over time. Other strategies include: a firm may oppose a resolution but may wish to advise in advance to give it an opportunity to explain its reasons or amend the resolution; or a firm may register disapproval and abstain, making it clear to management that unless the policy is changed than the firm will vote against it next year. It is also important to be aware of the role of proxy voting agencies. In some instances, a firm’s policy on how it will vote is decided by an external proxy voting agency either solely or in conjunction with its own internal corporate governance specialist. The survey obtains details of the number of votes cast in the quarter ended June 30 2006 and the number of portfolio companies affected. Evaluation and reporting In general, Asset managers’ clients will receive regular reports on their governance and engagement activities and will have the opportunity to question managers on their performance against the objectives they have set. We thus investigate the number of firms that report information on how they discharged their responsibilities to their clients, the frequency of such reports and the matters reported. The assumption behind adopting this indirect measure of engagement is our belief that preparing such reports requires a great deal of information collection and dialogue with the portfolio company management, not only relating to matters of trades but also how portfolio company management evaluates and presents its own practice and future company prospects. These reports normally entail two sets of information: (1) Details of all resolutions voted. (2) Details of meetings attended, either in summary or where there are issues. Variables definition The survey asked 33 UK managers about different aspects of fund managers’ engagement practice as of June 2006. As at 30 June 2006, these managers were invested in £507 billion of UK equities out of an estimated total of £800 billion UK equities managed by UK managers, accounting for 63 percent. In view of the preceding discussion, we use the following set of independent variables. Table I provides descriptive statistics. Policy is a dummy variable which takes the value 1 if the Asset manager is reported to have prepared a statement which sets out its policies in relation to the ISC Principles; 0 otherwise. It is likely that managers’ commitments to engagement are set out in client agreements such that they include provisions that address their policies on voting and adherence to the Statement. Market focus is a variable given by the inverse of the average number of companies financed in one particular market sector, per year. Engagement specialist is a dummy variable that takes the value 1 if the Asset manager has designated one or more Engagement (Corporate Governance) specialists, zero otherwise. Institutional fund experience is the average number of years of Asset managers’ experience in institutional investment.

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Table I. Descriptive statistics

Variable

Mean

Median

Min

Max

Policy Market focus Engagement specialist Institutional fund experience Institutional investor clients Electronic voting Voting agencies Fund size Fund age Interaction Reports Voting 1 Voting 2 Medical products Biotech and pharma Software and internet Electronics Telecom Media and entertainment Financial services Industrial products Food and consumer goods Other sector

0.918 0.647 0.493 9.76 0.752 0.639 0.385 11 5.3 0.674 0.927 0.678 0.271 0.325 0.266 0.371 0.134 0.067 0.153 0.074 0.384 0.492 0.116

– – – 8.01 – – – 18 3.0 – – – – – – – – – – – – – –

0 0 0 0 0 0 0 2.5 1 0 0 0 0 0 0 0 0 0 0 0 0 0 0

1 1 1 22 1 1 1 31 23 1 1 1 1 1 1 1 1 1 1 1 1 1 1

Institutional investor clients is the percentage of institutional investors as clients. Electronic voting is a dummy variable that takes the value 1 if the Asset manager votes electronically, zero otherwise. Voting agencies is a dummy variable that takes the value 1 if the Asset manager uses voting agencies, zero otherwise. Fund size is the amount under management of the Asset manager at the end of the sample period, in billions of current dollars. Fund age represents the age of the Asset manager in the year 2006. Industry is set of a dummy variables that we obtain the data from our survey instrument, which gave the following choices: Biotech and Pharma; medical products; software and internet; financial services; industrial services; electronics; consumer services; telecom; food and consumer goods; industrial products (incl. energy); Media & entertainment; other (specify). We construct a variety of engagement (dependent) variables that encapsulate different aspects of Asset managers’ engagement with portfolio companies. Interaction is a dummy variable that takes the value 1 if the Asset manager is reported to interact (hold meetings) with the company on a three or six monthly basis; 0 if it interacts with on an annual basis. Reports is a dummy variable which takes the value 1 if the Asset manager is reported to prepare monthly or quarterly basis for its clients; 0 otherwise Voting 1 is the total number of votes cast in year 2005-2006. Voting 2 is the total number of votes cast against the resolution (or absent) in year 2005-2006.

Results Table II provides probit results for four sets of independent variables; Interaction (column 1), Reports (column 2), Voting 1 (column 3) and Voting 2 (column 4). The results show that all organization and institutional effects are important in explaining the variation in Asset manager engagement policy outcomes. The models’ pseudo R 2’s range from 0.263 to 0.538 ( p , 0.001). The study uses a variety of measures to investigate the effects of organizational design and fund manager experience. Fund managers focusing on particular markets are much more involved with their companies as are those with institutional investor clients. Experienced managers actively engage with their portfolio companies and they also assist their operations by providing expert support. Communications with portfolio company management may take different forms. For example, concerns may be expressed through the firm’s advisers. However, when the firm decides to challenge portfolio company management on matters other than trading results this tends to be through structured processes. Fund managers regularly enter into dialogue with investee companies’ directors and senior management where there are concerns about matters such as strategy, Board composition and remuneration, management processes and audit issues. These relationships are captured by significant and positive coefficients on Interaction and Reports variables. The results also demonstrate that a great deal of engagement is done by means other Interaction Policy Market focus Engagement specialist Institutional fund experience Institutional investor clients Electronic voting Voting agencies Fund age Fund size Industry controls Observations X2 Model p-value Pseudo R 2

Reports

Voting 1

0.378 * * *

2.077 * * *

3.297 * * *

(2.44) 0.867 * * * (2.61) 2.785 * * * (2.56) 1.523 * * * (3.74) 0.774 * * * (3.11) 4.326 * * * (4.26) 2 2.278 * * * (2.34) 2 0.654 * * (0.01) 2 0.163 * * * (0.08) Yes 33 476.36 0.000 0.437

(2.27) 1.641 * * * (9.14) 2.189 * * * (2.16) 3.218 * * * (2.43) 1.815 * * * (3.85) 1.822 * * (1.28) 22.674 * * * (2.76) 0.062 (0.06) 20.005 * * (0.02) Yes 33 321.84 0.000 0.538

(7.44) 0.544 * * * (3.27) 3.653 * * (3.12) 2.384 * * * (3.75) 0.442 * * (2.14) 5.608 * * * (4.61) 0.117 * (0.21) 0.205 (0.01) 20.142 (0.01) Yes 33 345.21 0.000 0.416

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Voting 2 2.166 * * * (2.36) 0.157 * * * (1.15) 2.353 * * * (2.41) 0.249 * * * (1.52) 2.002 * * (2.42) 3.766 * * * (3.62) 0.219 * * (0.64) 2 0.541 * * (0.05) 2 0.171 * * * (0.09) Yes 31 318.34 0.000 0.263

Notes: The Table reports the estimated coefficient and the T-ratio (in parentheses), computed using Huber-White robust standard errors. In all regressions, industry controls are included but not reported; * * *, * *, * values significant at the 1, 5 and 10 percent level respectively

Table II. Fund managers and engagement

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than through voting such as meeting with the directors and senior management to express concerns, raise contention issues and obtain information about company strategy. Under the ISC principles, corporate governance best practice sets out the structures and processes by which a company should be controlled through its corporate board. For example, board should encourage positive entrepreneurial behaviour, while having appropriate checks and balances through its independent directors and the right balance of power to ensure decisions are wisely made. Within the context of engagement, the task of a fund manager is to oversee this process of change implemented by portfolio companies. By conducting regular meetings with portfolio company management, fund managers ensure management compliance with ISC’s detailed policy proposals. The results also show that organizational specialization matters. Measures capturing the role of organizational focus (i.e. market focus) are positively related to all four-criterion variables, although the coefficients for reports are slightly smaller then the other equations. Specialization in the form of sectoral knowledge to helping support the portfolio company in a particular sector and applying engagement expertise (the appointment of Engagement/Corporate Governance Specialists) result in how observed Institutional Fund Experience and Engagement Specialist are correlated with its engagement practice. The source of this specialization is obviously linked to the development of fund manager operations in one particular sector and may also have been influenced by engagement specialists, as this variable is significant and positive in all four regressions. However, it is important to note that fund managers have increasingly factor into their investment decisions and risk management strategies the results of independent corporate governance research and data. In January 2004, Myners (2004) reported on his “Review of the Impediments to Voting UK Shares”. One of his recommendations was that fund managers communicate voting instructions electronically. Since then there has been a marked increase in the number of managers that vote their UK shares electronically. In this study, we examined the impact of this practice on various aspects of investor engagement. As Table II shows, electronic voting is positively and significantly correlated with Voting 1 and Voting 2 as well as with Interaction and Reporting variables. This suggests that electronic voting has a positive impact upon the overall engagement approach of the fund managers. However, the use of voting agencies by fund managers has a negative relation with the Interaction and Reporting variables. This result signifies the role of internal capabilities that fund managers bring to bear upon their engagement practice. In general, these results stress the importance of responsible investors making use of their voting rights. This is in line with the ISC principle that institutional shareholders should seek to vote the shares that they own in a considered way, but also vote the shares in the best interest of the beneficiaries to whom they owe a fiduciary duty. Literature on business enterprises argues that firm size will strongly determine the extent of support given to portfolio companies (Gompers and Lerner, 1996). However, the variable representing the effect of Asset manager size shows negative correlations with all four dependent variables. Similarly, in relation to Asset manager age there are negative estimates for two of the four equations, suggesting that Asset manager age

does not have much bearing on the way Funds manage their portfolios, especially in relation to the support intensity for portfolio companies. The majority of the firms sampled had a policy to vote all their UK shares, where possible, international shares. One important finding is that the firms studied did not necessarily always support management as our survey results show. Fund managers could either take one of the two actions: they may vote against the resolution or consciously abstain. In both cases, fund managers convey their displeasure in relation to operations at portfolio company management. We find that fund managers’ own capabilities have a key role in deciding against a particular management resolution as the positive coefficients on engagement specialist shows. It is likely that the expertise provided by funds’ engagement specialists forms the basis for such decisions. Discussion and conclusions As the ISC Principles emphasize, the institutional investor is ultimately responsible for ensuring that custodians and service providers act in accordance with the principles. Asset managers can aid the institutional investor in exercising its fiduciary rights and responsibilities by monitoring the governance of the companies in which they invest on behalf of their clients closely, giving support to those which demonstrate an appropriate structure, and intervening to change those which do not. The ISC principle Six, for example, advocates an explicit activism strategy addressing when the fund will intervene, with what approach, and how effectiveness will be measured (ISC, 2002). The principle states that institutional investors should make considered use of their votes, and where practicable enter into dialogue. This suggests that investors can influence company governance in a variety of ways, including external control measures, internal governance measures, and measures relating to executive compensation that align incentives (Karpoff et al., 1996; Chidambaran and Woidtke, 1999). For instance, pension funds with a ‘universal owner perspective’ have an incentive to encourage companies to absorb negative externalities (Hawley and Williams, 2000). They do not necessarily punish companies for taking risks in production or service provision when there is an economic downturn, thus helping them to make more efficient tradeoffs between risk and insurance. The existence of shareholders with large stakes, as measured by monetary value, has also been assumed to provide a partial correction to free-rider problems, not least because of the fact that their costs of intervention may be relatively small (Stein, 2003). However, although the monetary value of shares in one company held by an institution may be large, the proportion of the total equity held is likely to be small. In this sense the institutional investor is in a similar position to the individual in a diffusely-held company in that it bears the full costs of monitoring and intervening where appropriate, but gains only a fraction of the benefit. Several other explanations have then been advanced to justify the activist approach of some institutional investors (Romano, 2002). First, it is suggested that investors may risk inadequate diversification if they sell their investment in a company. The cost of involvement is therefore seen as being offset by the benefit of a more widely diversified portfolio. Second, the growth in indexed funds has meant that institutions attempt to increase the performance of the market as a whole by targeting and intervening in under-performing companies. There are assumed to be spillover effects from the targeting of one company into the market

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as a whole. Finally, the increased use of anti takeover provisions by US companies is seen as restricting the operation of the market for corporate control, leading institutional investors to act to prevent their use. In a similar vein, Karpoff (2001) identifies three views of institutional investor activism. The first is that activist investors are monitors who ameliorate some of the incentive and control problems associated with large, diffusely owned, companies. Through their proposals and contact with companies, institutional investors are seen to indirectly influence managers to make organizational changes, change corporate governance or modify strategy. The second view is of activist investors as being bullies, interfering with the company’s management. This may have negative consequences as fund managers may lack appropriate abilities in their intervention with management, or their focus is on short-term performance to the detriment of the long term. Further, investors may be pursuing non-value maximizing objectives, for example, by adopting social welfare objectives. Finally, there is a view that investor activists are ineffective and have little influence on the policies, operations and values of targeted companies. This wide interpretation of the scope of investor activism underlines the importance of further empirical work to understand better active investors’ motives and consequences. There are now several studies of the effectiveness of institutional investors on company behaviour (Black, 1998; Gillan and Starks, 1998; Karpoff, 2001; Romano, 2002). The picture of the effect of activism on companies is, at first sight, somewhat confusing, with some studies suggesting that activism is effective whilst others report the opposite. These contradictory findings can be accounted for by differences in the design of the studies. First, studies differ in the definition of “success”, the dependent variable. Karpoff (2001) identifies six different criteria: (1) Increase in share price. (2) Improvement in accounting measures of performance. (3) Change in management and/or operations. (4) Adoption of proposals by activist investors. (5) Some action attributed to shareholder pressure. (6) A shareholder proposal receiving support from other investors. Second, studies differ in the event, the independent variable that represents the action by institutional investors (Gillan and Starks, 1998; Karpoff et al., 1996). This may be a proposal for a resolution by one or more institutions, the announcement that institutional investor(s) and a company have reached agreement, or the inclusion of a company in a list of targeted companies drawn up by an activist investor, such as California Public Employees Retirement System (CalPERS), or the Council of Institutional Investors (CII). Third, there are differences in the issue that is of concern: the adoption of anti take-over defences, management compensation, board structure, etc. Finally, there are differences in sample sizes and in the time period covered in the studies. This may be important because the effects of investor activism may have changed over time (Karpoff et al., 1996). Institutional shareholders are assumed to have an important role to play in corporate governance and yet the above literature suggests little association between institutional

shareholder activism and corporate performance. Various explanations have been advanced for the failure to demonstrate a connection between institutional shareholder activism and company performance, measured using accounting numbers or shareholder returns. One type of explanation for this is that institutional shareholders may have conflicts of interests, which inhibit their engagement. This may explain why shareholder activism in the US is associated with public sector pension funds. The other type of explanation is that institutional shareholders engage with investee companies to successfully bring about change, but the changes are not reflected in improved company performance, as measured by accounting profits and share returns. Karpoff (2001), for example, notes that: “Both proposals and private negotiations have prompted some firms to make small changes in their governance rules (e.g. appointment of independent board members), but there is little evidence that either has increased target firms’ earnings or had much effect on operations”. Extending this argument, Romano (2002) suggests that investor activism does not lead to improved company performance because activists are focusing on corporate governance issues, including board structure, restricting executive compensation, confidential voting, and takeover defences. Good corporate governance in itself may not necessarily be associated with superior company performance, and there is uncertainty about the effect of the adoption of takeover defences on shareholder wealth. Alongside these explanations is the view that institutional shareholders do not engage, or engage very little, with the companies in which they invest. For example, Black (1998), in his review of the US literature, concludes that the level of shareholder activism is low, and that institutions do not spend much on overt activism. The present study examines the extent to which investor activism exists in the UK, and the factors that contribute to investor activism. The picture that emerges from our analysis is that UK investor engagement is both shaped and supported by an institutional framework that contains trade organizations, such as the ISC, and electronic voting and monitoring. Fund managers’ own capabilities in terms of preparing a policy statement on engagement, employing engagement experts and focusing on particular markets also contribute to their propensity to engage with portfolio companies and the extent to which they comply with ISC Statement of Principles. A great deal of institutional shareholder activism has been in the area of corporate governance, both generally in the production of guidelines of best practice and specifically in engagement with companies whose standards of corporate governance practice fall short of best practice. However, effective monitoring and engagement in this area requires greater transparency and possibly mechanisms to support intervention. For example, entities responsible for executing votes on behalf of beneficiaries should clearly disclose both its voting policies as well as how it actually has voted in specific meetings. In addition, institutional shareholders should address any voting obstacles, which effectively disenfranchise shareholders. They can press issuers to disclose complete meeting information in a more timely manner, and thus remove restrictions on shareholders from making informed voting decisions. As our results show, ISC Statement of Principles has proved effective in providing a useful framework for monitoring and evaluation of investee companies, and these benefits can be further enhanced by strengthening fund managers’ specific capabilities in investor engagement.

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References Black, B.S. (1992), “Agents watching agents: the promise of institutional investor voice”, UCLA Law Review, Vol. 39, pp. 811-94. Black, B.S. (1998), “Shareholder activism and corporate governance in the United States”, in Newman, P. (Ed.), The New Palgrave Dictionary of Economics and the Law, Macmillan, London. Black, B. and Coffee, J. (1994), “Hail Britannia? Institutional investor behavior under limited regulation”, Michigan Law Review, Vol. 92, pp. 1999-2088. Chidambaran, N.K. and Woidtke, T. (1999), “The role of negotiations in corporate governance: evidence from withdrawn shareholder-initiated proposals”, working paper No. CLB-99-012, New York University Center for Law and Business, New York, NY. Gillan, S.L. and Starks, L.T. (1998), “A survey of shareholder activism: motivation and empirical evidence”, Contemporary Finance Digest, Vol. 2 No. 3, pp. 10-34. Gompers, P. and Lerner, J. (1996), “The use of covenants: an empirical analysis of venture partnership agreements”, Journal of Law and Economics, Vol. 39 No. 2, pp. 463-98. Hawley, J.P. and Williams, A.T. (2000), The Rise of Fiduciary Capitalism: How Institutional Investors Can Make Corporate America More Democratic, University of Pennsylvania Press, Philadelphia, PA. ISC (2002), The Responsibilities of Institutional Investors – A Statement of Best Practice, Institutional Shareholders’ Committee, ABI, London. Jensen, M. and Meckling, W.H. (1976), “Theory of the firm: managerial behavior, agency cost, and ownership structure”, Journal of Financial Economics, Vol. 3, pp. 305-60. Karpoff, J. (2001), “The impact of shareholder activism on target companies: a survey of empirical findings”, working paper, University of Washington, Washington, DC. Karpoff, J.M., Malatesta, P.H. and Walkling, R.A. (1996), “Corporate governance and shareholder initiatives: empirical evidence”, Journal of Financial Economics, Vol. 42 No. 3, pp. 365-95. Myners, P. (2004), Review of the Impediments to Voting UK Shares, report submitted to the Shareholder Voting Working Group. Romano, R. (2002), “Less is more: making institutional investor activism a valuable mechanism of corporate governance”, in McCahery, J. and Renneboog, L. (Eds), Convergence and Diversity in Corporate Governance Regimes and Capital Markets, Oxford University Press, Oxford. Stein, D.M. (2003), “Active and passive arguments: in search of an optimal investment experience”, Journal of Wealth Management, Vol. 6 No. 3, pp. 39-47. Corresponding author Roderick Martin can be contacted at: [email protected]

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Shaping exit and Shaping exit and voice: voice an account of corporate control in UK sports Lynne Nikolychuk

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King’s College, London, UK, and

Brian Sturgess Soccer Investor Ltd, Fulham, London, UK Abstract Purpose – The purpose of this paper is to help demonstrate the extent to which socio-cultural and market-oriented incentives jointly contribute to corporate control outcomes that prevail in the UK football industry. Design/methodology/approach – Illustrative case studies informed by analysis of financial performance data, discussion with key informants, review of official documents. Findings – The paper finds long term performance outcomes were influenced in substantive ways by actions led by shareholder groups pursuing largely non-market-oriented objectives. Research limitations/implications – Industry-specific empirical work that analyses how the interplay between voice and exit strategies influences corporate control outcomes is limited. This paper focuses on two UK cases and therefore would benefit expansion to further UK cases and comparative analyses to non-UK situations. Practical implications – The outcomes suggest that the market for corporate control in this particular industry context requires specific attention to actions driven by largely non-market-driven incentives. Originality/value – Previous papers have not provided detailed empirical-based evidence about how socio-cultural concerns have influenced corporate control outcomes in the case studies provided. Keywords Football, Customer loyalty, Sports, United Kingdom Paper type Research paper

Introduction The UK football industry provides an interesting context to study how voice and exit mechanisms jointly operate in a market for corporate control. One important characteristic is how its ongoing market orientation operates alongside interests that are largely based on a non-market driven rationale. It has been suggested that UK football has cultivated a model for corporate control worthy of exploitation throughout the European community (Arnaut, 2006). However, experimentation since the late 1990s, questions which corporate control model is the most suitable for this industry. Whilst the exit system became popular in the UK, it now appears to be faltering (Banks, 2002) and the voice system has become stronger (Supporters Direct, 2006). We argue that these evolving corporate control structures have a great deal to do with the specific ways in which voice and exit activities of particular shareholder groups have influenced, and thus shaped, the UK football industry’s current organising practices.

Management Decision Vol. 45 No. 5, 2007 pp. 841-852 q Emerald Group Publishing Limited 0025-1747 DOI 10.1108/00251740710753666

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We proceed by providing a brief industry background and outline our theoretical orientation. We then provide an overview of the market for corporate control in UK Football, followed by an analysis of two case examples: (1) Southampton Football Club. (2) Manchester United Football Club.

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The analyses focus on the interplay of voice and exit and compare the outcomes that prevailed. We conclude with a discussion and offer suggestions to further develop research. Industry background Socially situating football is essential to understand how the market for corporate control operates, and is evolving, within this industry. The underlying premise is that corporate control arrangements exist as outcomes from ongoing social relations amongst groups interacting with environmental factors such as ownership structure, or culture (Granovetter, 1985). Within this context, the socio-cultural importance of football is prominent. Literature, both from industry (Football Task Force, 1999) and academic (Brown, 2000; Fawbert, 2005) sources strongly endorse this view. Club customers are characterised by their loyalty to a specific club. Generations of family members and friends tend to support the same club and switching club allegiance is rare. An available substitute is a meaningless proposition. Shareholders that are also fans are, in this sense, “locked in” to their club investments and this situation is stable. Such tribal-like loyalty (Brown, 1998), can verge on the irrational, “you think nothing of travelling hundreds of miles to sit in a stadium with all the atmosphere of a wake, to show loyalty to your club. The same club that’s always thinking of ingenious new ways to bleed you dry” (Ingle, 2005). This article, as anecdotal evidence, generated over a thousand supporter responses with 90 per cent in agreement. Despite stability in the socio-cultural nature of football, significant economic changes have occurred. The largest shift that has changed corporate control arrangements relate to the commercialisation and globalisation of the sport. Football is now big business and is becoming bigger. Combined revenue for the world’s five largest football nations (England, France, Germany, Spain, and Italy) rose from e1.94 billion in the season 1994-1995 to e6.27 billion by the season 2004-2005. The UK has been leading this global phenomenon (Deloitte, 2006). In the UK, football’s three main revenue streams (match day attendances, broadcasting rights, and other commercial income) have grown much faster than real GDP. Combined turnover of the 20 Premier League clubs rose from £170 million in the season 1991-1992 to £1.33 billion in the season 2003-2004 (Deloitte, 2005). An important, and ongoing consequence of these changes is how this relatively new commercial impetus is competing with the sport’s traditional socio-cultural foundation (Morrow, 2003). We now outline the theoretical perspective that we adopt for the empirical cases that follow. Theoretical orientation A useful approach for studying corporate control within the context of football is the analytical framework proposed by Hirschman (1970), which develops the notions of

exit, voice, and loyalty to explain the alternative options available to rectify, in Hirschman’s terms, “repairable lapses” in economic performance. The exit option is any variation of ceasing involvement with the firm. For example, shareholders sell their shares or, customers stop buying the product. The voice option is any attempt to change a disagreeable situation, either through individual or collective appeal to management, with the intention of forcing a change in management practices. For example, shareholders call for management resignations or, football fans petition for reduced ticket prices. The effectiveness of either corrective mechanism depends, according to Hirschman, upon a number of situational factors. For competitive business firms, exit dominates and voice is underdeveloped. In market-oriented situations, a decline in quality leads to exit and falling revenue, which prompts management to improve quality to regain lost sales. Generally, the more elastic quality demand is, the more rapidly exit occurs. Hirschman argues that one of the reasons why the exit option prevails is because it tends to be relatively less costly even when voice options are available. However, the likelihood of voice increases with the degree of loyalty because these feelings motivate collective action and act as a barrier to exit, especially when substitution is limited. Thus, loyalty acts as an intervening factor between exit and voice systems. Hirschman suggests that both modes can be overdone. If quality elasticity demand is extreme, then an exit system is unlikely to work as a correction mechanism. Extreme inelasticity may result in too little action too late and extreme elasticity may result in rapid exit and firm extinction. Equally, if voice is too noisy, that is to say, protests become extreme, they may hinder rather than help remedial efforts. So, what might represent an optimal mix of voice and exit within the context of football? Hirschman proposes that the exit option will dominate for firms in a competitive market and voice gains importance where organisations have some non-market oriented objectives, such as voluntary associations, competitive political parties, and some business enterprises. This later type is not specified. Therefore, the conceptual model is open for empirical investigation. Other authors (Groenewegen, 1997; Nooteboom, 1999) provide further hints. They suggest that the exit option is a competitive market mechanism most closely associated with the Anglo-American form of corporate control while the voice option is a political solution, most closely associated with continental European countries and Japan. This comparison is relevant for football because it may help to explain why increasing commercialisation and globalisation (as described in the next section) has corresponded with migration toward an Anglo-American form of corporate control. We continue with an overview of the market for corporate control in UK football and describe how it has recently evolved. Market for corporate control in football The agency problem The market for corporate control literature considers agency problems that occur when there is a separation of ownership and control (Berle and Means, 1932; Fama and Jensen, 1983). Agency problems arise to the extent that management (agent) objectives diverge from those of the owners or shareholders (principal). Managerial discretion can adversely affect the economic performance of firms, according to owner objectives such as profit or value maximisation (Baumol, 1959; Williamson, 1963). Managerial

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discretion is greater the more information asymmetries exist between principals and agents and the wider distribution of property rights between them. The economic significance of agency issues is also influenced by the organisational and legal structure of the firm and by the institutional and competitive environment. Shareholder engagement is an active response to agency issues, which, in football, has increased alongside the sport’s commercialisation.

844 Ownership structures Three main ownership models operate in UK football. These are: (1) Clubs comprising members who collectively own the assets and elect officials on the one member one vote principle. (2) Limited liability companies comprising shareholders and a board of directors. (3) Public limited corporations (plc) with freely tradable equity. Football’s global governing body has established (FIFA, 2002) that there are 305,060 association football clubs registered globally. Most are small, amateur organisations. This organisational form precludes a market for corporate control. However, at the top level of professional football, particularly in the UK, clubs have long been incorporated as limited liability companies. More recently, there has been migration towards the plc model, with mixed results. In football, the agency problem is not clear-cut because there is some debate over what managers or club owners are trying to maximise. Sloane (1971) argues that clubs are less profit oriented than other commercial organisations because they are attempting to maximise utility with sporting performance, an important argument within the utility function. UK evidence suggests that over their history as limited liability companies, there have been long periods when the profitability of football clubs has been extremely poor (Szymanski and Kuypers, 1999). This arrangement did not previously lead to significant agency problems because voting equity was highly concentrated in the hands of football club directors. For example, in 1982, in half of England’s 1992 professional Football League clubs, more than 40 per cent of voting shares were owned by directors (Morrow, 2003; FIR, 1982). It has also been suggested that if a club’s team performance is the residual to be maximised then club supporters should be included as an element in the club’s production function (Szymanski and Smith, 1997). From this perspective, fans have an important role to play through the “atmosphere” they create and through demonstrations of support or dissension as a monitor on the team’s performance. For incentives to be effective, fans should be entitled to property rights in the performance residual to be maximised, giving them a dual role as customers and factors of production. McMaster (1997) also argues that the agency problem has occurred in football conversely because there is no separation of ownership and control and he advocates wider share ownership as a possible solution. However, as will be illustrated in the case studies that follow, the significant move to create a basis of supporter shareholders seems to have more effectively introduced a new conflict between shareholder groups rather than a trade-off between profitability and team performance. Adoption of the limited liability corporate model by many professional UK football clubs has raised the potential for conflict due to competing interests between the profit

motive and sporting performance. This dynamic was recognised at an early date. In order to restrain the ability of director-owners to trade-off financial against sporting interests, Rule 34, created in 1899, restricted the payment of dividends to shareholders to five per cent of the nominal value of the shares and forbade the payment of salaries to directors (Conn, 2004). This ruling eventually led to further changes in corporate form; the establishment of holding companies and public limited companies that permitted ownership of a club as a subsidiary. Tottenham Hotspur, the first club to use the plc ownership model, floated on the London stock exchange in 1982. This corporate structure was copied by a large number of other clubs since it allowed them to sidestep Rule 34, which was finally abandoned in 1998 in recognition of the Football Association’s (FA) failure to regulate potential conflicts of interest. By the end of 2001, there were 24 English and Scottish football clubs listed on either the primary and secondary stock markets in London with a combined market value of £991 million (Soccer Investor Weekly, 2002). This shift in ownership model has contributed to the genesis of shareholder activism. Emergence of a new “voice” Mechanism: Supporters’ Trusts Paradoxically, the drive to list clubs has opened up management to exit pressures and, by introducing thousands of committed fan shareholders, has created channels to focus the power of voice. By 2000, a government endorsed and funded body, Supporters Direct, was operating as a pressure group with the purpose of encouraging fans to group together to acquire shares in both listed and unlisted clubs. Collective voice began to be directed at the club’s management policies on issues such as ticket prices, player purchases, stadium relocation and development and fan representation (Hamil et al., 2000). In some cases, supporter shareholder groups have acquired sufficient equity to take control of some clubs. At present, nearly 67 per cent of the 92 fully professional football clubs in England have a supporters trust. The movement has also spread to lower leagues. Across England and Scotland there are 149 share-owning supporters’ trusts in existence holding the shares of an estimated 120,000 people. In total 13 clubs are now controlled by their local supporters, although only three of these play in the English Football League and none higher than League Division One. A total of 42 clubs have direct club board representation, of which 79 per cent are full directors. This voice mechanism has become a permanently embedded feature. The next section outlines the research design and methodology used to investigate the interplay between voice and exit for two empirical examples. Research design and methodology The research design chosen for this investigation is a comparative case study approach (Yin, 1994). The aim is to provide a concise, structured narrative analysis of voice and exit in two English football clubs during the period 1997-2007 and to compare the outcomes that prevailed. The two cases chosen are Southampton FC and Manchester United. They were selected because they were both operating in the top league at the start of this period and are examples of very different corporate control strategies. In addition, a preliminary review of other Premier League club corporate control activities during this period suggest that Southampton FC and Manchester United are indicative

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of the changes underway in this industry’s market for corporate control. For these reasons, the cases represent good illustrative examples. The analysis relies on primary and secondary data collection sources including: discussions with key industry informants, analysis of financial performance, and documents from official sources. The industry cases Southampton FC The recent corporate history of Southampton Football Club (FC) can be seen as the successful application of “voice” pressures, but as a failure of the “exit” mechanism from the perspective of those shareholders interested in the realisation of market value. The club is listed on the London Stock Exchange under the name Southampton Leisure Holdings plc (SLH). Southampton FC were one of the original founder members of the Premier League and remained in this top group until May 2005 when they were relegated to the league below, the Football League Championship. Relegation created much fan dissatisfaction with the policies of the club board and, in particular, with club and plc chairman, Rupert Lowe. A movement to create a Supporters Trust at Southampton FC for fan shareholders to lobby the club’s board started in the summer of 2005, shortly after the relegation. Supports also expressed their reaction to the perceived quality reduction through the forces of exit on season ticket sales. Average attendances for league matches at the club’s 32,000 seat capacity ground fell from 30,610 per game in the season 2004-2005, the club’s last in the Premiership, to 23,614 in 2005-2006, their first season playing in the Championship competition. The impact of relegation on Southampton’s financial performance was even more marked. For the 12 months ended 30 June 2006, turnover reported by the listed holding company Southampton Leisure Holdings (SLH) fell to £23.74 million from £44.83 million the year before. Profitability also fell with Southampton’s operating margin declining from minus 12.61 per cent in 2004-2005 to minus 45.47 per cent the following year leading to a decline in pre-tax profits from £0.23 million to a pre-tax loss of £3.04 million. Southampton Leisure’s share price fell from 58p on 19 July 2004 to a trough of 24p by 16 May 2005. By the end of 2005 with a share price of 35.5p and a market capitalisation of £9.97 million SLH shares were trading on a discount of 11 per cent to net asset value of £11.24 million as of 31 December 2005. Normally, this would provide a market signal for discontented shareholders to exit by selling shares to potential bidders. The first serious move towards a takeover occurred on 26 February 2006. Michael Wilde, a property entrepreneur and Southampton supporter with a corporate box at the club, acquired nearly 9 per cent of SLH and in the following months continued to acquire shares until reaching a total of 5,138,470 shares, giving him an 18.29 per cent holding. Wilde called an Extraordinary General Meeting (EGM) for 3 July with resolutions proposing the removal of five members of the SLH board to be replaced by Wilde and four of his nominees. Rather than making an open bid to acquire all of the equity, some of which was in the hands of institutional shareholders, Wilde acted as a catalyst for an effective campaign of “voice” alongside other supporter shareholders. A key part of Wilde’s success was how he exercised political influence by collaborating with dissatisfied shareholder supporters.

First, Wilde contacted the Trust Steering Committee in 2005 to register his support for establishing a new supporters’ trust (The Saints Trust, 2006a). The Trust was officially launched in February 2006 as The Saints Trust. Next, he further empowered the Trust by agreeing to proxy to them, the voting rights to 60,000 of his own shares which took the number of shares available to the Trust via proxy to 156,767 including shares already pledged by Trust founder members. The Trust then began purchasing its own shares and lobbied for policies such as lower ticket prices, a bigger budget for the team manager to buy players in order to seek promotion, fan representation on the board of SLH and the separation of the roles of chairman and CEO. In following, The Saints Trust supported the EGM resolutions put forward by Michael Wilde. They also persuaded the second largest shareholder, after Wilde, Leon Crouch, to join the Trust and to vote out the board. In return, The Saints Trust called for Crouch to have a seat on the board. It was the decision by Crouch to support the EGM resolutions that precipitated the resignation of the chairman, Rupert Lowe, and four directors, even prior to the EGM. This shift in corporate control model to explicitly incorporate systematic measures of voice via a supporters’ trust is ongoing at Southampton. Currently, The Saints Trust has 768 members, it owns 20,000 shares directly, and has proxies for a further 715,228 shares. It is debatable, however, whether the change in management in 2006 has resulted in any significant welfare gains. The share price value of SLH at 49.5p on 6 March is at the same level it was on 30 June at 52p the last trading day before the resignation of the directors. The club remains relegated and faces a further reduction in turnover due to the completion of its second year “parachute” television payment (a reduced amount received by relegated clubs). In this case, shareholder supporters ranging from The Saints Trust to large shareholders such as Wilde and Crouch could be viewed as using voice in an attempt to help secure an improvement in the perceived quality of the club’s product - the team’s performance. The Saints Trust supported Michael Wilde because they believed he would attract additional money into the club in order to invest in the team to help secure promotion back to the Premier League (The Saints Trust, 2006c). However, with effect from 28 February 2007, Michael Wilde resigned as a director of SLH and Southampton Football Club Ltd (SFC) because he was unable to secure new investment monies necessary to ensure the long-term financial stability of Southampton Football Club (The Saints Trust, 2007). Manchester United Football Club In contrast, the recent corporate history of Manchester United can be seen as a failure of “voice” by active shareholders and the relative strength of market forces. They were one of the founding members of the English Premier League, and have grown to be one of the most popular football clubs globally with an estimated supporter base of over 50 million fans. The club has also had the highest average attendance in English football for the past 34 seasons, with the exception of the season 1987-1989 during redevelopment of their Old Trafford ground which now has a capacity of 67,700 seats. Manchester United are the largest club in England in terms of turnover and in 2006 were the fourth largest in the world after Real Madrid, Barcelona, and Juventus. (Deloitte, 2007). By these measures, Manchester United holds a unique position in UK

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football as its most globally competitive club. It was an earlier adopter of the plc model and floated on the London stock exchange in 1991. Since Manchester United’s listing, alternative bidders have been attracted to take over the club; one offer which could retain the club’s listing and another which would revert the club to a private limited company. Both of these moves raised extreme voice efforts to stop a club takeover from occurring. The primary concern that drove dissenting shareholders into action was the anticipation that these bidders would have a negative impact on the quality of their club. In their view, the club would be primarily profit driven while long standing socio-cultural traditions of the club would be neglected. The voice efforts were formidable. The supporters’ group Independent Manchester United Supporters Association (IMUSA) effectively opposed a proposed £625 million takeover bid by broadcaster BSkyB controlled by Rupert Murdoch in 1998. A second pressure group was also formed “Shareholders United Against Murdoch” (SUAM) with the aim of encouraging supporters to buy shares in the club. On April 9 1999, the Department of Trade and Industry (DTI) blocked the bid, and SUAM was credited with having played a major role in this outcome (Hamil et al., 2000). SUAM became Shareholders United (SU) on 16 May 1999, a company limited by guarantee, created partly to enable supporters to have a greater say in the issues that concerned them, such as ticket prices and partly to reduce the risk of an unwanted party buying enough shares to take over the club. However, despite a virulent campaign, SU failed to prevent a second takeover threat and US businessman Malcolm Glazer acquired enough equity to take control of Manchester United plc on 13 May 2005. It was the sale of the 28.7 per cent stake held by Irish racing partners JP MacManus and John Magnier through their investment vehicle Cubic Expression that enabled Glazer to put in a full bid to acquire the company. The debt-financed takeover valued Manchester United at approximately £800 million and on 16 May Glazer’s investment vehicle Red Football Ltd. increased its equity stake to the 75 percent necessary to de-list the club and reverted its ownership structure to a private limited company. This action also extinguished fan shareholders’ ability to exert direct influence on the club’s policies. As a result, SU was shut down and resurfaced as the Independent Manchester United Supporters’ Trust (MUST). This Trust is recognised by Supporters Direct as the only supporters’ trust for Manchester United and is currently the largest supporters’ trust in the world. MUST retains its ongoing concerns that the private limited company (plc) model is harmful to the quality of the club’s performance. It has created a Phoenix Fund with over 30,000 members to raise money to buy back the club from Glazer if his debt funded acquisition falters. In addition, some dissatisfied shareholders engaged in a rare act of disloyalty – they shifted their allegiance to create an alternative club, called FC United of Manchester. By 8 July 2005, the club had 4,000 potential shareholders willing to invest money and over £100,000 in liquid assets. The club was admitted to the North West Counties Football League placing it nine levels below the FA Premier League in which Manchester United play. It is seriously questionable whether these remnants of extreme opposition have any ongoing influence on current management practices. Indeed, it might be argued that an expectation of diminished socio-cultural values in terms of fear about potential quality declines in team performance has not occurred. By many measures, there has been an improvement since the change in corporate control structure. For example, in February

2007, Manchester United announced an increase in operating profit of 8 per cent from £46.1 million in 2005 to £49.7 million in 2006. Since June 2006 the club has been enjoying the benefit of its four-year £56.5 million shirt sponsorship deal with US insurance giants AIG, and seen match day revenue increase with the expansion of the Old Trafford stadium capacity from 68,000 to 76,000. In addition, reversion to a private limited company model has not led to an exit by supporters. In the season 2005-06, the average crowd at Premier League matches at Old Trafford has been 75,776. There is still excess demand for Manchester United tickets. For the season 2006-2007 there were 6,000 unsuccessful ticket applications and, despite sales of 64,000 season tickets, there is a waiting list of 10,000 (Soccer Investor Weekly, 2007). These outcomes suggest that Manchester United is successfully balancing the interplay of socio-cultural objectives and commercially oriented success. Discussion and implications for future research In this paper we have looked at how shareholder groups have sought to influence the market for corporate control in the UK football industry. In particular, we have shown how shareholders of two clubs in the top professional league, the FA Premier League, behaved in different ways following perceived declines in quality. In the case of Southampton Football Club, the quality change was the relegation of the team from the Premier League into the division below, the Football League Championship competition. In the case of Manchester United, the perceived quality change was more anticipated than realised; it was expected that a club takeover would lead to a neglect of the club as a socio-cultural asset. In this concluding section, we consider a plausible explanation for the differing behaviours and outcomes of these two cases in relation to Hirschman’s framework on exit, voice, and loyalty. The cases demonstrate how loyalty is a distinguishing feature in the UK football industry that effects the interplay of voice and exit mechanisms in response to declines in quality demand. We have shown how longstanding, ongoing, socio-cultural traditions have operated alongside increasing market forces arising from industry growth and globalisation. We have also described how some shareholder groups are reluctant to exercise an exit option because: . They generally do not switch allegiance to another rival team; and . They prioritise their investment objectives towards team performance rather than to traditional economic measures of return. This leads to reluctance to adopt a market oriented, exit option and we have considered the extent to which loyalty has led to exercising voice. In the cases considered, both forces of exit and voice operated, albeit with differing results. In the Manchester United case, we saw that market forces prevailed, resulting in a failed voice strategy. Equally, the forces of exit reinstated the club from a plc to its former private limited company status. Here, we saw that voice was activated in anticipation that quality decline would result from a transfer of control to owners perceived to be predominantly driven by profit potential. Although market forces eventually prevailed, these efforts were contested by shareholder groups that effectively eliminated one takeover bid. Further, shareholder supporters, even after failing to prevent an eventual takeover, took action that Hirschman would describe as extreme. Some shareholders established an alternative club and created a structure to

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pool funds in anticipation of financial failure of the club’s current ownership. This resonates with Hirschman’s view that extreme acts of voice tend to be ineffective and that the exit option dominates in competitive situations. In the Southampton FC case, it can be argued that the commercial impetus was relatively less forceful and shareholders leading the ownership takeover, held strong socio-cultural convictions with the club. As described by the second largest shareholder, Leon Crouch, and key to the takeover, “A football club is not a place to invest money in if you are looking to make money . . . the current board have forgotten this and seem to have lost sight of the fact that Saints are first and foremost a football club for the community of Southampton” (The Saints Trust, 2006b). In this instance, voice was effective through establishing a shareholder trust and collaborating with larger shareholders who promoted their club support as a priority over profit motivation. However, this outcome has not led to improving quality. In Hirschman’s terms, voice has been effective for shareholder groups to express their interests but this does not necessarily lead to efficiency improvements. These two cases illustrate a further, general point in the market for corporate control in football. The listing of clubs has helped create a number of different types of shareholders, all of whom do not often share the same objectives. In consequence, the objectives and actions of these different shareholder groups have an uncertain efficiency and welfare impact on the market for corporate control. Despite the phenomenal growth in the number of supporters’ trusts in the UK, and what has been seen by some as the failure of the listed model (Banks, 2002), it is difficult to see, as yet, what is the optimal combination of exit and voice. The experiences of the two clubs we described are embedded within a larger, growing, and increasingly globalised environment. Many listed clubs have returned to private equity corporate forms through delisting or takeover, but on the other hand some clubs owned by supporter shareholders have sold out to smaller cliques of owners primarily for financial reasons. Future research in this industry needs to consider the optimal mix of exit, voice, and loyalty in relation to the scale of the firm. It is perhaps significant that there are no supporter shareholder owned clubs higher up the football ranking system than Brentford United in the English Football League One. Our research suggests that there may also be other significant differences relating not only to clubs’ size within the domestic market, but also to their global presence. Manchester United, unlike Southampton FC, is recognised as an international brand. It is perhaps less feasible for non-domestic fans to apply voice as opposed to exit pressures to express dissatisfaction with perceived quality declines in performance. Although clubs like Manchester United, as much as Southampton FC, are seen as community assets within their domestic context, the global reach of the former has an evident impact on the operation of the mechanisms of exit, voice and loyalty. Hirschman recognised that these mechanisms are not static and so further research should attend to how changes in ownership and control are enacted over time. A useful study would be to contrast the efficiency and stability of organisational forms of clubs with similar global reach but with very different ownership structures. References Arnaut, J.L. (2006), Independent Europe Sports Review, pp. 67-71, available at: www. independentfootballreview.com/doc/A3619.pdf

Banks, S. (2002), Football’s Going Down, Mainstream, Edinburgh. Baumol, W.J. (1959), Business Behavior, Value, and Growth, Macmillan, New York, NY. Berle, A. and Means, G. (1932), The Modern Corporation and Private Property, Macmillan, New York, NY. Brown, A. (1998), Fanatics! Power, Identity and Fandom in Football, Routledge, London. Brown, A. (2000), “European football and the EU: governance, participation, and social cohesion – towards a policy research agenda”, Soccer and Society, Vol. 1 No. 2, pp. 50-67. Conn, D. (2004), The Beautiful Game? Searching for the Soul of Football, Yellow Jersey Press, London. Deloitte (2005), Annual Review of Football Finance: A Changing Landscape, Sports Business Group, Deloitte, Manchester, June. Deloitte (2006), Annual Review of Football Finance, Sports Business Group, Deloitte, Manchester. Deloitte (2007), Football Money League: The Reign in Spain, Deloitte, Manchester. Fama, E.F. and Jensen, M.C. (1983), “Separation of ownership and control”, Corporations and Private Property: A Conference Sponsored by the Hoover Institution, June, Journal of Law and Economics, Vol. 26 No. 2, pp. 301-25. Fawbert, J. (2005), “Football fandom and the traditional football club: from ‘Cockney parochialism’ to a European diaspora?”, in Magee, J. et al. (Eds), “The Bountiful Game?”, Football Identities and Finance, Vol. 8, CSRC, Belfast, pp. 99-119. FIFA (2002), The Big Count, Fe´de´ration Internationale de Football Associations, Zurich. FIR (1982), English Football League Clubs – Status and Performance, Financial Intelligence and Research (FIR), London. Football Task Force (1999), Football: Commercial Issues, a report submitted by the Football Task Force to the Minister for Sport. Granovetter, M. (1985), “Economic action and social structure: the problem of embeddness”, American Journal of Sociology, Vol. 91 No. 3, November, pp. 481-510. Groenewegen, J. (1997), “Institutions of capitalism: American European and Japanese systems compared”, Journal of Economic Issues, Vol. 31 No. 2, pp. 333-45. Hamil, S., Michie, J., Oughton, C. and Warby, S. (2000), Football in the Digital Age. Whose Game Is it Anyway?, Mainstream, Edinburgh. Hirschman, A.O. (1970), Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, Harvard University Press, Cambridge, MA. Ingle, S. (2005), Guardian Unlimited, 2 September, available at: http://football.guardian.co.uk/ commentary/story/0,9753,1551650,000.html McMaster, R. (1997), “The market for corporate control in professional football: is there an agency problem?”, Journal of the Institute of Economic Affairs, Vol. 17 No. 3, September, pp. 25-9. Morrow, S. (2003), The People’s Game? Football, Finance and Society, Palgrave Macmillan, Basingstoke. Nooteboom, B. (1999), “Voice- and exit-based forms of corporate control: Anglo-American, European, and Japanese”, Journal of Economic Issues, Vol. XXXIII No. 4, December, pp. 845-60. (The) Saints Trust (2006a), Saints Trust Meeting with Michael Wilde, News, 5 March. (The) Saints Trust (2006b), News, Saints Trust Meets with Leon Crouch, 12 May. (The) Saints Trust (2006c), News, Saints Trust Welcomes Crouch Announcement, 29 June.

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(The) Saints Trust (2007), News, Wilde Resigns from SFC Board, 26 February. Sloane, P.J. (1971), “The economics of professional football: the football club as a utility maximiser”, Scottish Journal of Political Economy, Vol. 8, pp. 121-46. Soccer Investor Weekly (2002),Vol. 77, 8 January, Soccer Investor Ltd, London, p. 13. Soccer Investor Weekly (2007), Vol. 292, 2 February, Soccer Investor Ltd, London, pp. 6-13. Supporters Direct (2006), “£1.8 million funding boost for the ‘beating heart’ of football”, The Supporters Trusts Initiative, Vol. 24, p. 9. Szymanski, S. and Kuypers, T. (1999), Winners and Losers: The Business Strategy of Football, Viking, London. Szymanski, S. and Smith, R. (1997), “The English football industry: profit, performance, and industrial structure”, International Review of Applied Economics, Vol. 11 No. 1, pp. 135-53. Williamson, O.E. (1963), “Managerial discretion and business behavior”, American Economic Review, Vol. 53, pp. 1032-57. Yin, R.K. (1994), Case Study Research: Design and Methods, 2nd ed., Sage Publications, London. Further reading Barry, B. (1974), “Exit, voice, and loyalty: responses to decline in firms, organization, and states by Albert O. Hirschman”, British Journal of Political Science, Vol. 4 No. 1, January, pp. 79-107. Fama, E.F. (1980), “Agency problems and the theory of the firm”, Journal of Political Economy, Vol. 88 No. 2, pp. 288-307. Giulianotti, R. (1999), Football: A Sociology of the Global Game, Polity Press, Cambridge. Johnson, J.L., Daily, C. and Ellstrand, A. (1996), “Boards of directors: a review and research agenda”, Journal of Management, Vol. 22 No. 3, pp. 409-38. Lopez de Foronda, O., Lopez Iturriaga, F. and Santamaria, M. (2007), “Ownership structure, sharing of control and legal framework: international evidence”, Social Science Research Network, Industrial Organization Abstracts: Firm Structure, Purpose, Organization and Contracting, Vol. 8 No. 8, Working Paper Series, February, available at SSRN: http://ssrn. com/abstract ¼ 902870. Monopolies and Mergers Commission (1999), British Sky Broadcasting Group plc and Manchester United plc: A Report on the Proposed Merger, Cmnd 4305, The Stationery Office, London. Wilkesman, U. and Blutner, D. (2002), “Going public: the organizational restructuring of German football clubs”, Soccer and Society, Vol. 3 No. 2, pp. 19-37. Corresponding author Lynne Nikolychuk can be contacted at: [email protected]

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Intangible economy: how can investors deliver change in businesses? Lessons from nonprofit-business partnerships

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Maria May Seitanidi Brunel University, Uxbridge, UK Abstract Purpose – The purpose of the paper is to investigate the following issues. Investors traditionally prioritised tangible outcomes (money, land, machinery) in order to protect their financial assets. However, the intangible economy (trust, human resources, information, reputation) that co-exists draws attention to new expectations that request the continuous, active and within the public sphere involvement of investors in order to protect their assets by prioritising intangible resources. Design/methodology/approach – In this paper the case of non-profit-business partnerships is employed in order to demonstrate how change can be achieved. Findings – The paper finds that investors in intangible outcomes who aim to achieve change in corporations share the same limitations within the financial and non-financial field. Originality/value – The paper highlights investment in the intangible economy as a mechanism of co-determining the priority of responsibilities in the context of corporate social responsibility. The role of investors is crucial in facilitating the shift from the tangible to the intangible economy. Keywords Intangibles assets, Corporate social responsibility, Non-profit organizations, Partnership Paper type Research paper

Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted (Albert Einstein).

Introduction “How many Enrons would it take to destroy global capitalism by leading shareholders to withdraw their financial support for the corporate community?” asks intelligently Solomon (2004, p. 7). This is currently the epitome of why corporate governance mechanisms, policies and systems are put in place: to safeguard the existing capitalist system which prioritises tangible resources remains unchanged. However over the last decades, the relationship between the market and society has been going through rapid transformation. Corporations emerged as powerful actors controlling a multitude of resources and eager to attain access not only to financial but equally to non-financial resources, which they gradually revaluate as equally, if not more important than the monetary resources. On the other hand, the on-going empowerment of civil society organisations has played an important role in transforming non-profit entities into equally powerful actors of change within society (Doh and Teegen, 2002; Bendell, 2000). The legitimacy of corporations is not any more subject to government regulation as “social actors have emerged to raise questions and, in some cases, directly intervene in the governance of major corporations” (Clark et al., 2008).

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While the influence of business has been increasing (Solomon, 2004) similarly the demands for an institutionalised level of responsibilities has found voice in the conceptualisation of corporate social responsibility (CSR) (Crane and Matten, 2004). CSR is a call for business to operate in a responsible way, which appeared as an antiphon to the divorce of ownership and control aiming to reform the practices of business by introducing an organised and institutionalised response from within corporations. The concept of CSR is employed in this paper as a lens to examine the failure of investors’ influence in corporate management. Although capitalism as a political and economic system survived in the twenty- first century (Solomon, 2004, p. 7) it currently undergoes a transformation. We have moved from the twentieth century of shareholder supremacy where tangible resources were prioritised to the twenty-first century of stakeholder transcendency where intangibles gradually push through obscurity. Within the financial community the concept of corporate social responsibility (CSR) is currently appropriated serving profitability, a tangible resource, through the belief that being ethical, an intangible resource, increases profitability (Hancock, 1999; Monks, 2001; Co-operative Bank, 2001) or by employing CSR as “a secondary risk management” (Power, 2004, pp. 34-35) strategy in order to safeguard their corporate reputation (intangible). The paper argues that the nature of CSR has influenced the practices of new governance mechanisms within the financial (e.g. socially responsible investment-SRI and shareholder activism) and social spheres (nonprofit-business partnerships). In effect they all share the same systematic failures characterised largely by their inability to deliver systematic change within corporations. Corporate social responsibility as a driver for change Parallel to the prominence of profit attainment through the operations of business sprang the increase in the misuse of corporate power due the original “divorce of ownership and control” (Solomon, 2004, p. 3). As a result the responsibilities that used to reside only with the owner(s) of a corporation who also had the control of business were separated and dispersed among shareholders and management. The effects of the above were beneficial for business profitability but in many cases detrimental for wider parts of society due to corporate greed; examples include: overpriced stock price, excessive executive remuneration, selling knowingly unhealthy or dangerous products; destroying the environment; unfair treatment of employees and so forth. These impacts have been extensively discussed in the literature (Hutton, 1995; Hutton and Giddens, 2001; Crane and Matten, 2004). Hence when any of the above instances of human greed would surface on the public sphere corporations were confronted with reputational crisis which impacted with the public’s perception of their role. Such crises gradually gathered momentum resulting in cynicism towards business which according to Tevino and Nelson (2007, p. 3) “has become an epidemic throughout society”. While the influence of business has been increasing (Solomon, 2004) similarly the demands for an institutionalised level of responsibilities has found voice in the conceptualisation of corporate social responsibility (CSR) (Crane and Matten, 2004). The European Commission’s Green Paper (Commission of the European Communities, 2001) defines CSR as: . . . a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis.

CSR is largely voluntary in nature and as such has gathered momentum “testified by the wide array of initiatives that range from indicators for responsible practices in the stock exchange markets[1] to social and environmental reporting[2] and a multitude of corporate community involvement programmes” (Seitanidi and Crane, 2008). One of the failures of the voluntary concept of CSR is “characterised by many unsystematic practices, i.e. constellations of arrangements that are fit for purpose within specific contexts but which lack transferability and sustainability” (Seitanidi and Crane, 2008). On the other hand one of the positive results of CSR is that it has elicited intensification and debate within all sectors of society with regard to the responsibilities of each sector in addressing environmental and social issues (Seitanidi, 2006). Corporate Social Responsibility (CSR) is a worldwide phenomenon that has been driven by all sectors of society, i.e. by business (McWilliams and Siegel, 2002; Zadek, 2001), by non-profit organisations (Bendell and Lake, 2000) and by government (Moon, 2004). Moon (2002) argues that the network mode of operation of business with government and nonprofit organisations (NPOs) represents a new system of re-orientation of governance roles among the sectors whereby the increased interdependencies were guided by the pursuit of shared interests and values. The central claim of CSR initiatives is to develop beneficial changes within society. However, due to its voluntary character it lacks systematic and consistent delivery of outcomes across its different manifestations. One of these manifestations of CSR is within the financial field and its interface with corporate governance. Solomon (2004, p. 15) suggests that the interface between the two is the “management quality”. In other words, the extent to which managers integrate social and environmental concerns in their financial decisions and practices both systematically and consistently. Socially responsible investment and shareholder activism are interfaces, which aim to deliver positive changes within corporations. The next section will discuss briefly each one in order to highlight their intangible characteristics and the rational behind the failure to deliver systematic change in businesses. SRIs and shareholder activism Within the above climate the interaction between the different types of investors and corporations has attracted attention due to the central claim suggesting that change can be delivered within companies (Haigh and Hazelton, 2004). Some of the interfaces through which investors can deliver these changes are through socially responsible investments (SRIs) (Haigh and Hazelton, 2004; Jayne and Sherratt, 2003) and shareholder (Haigh and Hazelton, 2004; Lewis and Mackenzie, 2000) activism. SRI is a process by which investment institutions are being encouraged to prioritise issues such as environmental stewardship, employee and community welfare when making decisions about their portfolio companies instead solely looking at the financial performance of a corporation (Jayne and Sherratt, 2003; Pridham, 2001). As suggested by Haigh and Hazelton (2004, pp. 67-68) the claim that SRIs can deliver in their current form of practice towards systematic corporate change is unsubstantiated. They suggest that: First, SRI funds in all regions command negligible market share, which discounts the argument for a direct effect on companies. Second, even if SRI funds commanded greater market share, any effects on security prices would be short-lived, given liquid capital

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markets. Third, there are no guarantees that financial markets will look to SRI funds to signal undisclosed future revenue growth or costs, and accordingly follow investment actions of SRI funds.

In effect SRI funds have not changed their priorities in their decision making process, i.e. to prioritise the positive social and environmental impacts of companies through their operations. Instead, their decision making process prioritises the tangible financial outcome as the primary criterion upon which they base the inclusion of a company in their portfolio of investments. As a result “they contribute to the economic forces that cause socially inequitable practices to arise in the first place . . . Capital markets thus ‘reward’ companies that inter alia use the lowest prices for their production” (Haigh and Hazelton (2004, p. 66). As such this is a systematic failure to move beyond the tangible outcomes and prioritise the intangible outcomes such as trust in the quality of decisions that incorporate the responsibility towards society. Nisar (2006, p. 384) suggests that “intangible factors such as organizational knowledge, product innovation and employee morale, rather than physical assets, like real estate, are now the source of greatest value”. Indeed ethical, social and environmental practices can be grouped within the realm of intangibles as they deliver positive benefits towards the corporate reputation. More importantly since SRIs aim to encourage change within corporations by transforming their organisational practices predominately it aspires to transform the organisational culture. “Organisational transformation is a mode of social change that involves a sharp and simultaneous shift in strategy, structure, process and distribution of organisational power” (Shen, 2005, p. 3). In fact, according to Martin (2000, p. 452): . . . to change is to take different actions than previously. To take different actions than previously means to make different choices. Different choices produce change. The same choices produce sameness, a reinforcement of the status quo . . . To espouse a different operating principle (e.g. we have decided to become customer focused) from the past does not represent change. Only if different choices lead to action on the different operating principle will change be produced. As Argyris observes, there is often a substantial gap between espoused theory and theory in use.

According to the UK Social Investment Forum (2007) there are three strategies for investors to get involved: (1) Ethical screening. (2) Shareholder influence. (3) Cause-based investing. All three require consideration of and access to “ethical, social and environmental” information (Jayne and Sherratt, 2003, p. 3). In fact due to the absence of external monitoring and verification from people who have knowledge, experience and access to what constitutes ethical or environmental practices the disclosure of corporate information (Laufer, 2003), upon which for example ethical screening is based, corporate reporting is often seen as a form of green (Lydenberg, 2006; Stittle, 2002) or ethical washing. Hence the people who make decisions in SRIs have not the set of skills and access to information that would allow them to make high quality decisions that would deliver organisational or industry change.

Similarly, shareholder activism is “the process by which shareholders of a listed company, under the provisioning of securities legislation in various jurisdictions, can requisition its members to meet and vote on specific resolutions” (Haigh and Hazelton, 2004, p. 60). They suggest that the current mechanisms of shareholder activism have been largely unsuccessful due to their ad hoc character to address social and environmental issues. The Cadbury Report (The Cadbury Code, 1992) suggested that institutional investors should arrange regular one-to-one meetings with corporate managers, should file resolutions in order to positively influence social and environmental issues and should pay attention to the composition of the board of directors (Solomon, 2004, p. 118). In fact Haigh and Hazelton (2004, p. 50) suggest that although in some countries such practices have been embraced however in reality there are only “isolated instances of ‘success’ in achieving outcomes (which) mask the reality that systematic change to industrial practices or engagement with issues at an industry level has not been the focus of shareholder activists”. An encouraging exemption is the coalition of five environmental organizations: Friends of the Earth, Greenpeace, US Public Interest Research Group, Bluewater Network, and the Center for International Environmental Law, who endorsed a total of 49 environmental shareholder resolutions[3] (Friends of the Earth, 2007). Friends of the Earth and Greenpeace have the mandate, in-depth information, expertise and campaigning skills in order to make informed decisions about the environmental issues that a corporation is facing. Largely shareholder resolutions are seen leading to gradual ad hoc interventions to environmental and social problems “unlike to result in long-term desired social outcomes” (Haigh and Hazelton, 2004, p. 67). More importantly the financial elites involved usually in the engagement process prefer the route of “quite diplomacy” (Clark et al., 2008) holding discussions behind closed doors in a “club-like atmosphere” where “spontaneity is not encouraged” (ibid). The reluctance to overtly and publicly raise issues due to the overlapping networks of fund managers, insurers, analysts and corporate directors captures the potential for systematic and continuous change through shareholder activism. Unlike the environmental NPOs the individual and institutional investors lack the information and more importantly the necessary skills that would increase the potential of delivering change, including: confidence, confrontational writing and speaking, argumentation based on in depth specialist information, developing creative discourse around a technical issue, imagining alternatives and so forth. The common denominator of the above interfaces aiming to deliver change is their failure to deliver: . Continuous and substantial change rather than in ad hoc cases (Haigh and Hazelton, 2004). . Through active engagement (Lewis and Mackenzie, 2000) instead of through “passive market signalling” (Lewis and Mackenzie, 2000, p. 215). . Within the public arena in an overt fashion as opposed to holding “conversation amongst financial elites about common interests” (Clark et al., 2008). Moreover, the intangible character of the changes to be delivered is confronted with the prioritisation of tangible resources, predominately financial, and the lack of skills related to intangible resources.

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In order to demonstrate how change can be delivered successfully in a business by developing the necessary skills the case study between WWF and Lafarge is presented below within the context of a nonprofit-business partnership. Although the case is outside the financial arena it lies within the new forms of flexible governance, where also SRIs and shareholder activism would be categorised.

858 A case study from nonprofit-business partnerships: WWF-Lafarge Partnerships between Nonprofit organisations (NPOs) and Business (BUS) is one of the most challenging ways that organizations have been implementing CSR. NPO-BUS partnerships are one of the three different types of dual partnerships (Figure 1) referred to as “social partnerships” (Waddock, 1988; Googins and Rochlin, 2000) or as recently named “cross-sector partnerships that address social issues” (CSSPs) (Selsky and Parker, 2005, p. 1). A fourth type, tripartite partnerships, involves all three sectors: profit, government and non-profit organisations (Figure 1). According to Waddock (1988, p. 18) social partnerships are: a commitment by a corporation or a group of corporations to work with an organisation from a different economic sector (public or nonprofit). It involves a commitment of resources – time and effort – by individuals from all partner organisations. These individuals work co-operatively to solve problems that affect them all. The problem can be defined at least in part as a social issue; its solution will benefit all partners. Social partnership addresses issues that extend beyond organisational boundaries and traditional goals and lie within the traditional realm of public policy – that is, in the social arena. It requires active rather than passive involvement from all parties. Participants must make a resource commitment that is more than merely monetary.Delivering change towards social (e.g. education, health) and environmental issues within corporations is similarly the main focus of social partnerships by combining organisational resources in order to offer solutions that benefit both partners, but also society at large. As such, NPO-BUS partnerships represent the alignment of strategic business interests with societal expectations, expressed through NPOs (Covey and Brown, 2001; Austin, 2000). Partnerships offer important insights into implementation of CSR, not least because BUS-NPO partnerships are seen as governance mechanisms (Moon, 2002) that can deliver changes within the new arena of ‘ad hoc’ social policy. The aim of this section is to present the success of a partnership in delivering change. In so doing, the paper compares new types of corporate engagement across the financial and social arena in order to suggest how change can be delivered.

Figure 1. Cross sector social partnerships

One of the most widely recognised NPOs is WWF, an environmental nonprofit organisation that used to have exclusively collaborative relationships with BUSs. One of its partnerships is with Lafarge, the world leader in construction materials. The relationship between the partners started in 2000. Seven years into the partnership the relationship has reached maturity where “WWF is contributing the expertise Lafarge needs to develop and improve its environmental policies and practices and to raise awareness of the importance of sustainability and biodiversity conservation” (WWF, 2007). In 2003 WWF moved beyond its collaborative approach to use confrontation and to publicly challenge the corporation reclaiming its NGO identity and responsibility. In fact, in 2003 WWF UK returned its share of a £3.5 million funding to Lafarge “because they refused to abandon plans to build the UK’s biggest superquarry on an unspoiled Scottish island” (Third Sector, 2003). The original partnership was between WWF International and Lafarge; the UK branch of WWF opposed the quarry before the beginning of the partnership, therefore they rejected the money, as they did not want to create confusion about their position. The web site of WWF Scotland remarked in 2004: Since the start of the international partnership between WWF and Lafarge in 2000, WWF has consistently and fully supported the actions taken by Scottish NGOs opposed to the quarry (LINK Quarry Group), and has repeatedly affirmed its strong opposition to the proposed 600 hectares quarry . . . The history of this controversy demonstrates that engaging in partnerships with companies does not prevent WWF from criticising and opposing any controversial aspect of our partners’ activities. WWF believes that it is important to engage with business and industry in the push towards a more sustainable future, and will continue to seek out partnerships that, it strongly believes, can contribute globally to significant social and environmental benefits (WWF, 2004).

In April 2004, WWF’s web site welcomed the decision of Lafarge not to pursue its interests further in the development of the quarry. The above is one incident where WWF, a collaborative NPO, publicly challenged a partner and returned money, hence externalising the conflict and placing within the social arena. So far it appears to be the only UK charity that used this approach publicly, although Greenpeace UK made similar remarks about their intention to pursue a similar tactic: . . . companies need to know that if they don’t move far enough that people are going to come back and they’re going to campaign (Greenpeace, Marketing and Fundraising Director, cited in Seitanidi, 2006, p. 229).

The change in WWF’s political position marks an important shift in one of the traditionally collaborative NPOs as it emphasizes the need for a ‘weapon’ that collaborative NPOs need to employ in order to challenge corporations and push them towards change: You don’t negotiate unless you have some weapon that you can use. In those negotiations you don’t have a power to negotiate. What in fact happened in many instances was that yes from time to time the corporation-discussed issues with the NGO. But they began to set limitations in the way the NGO could operate. If the NGO criticised then the company professed to be angry, because we are engaged into discussion with you. So, that process of co-option in fact silenced quite a lot of NGOs (General Secretary, International Textile, Garment and Leather Workers’ Federation, cited in Seitanidi, 2006, p. 229).

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The ability of an NPO to externalise the conflict and increase the reputational risks for the business partner appear to be important in order to facilitate organisational change in BUSs. However, it seems possible only when there is no financial dependency from the BUS partner; the NPO holds a strong reputation and is well-established, as was the case with WWF. The NPO could afford to return £3.5 million, which in fact might not be the case with other NPOs or indeed in case of financial dependency between two social actors. Partnerships have been portrayed by executives in NPOs as “opportunistic” (Seitanidi, 2006, p. 250) however there are instances that confirm the potential for delivering change, as in the above case. Within the research on NPO-BUS partnerships of Seitanidi (2006) the potential of challenging a partner within a partnership relationship has been further confirmed in one more occasion. Another incident that occurred was within another partnership case study; Prince’s Trust returned money to its partner, the Royal Bank of Scotland Group, due to a disagreement on the role of a funded position by the Bank within the course of the partnership (Seitanidi, 2006).The confrontational approach espoused by collaborative NPOs safeguards their autonomy and independence both within the organisation but also externally with their stakeholders. In social partnerships the primary aim is to serve society and not the organisational needs (Seitanidi, 2006). In fact the social character of partnerships might indeed appear against the organisational needs (one of the basic one for NPOs is funding) as was the case with Lafarge and WWF. By returning the money to Lafarge WWF UK forced change within the BUS and in effect Lafarge changed their actions. However, it appears that in most cases the politics of NPO-BUS partnerships fail the societal dimension of partnerships by capturing the potential of organisational core changes within the convergence of need for tangible resources rather than divergence of missions and hence intangible resources (Seitanidi, 2006). It appears that the experienced collaborative NPOs (e.g. WWF) only recently realised the risks in forging close relationships with BUSs and decided to assume a more critical role even publicly similar to the confrontational NPOs (such as Friends of the Earth, Greenpeace). One way to break the financial dependency within close relationships where money are transferred from one partner to the other is to develop the necessary set of skills to challenge corporations in order to force change by developing closer collaborations among diverse NPOs. As a result the closer collaboration among the different NPOs, but also the exchange of information and facts, might increase openness and transparency in NPO-BUS partnerships, increase civil society’s trust of organisations and institutions, and might also allow partnerships to reclaim their societal role. Investors in intangible outcomes As becomes obvious from the above, there is a category of outcomes that can be classified as intangibles, including knowledge, capabilities and skills. The intangible assets were considered as early as 1987 to be the most important resource for a company (Itami and Roehl, 1987), one expression of which is the core competencies (Prahalad and Hamel, 1990). Organisations, predominately BUSs, actively engage in acquiring or internally producing, intangible resources, as they are likely to increase the value of the company (Sanchez et al., 2000). As Galbreath (2002, p. 116) points out,

one of the most far-reaching changes in this field in the twenty-first century concerns what constitutes value and what the rules of value creation might be. Moving from the tradition of tangible to intangibles and to relationship assets constitutes a change in perceiving where the value of the firm is positioned today: “what becomes easily apparent is that the firm’s success is ultimately derived from relationships, both internal and external” (Galbreath, 2002, p. 118). The relationship between NPOs and BUSs is seen today as a source of cross-sector intangible outcomes that can benefit all parties. It is important, however, to distinguish between the different types of outcomes with regard to who is the recipient of the benefits. The meaning of the verb “invest” is “to put (money or effort) into something to make a profit or achieve a result” (Cambridge Dictionary of American English, 2007). The above definition captures both the tangible and intangible dimensions of an investment. In the case of shareholders, money is invested in order to allow the company to grow and prosper. In the case of stakeholders (Freeman, 1984) effort is invested in order to align the company with the expectations of society hence to safeguard its social legitimacy (sustainability). Today making an investment into tangible resources is not enough. Increasingly there is a need to equally invest and protect the intangible resources. This creates new expectations from investors as they require the development of new skills. Hand and Lev (2003, p. 2) suggest that: Wealth and growth in modern economies are driven primarily by intangible assets, defined as claims to future benefits that do not have a physical or financial form. Patents, bioengineered drugs, brands, strategic alliances, customer lists, a proprietary cost-reducing internet-based supply chain – these are all examples of intangible assets. The more traditional physical and financial assets are rapidly becoming commodities, since they are equally accessible to competitors, and consequently yield at least a competitive return on investment . . . As a result intangibles are increasingly taking center stage in firm’s business strategies and the valuation calculus performed by investors.

In order for investors to be considered as ethical they need to prioritise the intangible (positive social and environmental outcomes) rather than financial outcomes. They could further leverage their investment by closely monitoring the processes that affect the intangible resources as a matter of priority and by seeking relevant expertise. Nonprofit organisations can be a source of in-depth technical knowledge and valuable information that will allow ethical investors to assess their portfolio investments. The relationships between financial investors and corporations are in close proximity with each other constrained by financial dependency similarly with NPO-BUS partnerships. In order for continuous and substantial change to take place there is a need to address systematically the failure to deliver change due the relationship proximity, i.e. to externalise the conflict of interest that exists between the aims of an SRI fund and the corporation by entering into strategic partnerships with more experienced social actors on relevant issues (such as environmental NPOs). Through active engagement between stakeholders that hold knowledge and expertise and within the public arena, fostering an overt conversation would entail a strategy for not only protecting but also leveraging intangible assets. For example, a type of investment made by a corporation to a NPO within a partnership relationship is

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equally reciprocated by the NPO towards the corporation. Hence, in the case of the formation of a social partnership we experience a reciprocal intangible investment. Similarly the relationship between an SRI and a corporation can entail an intangible asset if it does not serve as a priority the maximisation of profit. Such relationships are intangible assets as the reputation of SRIs (an intangible asset) is at stake due to their responsibilities towards their clients. The role of investors is crucial in facilitating the shift from the tangible to the intangible economy, by co-determining the responsibilities of corporations together with other stakeholders. The investment and protection of intangibles requires the development of new skills such as knowledge based confidence, confrontational writing and speaking, argumentation based on in depth specialist information, developing creative discourse around a technical issue, imagining alternatives; skills that traditionally have been developed by stakeholders (such as environmental NPOs). Drucker, 1989 suggested that an important and unexpected positive outcome for BUS is the new management practices BUS can learn and adapt from NPOs which have experience with multiple bottom lines, similar to the recent triple bottom line perspective that BUS need to attend to. Moon (2004, p. 1) suggested that in the UK “CSR was part of a wider re-orientation of governance roles”. It seems that CSR implementation needs to progress to a higher level of sophistication in order to incorporate mechanisms that will prioritise intangibles assets. Hence more research is required into intangibles within the context of Corporate Social Responsibility. Based on the above there is a difference between espousing a change discourse and claiming that SRIs, shareholder activism or NPO-BUS partnerships have influenced corporations in order to deliver organisational change. Organisations that work in high proximity over time is difficult to challenge and confront their “partners” in order to deliver change. Delivering positive societal outcomes would need the development of new skills. Similarly with the collaborative NPOs, SRI funds and shareholder activism need to assume a more critical role towards BUSs and increase their collaboration within their own sector and across different sectors in order to contribute and strengthen the societal dimension of their role. Notes 1. In the London Stock Exchange FTSE4GOOD is a special index that includes companies that meet the inclusion criteria that offer testimony of responsible practices. For more information: www.ftse.com/Indices/FTSE4Good_Index_Series/Criteria_Documents/index. jsp Also in the US the Dow Jones Sustainability Index (DJSI), launched in 1999, a global index that aims to track the financial performance of sustainability-driven companies worldwide and currently manages over 4 billion EUR. For more information: www. sustainability-indexes.com/htmle/other/faq.html 2. In 2005 the GRI reported 750 companies that used the Sustainability Reporting guidelines (GRI, 2006). The Global compact reported that world wide (last update of information on line 29th March 2006) 2,500 businesses are included in its network (Global Compact, 2006). 3. According to Friends of the Earth: “Major categories of environmental resolutions include: global warming, energy, genetically engineered food, environmentally sensitive areas, toxics, and sustainability reporting” (Friends of the Earth, 2007).

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Hutton, W. and Giddens, A. (2001), On the Edge: Living with Global Capitalism, Vintage Books, London. Hutton, W. (1995), The State We’re in, Vintage Books, London. Itami, H. and Roehl, T. (1987), Mobilizing Invisible Assets, Harvard University Press, Cambridge, MA. Jayne, R.M. and Sherratt, G. (2003), “Socially responsible investment in the UK – criteria that are used to evaluate suitability”, Corporate Social Responsibility and Environmental Management, Vol. 10, pp. 1-11. Laufer, W.S. (2003), “Social accountability and corporate greenwashing”, Journal of Business Ethics, Vol. 43, pp. 253-61. Lewis, A. and Mackenzie, C. (2000), “Support for investor activism among UK ethical investors”, Journal of Business Ethics, Vol. 24, pp. 215-22. Lydenberg, S.D. (2006), “Envisioning socially responsible investing: a model for 2006”, Journal of Corporate Citizenship, Vol. 7, pp. 57-77. McWilliams, A. and Siegel, D. (2002), “Additional reflections on the strategic implications of corporate social responsibility”, Academy of Management Review, Vol. 27 No. 1, pp. 15-16. Martin, R. (2000), “Breaking the code of change. Observations and critique”, in Beer, M. and Nohria, N. (Eds), Breaking the Code of Change, Harvard Business School Press, Boston, MA. Monks, R.A.G. (2001), The New Global Investors: How Shareholders Can Unlock Sustainable Prosperity Worldwide, Capstone Publishing, Oxford. Moon, J. (2002), “Business social responsibility and new governance”, Government and Opposition, Vol. 37 No. 3, pp. 385-408. Moon, J. (2004), “Government as a driver for corporate social responsibility”, Research Paper Series, No. 22-2004, International Centre for Corporate Social Responsibility, Nottingham University Business School. University of Nottingham, Nottingham. Nisar, T.M. (2006), “Bonuses and investment in intangibles”, Journal of Labor Research, Vol. XXVII No. 3, pp. 381-95. Power, M. (2004), The Risk Management of Everything. A Demos Publication, Demos, London. Prahalad, C.K. and Hamel, G. (1990), “The core competence of the corporation”, Harvard Business Review, May-June, pp. 71-91. Pridham, H. (2001), “Better return from adopting higher principles”, Guardian Unlimited, 25 January, available at: www.guardian.co.uk/Money_Observer/Story/0,428307,00. html#article_continue (accessed 12 March 2007). Sanchez, P., Chaminade, C. and Olea, M. (2000), “Management of intangibles. An attempt to build a theory”, Journal of International Capital, Vol. 1 No. 4, pp. 312-27. Seitanidi, M.M. (2006), “Partnerships between nonprofit organisations and businesses in the UK. A critical examination of partnerships”, PhD thesis, International Centre for Corporate Social Responsibility (ICCSR), University of Nottingham, Nottingham. Seitanidi, M.M. and Crane, A. (2008), “Implementing CSR through partnerships: understanding the selection, design and institutionalisation of nonprofit-business partnerships”, Journal of Business Ethics, special issue on CSR Implementation, forthcoming. Selsky, J.W. and Parker, B. (2005), “Cross-sector partnerships to address social issues: challenges to theory and practice”, Journal of Management, Vol. 31 No. 6, pp. 1-25. Shen, J. (2005), “Expanding the frontier of global knowledge: introduction”, Journal of Organisational Transformation and Social Change, Vol. 2 No. 1, pp. 3-8.

Social Investment Forum (2007), Introduction to Socially Responsible Investing, available at: www.socialinvest.org/areas/sriguide/ (accessed 12 March 2007). Solomon, J. (2004), Corporate Governance and Accountability, 2nd ed., John Wiley & Sons, Chichester. Stittle, J. (2002), “UK ethical reporting – a failure to inform: some evidence from company annual reports”, Business and Society Review, Vol. 107, pp. 349-70. Trevino, L.K. and Nelson, K.A. (2007), Managing Business Ethics. Straight Talking About How to Do it Right, 4th ed., John Wiley & Sons, New York, NY. Third Sector (2003), WWF Rejects Funds in Quarry Row, 3 December, available at: www. thirdsector.co.uk/charity_news/full_news.cfm?ID ¼ 8781 (accessed 4 December 2005). Waddock, S.A. (1988), “Building successful partnerships”, Sloan Management Review, Summer, pp. 17-23. WWF (2004), Lafarge Drops Scottish Quarry Plan, available at: www.wwf.org.uk/news/scotland/ n_0000001177.asp (accessed 4 December 2005). WWF (2007), Lafarge-WWF Conservation Partner, available at: www.panda.org/about_wwf/ how_we_work/businesses/businesses_we_work_with/conservation_partner/cp_lafarge/ index.cfm (accessed 18 March 2007). Zadek, S. (2001), The Civil Corporation: The New Economy of Corporate Citizenship, Earthscan, London and Stirling, VA. Further reading Thomsen, M. (2001), Environmental Groups Endorse Shareholder Resolutions. Corresponding author Maria May Seitanidi can be contacted at: [email protected]

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The governance of going private transactions The leveraged buyout board of directors as a distinctive source of value Michael R. Braun University of Montana, Missoula, Montana, USA, and

Scott F. Latham Bentley College, Waltham, Massachusetts, USA Abstract Purpose – The purpose of the study is to explore the board of directors in leveraged buyouts (LBOs) as a distinct source of value creation and to conceptually investigate the going-private transaction via LBO as a response to deficient governance structures as well as the post-buyout board restructuring. Design/methodology/approach – The paper provides a review of the literature on LBOs boards, and relies on agency theory and the resource dependence perspective to develop testable propositions. The work suggests that the board as a particular source of efficiency gains in LBOs warrants further empirical research. Research limitations/implications – The paper gives strong credence to the argument that boards represent a unique source of value creation in LBOs. Previous agency-theoretic work is complemented by focusing on the monitoring function of the board, but resource dependence theory introduced to suggest the importance of a strategic service and support function. The work is conceptual in nature and thus requires subsequent empirical testing to verify assertions set forth in this study. Practical implications – The paper shows that incentives of managerial equity participation and the discipline of debt are gradually losing their distinctiveness in today’s buyout industry. To compete in an increasingly crowded environment, LBO specialists need to identify new sources of value to generate attractive returns for their investors. Originality/value – The paper extends the existing LBO literature by introducing resource dependent as a complementary framework. Given that the traditional LBO literature examines the discipline of debt and managerial ownership that explain their efficiencies, the role of LBO boards as a distinct value creation mechanism in buyouts is introduced. Keywords Leveraged buy-outs, Boards of Directors Paper type Research paper

Management Decision Vol. 45 No. 5, 2007 pp. 866-882 q Emerald Group Publishing Limited 0025-1747 DOI 10.1108/00251740710753684

Introduction Coming on the heels of some of the most notorious governance debacles (e.g. Adelphia, Enron, and Tyco), the leveraged buyout market (here used synonymously with going-private transactions, as per Halpern et al., 1999) is currently experiencing the largest boom in nearly two decades (Mendell and Radler, 2006). With over $2.5 trillion in acquisition potential (Weinberg and Vardi, 2006), US and foreign buyout shops are scouring the globe for publicly-traded companies that can be restructured for investor gains via LBO. Recent notable buyouts of well-known public firms include food grocer Albertson’s, pet retailer Petco, and Hertz, the car rental company, as well as the record-breaking buyout of hospital operator HCA for $31 billion.

To account for the LBO’s longstanding and widespread success, researchers (e.g. Peck, 2004; Holthausen and Larcker, 1996; Mian and Rosenfeld, 1993; Kaplan, 1989; Jensen, 1989, 1986) have relied predominantly on agency theory. Specifically, they treat the LBO as a form of investor activism of public firms that have incurred agency costs beyond an optimal point. Pre-buyout, firms are plagued by significant agency costs in the form of free cash flows, mostly because managers’ and shareholders’ interests and goals are misaligned. Post-buyout, however, free cash flows are diverted towards debt repayment, thus curtailing managers’ inefficient use of firm resources. Furthermore, insider equity increases, thus aligning interests between shareholders and managers towards shareholder value maximization. As such, the discipline of debt and the incentives of managerial ownership in the firm represent the two leading explanations for why LBOs occur and how they improve performance (Halpern et al., 1999; Fox and Marcus, 1992; Smith, 1990; Jensen, 1989). Since the 1980s, however, the buyout market has adapted to an environment that offers significantly lower leveraging power. By 2000, average equity contributions to buyouts hovered around 38 percent, versus an average of 13.4 percent in 1989; whereas debt contributed 51 percent of an LBO’s value creation during the 1980s, it only contributed 32 percent in the 1990s and, in 2001, around 25 percent (Jin and Wang, 2002). Furthermore, Baker and Smith (1998) note that the fundamental ideas of the buyout regarding the incentives of increased ownership by management have been accepted by and built into modern day corporate practice to the point that, according to Kaplan (1997, p. 1), referring to a founding partner of buyout firm KKR, “we are all Henry Kravis now”. What has become apparent is that the traditional scholarly tenets concerning value drivers in LBOs, for one, may have less explanatory power to justify the longevity and continued success of the buyout market and, secondly, may be complemented by other justifications. As such, these shifts in the way buyouts are accomplished force a re-evaluation of the general understanding of the LBO phenomenon. In this article, we explore the buyout board of directors as a distinctive source of value for the following reasons. First, LBO boards are considered the pinnacle of investor activism (Jensen, 1989) – that is, they represent “value-maximizing” boards (Gertner and Kaplan, 1996, p. 1) that are optimally structured to yield strong returns to investors. As such, closer scrutiny of buyout board characteristics that leads to favorable shareholders returns is warranted. Second, because buyout boards are structured absent of public market forces, the study of LBO boards can inform on the extent to which buyout managers and owners can make the most not just of monitoring but also of strategic resource functions of their boards. And third, as mentioned above, the search for alternative sources of value in LBOs is becoming increasingly important because managerial incentives and the heavy use of debt are gradually losing their distinctiveness in today’s buyout industry. As such, research based on long-standing agency-theoretic justifications for the LBO may need to be revisited using additional theoretical lenses. Based on evidence in the extant LBO literature, we reach beyond agency theory to also include the resource dependence perspective (Pfeffer and Salancik, 1978) as an underlying principle for the LBO phenomenon. In light of the changing dynamics in the buyout business, we deem research on additional explanations for the LBO’s staying power and growing impact on the global economy to be especially timely and appealing.

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We attend to the following research questions: Do board structures predict those companies engaging in buyouts versus those that do not engage in buyouts (i.e. Continuing Firms)? Does the board composition change during the buyout phase and, if so, to what extent? We begin by reviewing the narrow literature on the board of directors as a distinct source of value in LBOs. We subsequently discuss the function of the board from an agency-theoretic view as well as from a resource dependence perspective and integrate the literature on LBOs and research on boards of directors in order to develop sets of propositions. We conclude the article by discussing implications, limitations, and avenues for future research. Literature review The board of directors as a source of value in LBOs Only a handful of researchers (Lorsch et al., 2004; Cotter and Peck, 2001; Gertner and Kaplan, 1996; Holthausen and Larcker, 1996; Singh, 1990; Baker and Wruck, 1989) have considered, directly or peripherally, the LBO as a response to defective boards of directors and the extent to which, post-buyout, the restructured board serves as a distinct source of value. From an agency-theoretic perspective, the LBO promises to repair what Jensen views as severe monitoring inadequacies in boards of public firms. An effective board of directors, agency theorists argue, should comprise outside directors who, independent of management’s sway, can represent and protect the interests of shareholders (e.g. Dalton et al., 1998; Zahra and Pearce, 1989; Fama and Jensen, 1983b). In contrast, Jensen (1989, p. 64) acknowledges that “the idea that outside directors with little or no equity stake in the company could effectively monitor and discipline the managers who selected them has proven hollow at best.” To mend this deficiency, the LBO effectively replaces passive outsiders with active investors, represented predominantly by buyout specialist. Since these buyout specialists often hold a majority of the equity in LBOs, they exercise considerable control over managers by constituting the majority of the board of directors (Cotter and Peck, 2001; Holthausen and Larcker, 1996; Seth and Easterwood, 1993; Kaplan, 1991). Singh (1990) provides some of the earliest large-sample findings on board changes after buyout by confirming that the proportion of directors representing stakeholders other than stockholders decreases significantly post-buyout. This decrease is predominantly attributable to the addition of buyout specialists who replace other types of representatives, including pre-buyout board members, other CEOs, prominent citizens, and specialists such as lawyers and bankers. As such, the post-buyout board is modified to reflect interests of a selected constituency comprising managers, equity investors and senior lenders. Singh (1990, p. 127) concludes that “the ‘engine’ which drives these operational changes in firms undergoing buyout relates to radical changes in governance of the firm (including) a more focused board”. An unpublished paper by Gertner and Kaplan (1996) is worth mentioning since, to these authors’ knowledge, it is the only study that centers exclusively on exploring the board of directors of LBOs. To help identify effective board characteristics, the authors rely on the premise that the buyout specialist-controlled board, from an agency theoretic perspective, represents an optimal board structure. Because buyout specialists receive a 20 percent share of the profits, with 80 percent going to their investors, and because the ability to raise future from investors for buyouts depends on a track record of positive gains, buyout specialists are strongly motivated to maximize

shareholder value. In addition, with buyout specialists occupying a non-management role, they are less likely to derive private benefits of control. As such, the principal and agent role of buyout specialists effectively mitigates agency costs. Gertner and Kaplan compare the board structures of 59 reverse leveraged buyouts to an industry- and size-matched sample, following these structures from the SIPO year to the second fiscal year post-SIPO. The study is largely descriptive and lacks any theoretical treatment of the variables observed. However, the extent of variables included in their empirical analysis is commendable. Aside from tracing measures of board composition, including board size, number/percentage of inside and outside directors, and number/percentage of LBO specialist directors, the authors also include variables on board ownership, board compensation, board meeting and committee structure, and director characteristics. Two case studies, by Baker and Wruck (1989) and Lorsch et al. (2004) are particularly insightful in that they intimate a board function other than the agency-prescribed monitoring role. Baker and Wruck (1989) explore the organizational changes in the U.M. Scott and Sons Company, a unit sold by ITT Corporation in a divisional leveraged buyout (D-LBO). Apart from verifying agency-theoretic justifications of debt and managerial ownership in improving the operating performance of U.M. Scott, the authors’ account (Baker and Wruck, 1989, p. 182) involves the buyout specialist’s decision to add a leading turf researcher to the board: Our objective was to find the best turf specialist and researcher in the country. We wanted someone to keep us up with the latest developments and to scrutinize the technical aspects of our product line.

Interestingly, this observation remains grounded in the confines of agency-based explanations even though it strongly hints at the service and support function of the board of directors invoked by resource dependence theorists, discussed in more detail in a later section. Similarly, a recent Harvard business case study by Lorsch et al. (2004) details governance changes in he public-private-public buyout cycle of Kinetic Concepts Inc. (KCI). In-depth interviews of board members give strong credence to a more service and support role of the board, in addition to its oversight function. For instance, the post-buyout board was subsequently expanded to include more independent directors with industry savvy to balance out the agency concentration. As one investor justified: We’ve had the outside board members because I don’t think we should just be sitting across from management in an adversarial role (Lorsch et al., 2004, p. 7). we’d much prefer to use (additional seats) for additional industry expertise. You only need so much financial acumen at the table (Lorsch et al., 2004, p. 10).

Post-buyout, the new 11-member board included an academician, a Medicare reimbursement specialist, a customer base representative, and a former CFO to chair the audit committee, indicating a wide range of experiences and expertise accessible to the CEO. Our review of the literature on LBO boards suggests only peripheral treatment in terms of its unique and influential contributions in the restructuring process. In many cases (e.g. Cotter and Peck, 2001; Holthausen and Larcker, 1996; Singh, 1990), discussions of the LBO board are largely descriptive and, for the most part, lack

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rigorous theoretical consideration. For studies that dedicate focused attention to board enhancements throughout the buyout process (Lorsch et al., 2004; Gertner and Kaplan, 1996; Baker and Wruck, 1989), analyses of LBO boards remain grounded firmly within the confines of agency theory. However, as indicated above, agency-theoretic justifications of the LBO board’s value contribution may be enhanced through additional theories, in our case resource dependence perspective. The remainder of this article synthesizes the literature on the function of the board based on agency theory and resource dependence. Subsequently, we develop propositions to organize our discussion around: . Board structures that predict companies engaging in buyouts versus those that do not engage in buyouts; and . The extent to which boards of LBOs are altered during the buyout phase. Development of propositions The agency role of the board of directors Agency theorists view boards of directors as the primary means available for the protection of shareholder interests (Fama and Jensen, 1983). In this theoretical context, the board is often assigned a “control” role (Hillman and Dalziel, 2003; Hillman et al., 2000; Boyd, 1990; Zahra and Pearce, 1989) wherein the focal point of analysis lies in finding optimal structures that maximize the board’s disciplining and monitoring capabilities, thus minimizing managers’ actions of self-interest. By controlling managers’ actions and making them more sensitive to firm value using various alignment mechanisms, the board can effectively mitigate agency costs inherent in the separation of ownership and control and thus improve firm performance (Zahra and Pearce, 1989; Mizruchi, 1983; Fama, 1980). Prescriptively, agency theorists argue for specific board structures on dimensions such as director independence, leadership structure and size. The ideal board should be composed largely of independent outside directors who can resist attempts by managers and other insiders to influence the board (John and Senbet, 1998; Johnson et al., 1993; Kosnik, 1987). Jensen (1989, p. 865) even goes so far as to recommend that the CEO represent the only insider on the board, arguing that “the possibility of animosity and retribution from the CEO is too great” for additional inside board members. In terms of board leadership structure, shareholders are better served by non-duality, i.e. when a CEO does not simultaneously occupy the chair position. CEO duality, which exists when the chief executive officer of a firm also holds the title of chairperson, promotes CEO entrenchment by reducing the efficacy of board monitoring (Finkelstein and D’Aveni, 1994). Lastly, larger boards are viewed to be more effective since they restrict domination by top management (Zahra and Pearce, 1989). For one, a larger board makes it more difficult for the CEO to gather consensus on firm decisions that can lead to shareholder losses (Singh and Harianto, 1989). Furthermore, as the board grows in size, it gains the necessary independence to mitigate CEO power and use its decision control to ratify or refute the decisions of top management (Ocasio, 1994; Zahra and Pearce, 1989). Nevertheless, some agency theorists invoke a caveat on the benefits of larger boards. Jensen (1989), building on arguments by Lipton and Lorsch (1992), maintains that oversized boards result in passive supervision of management, accordingly suggesting that “when boards get beyond seven or eight people they are less likely to function effectively and are easier

for the CEO to control” (1993, p. 865). Thus, the agency view on board size is: larger boards are better – but to a degree. Given reliable theoretical justifications and empirical evidence (Dalton et al., 1998; Johnson et al., 1993) that agency problems are at the root of corporate restructurings, especially leveraged buyouts (Hoskisson et al., 1994; Bethel and Liebeskind, 1993; Lewis, 1991; Markides, 1992), the expectation is that agency theory will strongly support this exploration of governance structure of the firm throughout the buyout process. However, before developing relevant agency-based propositions, we introduce the resource dependence role of the board of directors as a theoretical perspective that can add explanatory dimensions to the board as a distinctive source of value in buyouts. Resource dependence role of the board of directors In a seminal article on the impact of boards of directors on firm performance, Zahra and Pearce (1989) call for an integrative approach by suggesting that boards also be viewed in terms of their strategic service and support function. According to the authors, this functionality assigns the board an institutional role in securing external resources for the firm. Specifically, board members who bring experience, expertise and a set of connections can benefit the firm by “enhancing company reputation, establishing contacts with the external environment, and giving counsel and advice to executives (Zahra and Pearce, 1989, p. 292)”. This ability of the board to bring necessary resources to the firm and its managers is most reflective of the resource dependence perspective (Daily and Dalton, 1994; Hillman and Dalziel, 2003; Zahra and Pearce, 1989). From a resource dependence view, the board of directors acts to coopt external organizations with which the firm is interdependent. Cooptation refers to the inclusion of outside constituents for diffusing external threats and garnering support essential for organizational survival. Specifically, cooptation represents “the process of absorbing new elements into the leadership or policy-determining structure of an organization as a means of averting threats to its stability or existence” (Selznick, 1949, p. 13). Thus, boards that coopt essential resource requirements of a firm can increase its likelihood of survival and success (Pfeffer, 1972; Singh et al., 1986). Concerning specific recommendations, research dependence theorists focus primarily on the broad categories of board size, board composition, and board interlocks. Board size is determined by a firm’s need to externally link with its environment (Pfeffer and Salancik, 1978; Pfeffer, 1972). Accordingly, the stronger the need for coopting, the larger the board will be to supply the firm with critical resources. Board composition concerns insider-outsider board member ratios, directors’ relevant experiences, as well as directors’ expertise. The ratio of outsider board representatives is predicated on the degree to which the organization depends on external resources. Relying on the rationale of resource dependence, Daily and Dalton (1994) maintain that the more uncertain a firm’s environment, thus necessitating as many valued resources and information as possible, the more important the inclusion of outside representatives on the board. Under these circumstances, outsiders can supply the critical skills, experience and relationships necessary to effectively manage interdependencies. Taking a more fine-grained approach to individual board member characteristics, resource dependence theorists suggest that individual

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experiences and expertise can inform on the resources that are absorbed and secured by a firm. For example, firms with larger capital requirements should create board interlocks that coopt representatives from financial institutions, thus reducing the uncertainty of access to future funding (Pfeffer, 1972). While empirical studies using resource dependence to test the board-performance relationship are much scarcer than agency-based ones, their findings nevertheless provide strong support for the resource dependence role of the board (e.g. Gales and Kesner, 1994; Pearce and Zahra, 1992; Provan, 1980; Pfeffer and Salancik, 1978; Pfeffer, 1972). Thus, conceptually and empirically, the resource dependence perspective offers a strong explanatory theory on the board’s role in the management of the firm. Furthermore, LBO studies by Baker and Wruck (1989) and Lorsch et al. (2004) have implicitly substantiated the notion that directors represent critical links to external resources that can aid post-buyout restructuring. As noted, both theories put forward strong prescriptive recommendations concerning board attributes that can improve or sustain firm performance. We subsequently develop two sets of propositions divided into the various stages of the board’s evolution over the course of the buyout: pre-buyout and changes during buyout. Distinguishing predictors of LBOs versus continuing firms Board size. As is evident from the literature review in the previous section, agency and resource dependence recommendations for optimal board size are incongruent. From an agency perspective, an oversized board is inefficient because it increases potential free riding problems, in turn making difficult adequate monitoring of managerial behavior (Jensen, 1989). Thus, the oversized board represents a particular source of agency costs. In contrast, resource dependence treats larger boards as “wells” of social contacts and strategic expertise that can stabilize the firm within its uncertain environment. Furthermore, the heterogeneity in member background, values and skills found in larger boards makes directors less susceptible to managerial domination (Zahra and Pearce, 1989). As such, agency views suggest that LBO candidates will have larger boards that incur agency costs and lead to subsequent performance decline. On the other hand, LBO candidates may reflect an absence of the large boards that can deliver necessary links to external constituents. Given this irreconcilability of agency and resource dependence positions on effective board size, we therefore offer competing propositions. The purpose of proposing contrasting views is that subsequent analyses will be more robust (Platt, 1964), with any resulting reconciliations possibly revealing contingency relationships (Finkelstein and D’Aveni, 1994): P1a. Firms with larger boards are more likely to engage in LBO. P1b. Firms with smaller boards are more likely to engage in LBO. Board leadership structure. For agency theorists, an agency control involves the separation of the roles of CEO and chair. This non-duality provides the board of directors, as the primary monitoring mechanism, the means to effectively monitor the executives. More precisely, by assigning decision management to the CEO and retaining decision control, the board maintains the authority to ratify and monitor the decisions made by the CEO (Boyd, 1995). In the absence of a non-dual structure, shareholders suffer from rising agency costs that negatively impact firm performance.

In the context of corporate restructuring via buyout, the expectation is that firms engaging in LBO suffer from CEO duality-related managerial entrenchment. On the other hand, firms with independent leadership structure (CEO non-duality) maintain appropriate checks and balances, avoiding agency-related problems and thus the need to restructure: P2a. Firms with a dual leadership structure are more likely to engage in LBO. Resource dependence theorists, in contrast, view firm advantages to dual leadership structures. Pfeffer (1972) argues that the symbolic role of a manager is as important to the well-being of the firm as the administrative one since the semblance of strong leadership communicates the firm’s stability and legitimacy to the external environment. Finkelstein and D’Aveni (1994, p. 1084) in particular invoke this resource dependence view to explain the benefits of CEO duality in creating “an illusion of stability and a sense that a dominant leader, not the environment, is determining organizational destiny”. Thus, we expect LBO candidates to lack the clear leadership necessary to attract and retain vital resource link. In effect, the absence of authoritative leadership in the form of a dual leadership structure will lead firms to lose external constituents. Firms lacking resource relationships will thus be forced to restructure via buyout: P2b. Firms with a non-dual leadership structure are more likely to engage in LBO. Board independence. Agency theory and the resource dependence perspective are for the most part in alignment concerning the preferred board independence, albeit for different reasons: the more outsiders, the better off the firm. As discussed before, agency theory treats outside directors as the primary mechanism to monitor opportunistic managers. However, Jensen (1989) makes their efficacy contingent on their functional involvement (i.e. active investors), the motivation for which derives from having ownership interests in the firm. On the other hand, resource dependence is less concerned with the board’s monitoring role and more with the extent to which outside directors can support managers, especially as environment uncertainty increases. Outside directors, bringing to the firm an outward posture, create crucial links to the external environment. As such, the more outside directors represented on the board, the more likely that the board will reflect heterogeneous resources, perspectives and skills (He, 2005; Pfeffer and Salancik, 1978). Faltering performance in firms that triggers a need for restructuring via LBO should be reflected in inadequate outsider representation on the board. From an agency perspective, insider-dominated boards allow managers to put firm resources toward inefficient use, as indicated by Jensen (1986) free cash flow hypothesis. The presence of large free cash flows and the absence of growth opportunities thus cause undervaluation of assets in the marketplace. From a resource dependence perspective, a board without adequate outsiders fails to secure the external ties that permit the firm from performing effectively. In either case, more outsider directors represent the preferred board arrangement for firm performance: P3a. Firms with less board independence are more likely to engage in LBO. The inherent difficulty in having concurring agency theoretic and resource dependence predictions is that any confirmation cannot be attributed to one particular theory. This

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problem is acknowledged by Dalton et al. (1999) and Gales and Kesner (1994) who invoke similar reasoning in their study investigating causes and consequences of bankruptcies. To rectify this problem, it is important to focus on the absolute versus the relative value of outsiders in the context of agency and resource dependence situations. Agency theory strongly recommends that, particularly in agency-laden situations, outside directors should dominate the board; that is, the largest absolute ratio of outsiders to insiders which can constrain self-serving managerial actions. Jensen (1989) permits the CEO to remain on the board as the only internally-oriented strategic actor. However, it is the overpowering outsider majority on the board that serves to keep a watchful eye on managers. Alternatively, resource dependence perspective acknowledges the contributions of outsiders as resource providers, but not at the expense of insiders. Pfeffer (1972) proposes an ideal insider-outsider director ratio unique to an industry, with deviations from the ideal – that is, the firm’s ideal relative to its environment – leading to underperformance. The argument for this balanced board, reemphasized by Harris and Shimizu (2004), Hillman and Dalziel (2003), Dalton et al. (1999), and Zahra and Pearce (1989) among others, is that outsiders without relevant knowledge of the focal industry and firm are limited in their ability to effectively link the firm to outside resources. As such, insiders bring a different but complementary type of board capital to the firm. By facilitating and/or interpreting firm-specific information (Baysinger and Butler, 1985) and integrating their functional knowledge (Hill and Snell, 1988), insiders’ input “of such ‘real time’ expertise may be especially vital to unprepared directors” (Harris and Shimizu, 2004, p. 779). This discrepancy in the resource dependence view of board independence suggests that too many or too few outsiders may be less advantageous for a firm and that optimal board composition may entail a combination of insiders and outsiders. We thus submit the following proposition as an alternative to the previous agency-based justification: P3b. There will be an inverse u-shaped relationship between board independence and the probability that a firm engages in LBO. Director experience. Resource dependence theorists (e.g. Hillman et al., 2000; Pfeffer and Salancik, 1978; Pfeffer, 1972) include measures of board member experience and expertise in efforts to more thoroughly detail the resource capabilities provided by directors. Director experience allows directors to receive more board memberships, which in turn creates more knowledge and experience (Haunschild and Beckman, 1998; Haunschild, 1993). Harris and Shimizu (2004) observe, “knowledge and experience may come, in part, through prior managerial duties, but it is most commonly viewed as coming from directors’ membership on other boards”. While these interlocks are first and foremost means to managing resource dependence through cooptation (Pfeffer and Salancik, 1978), they also represent inexpensive, trustworthy and credible sources of strategic information that allow managers to learn of best business practices and to gauge the business environment (Haunschild and Beckman, 1998; Useem, 1984). Haunschild and Beckman (1998) find that: executive brought firsthand knowledge of the actions of other firms to their own firms through interlock contacts, and this knowledge affected their firms’ activities. Given the empirical support based on resource dependence for the informational benefits of board interlocks, firms taking the LBO option should exhibit lower levels of director experience in the form of board memberships. By failing to create the

necessary networks and thus access critical knowledge needed to stabilize the firm within its competitive environment, firms with fewer board interlocks, reflected in their poorer performance, will seek to restructure via buyout. As with benefits arising from outside directors’ extended board tenure using a combination of agency and resource dependence arguments, a case for more director experience can be made. The know-how gained from multiple board memberships may enhance directors’ competency to supervise managers. In addition to the strategic information obtained from board interlocks, outside directors may also become exposed to best governance practices that can help guide them through their roles as effective monitors. Insiders on the firm board who occupy outside directorships on other boards may be more attuned to board structures that effectively allocate responsibilities of decision management from decision control. Thus, from the perspectives of strategy, support and control roles of boards of directors, firms with lower levels of director experience in the form of board interlocks will lack the appropriate strategic scanning abilities, resource links and monitoring controls to function effectively: P4.

Firms with lower levels of director experience are more likely to engage in LBO.

Director expertise. As mentioned in the previous review on resource dependence perspective, director expertise represents another indicator of the access to resources brought by board members. Pfeffer (1972) showed that hospitals with external funding coopted board members with money-raising expertise. Similarly, Hillman et al. (2000) demonstrated that firms transitioning from regulation to deregulation invited business professionals to sit on the board, reflecting a need for expertise in a newly competitive environment. By applying resource dependence and agency theory in tandem, the following question can be posed: does the board represent the expertise needed to monitor agency-laden firms? That buyout candidates overwhelmingly demonstrate significant free cash flows incurred by agency conflicts implies a clear absence of board capital necessary to monitor firm resources. More specifically, the type of resource required to attend to effective monitoring of shareholder value may best be represented by directors with knowledge in areas such as finance and law. In contrast, while politicians, for example, can represent community interests and groups, their contribution in terms of firm resource allocation and use may be much less effective. As such, the expectation is that firms faced with the LBO decision due to accumulated free cash flows display a deficiency in monitoring-related director expertise: P5.

Firms with lower levels of monitoring-related director expertise are more likely to engage in LBO.

Changes in post-buyout board composition Along with the reorganization in debt levels and managerial incentives, LBOs, during the post-buyout phase, should also exhibit considerable improvements to the board of directors in response to deficiencies from being publicly since LBO owners are at liberty to optimally reconfigure the board away from the scrutiny of the public markets. As such, they may add wanted or shed unwanted directors to enhance the firm during the post-buyout period.

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Lynall et al. (2003) maintain that the accurate study of board composition is dependent on the application of the correct theory to the relevant life cycle stage of the firm. By dividing a firm’s life cycle into three distinct stages (entrepreneurial, collectivity, and formalization and control), the authors assign appropriate theories with predictive and explanatory power. The later life cycle stage of formalization and control, in which firms face strong cash flows and few growth opportunities (Jawahar and McLaughlin, 2001), calls for governance controls, stability of production, formalization of structure, and managing environmental linkages. As such, the authors propose that boards formed in this latter stage will address resource dependence and agency needs of the firm. Arguing for an emphasis on agency controls in this stage, Lynall et al. (2003, p. 426) state that “an external financier’s preferred board will have an investor perspective, possessing skills and expertise valued by shareholders (e.g. governance/monitoring)”. LBO boards should therefore be refigured post-buyout to reflect buyout investors’ agency orientation. The expectation is that pre-buyout monitoring deficiencies are repaired during the post-buyout phase: P6a. Post-buyout, LBOs will exhibit smaller boards than prior to buyout. From a resource dependence perspective, board size should increase as key directors with access to critical resources are invited to sit on the board. According to Pfeffer and Salancik (1978), board size is a function of the financial requirements and health of the organization. Given the buyout’s heavy reliance on debt financing and its need for operational restructuring to improve firm performance, resource dependence theory indicates that the board should grow to reflect the addition of resource access vehicles that were absent pre-buyout. As in the previous set of propositions on predictions concerning board size, agency and resource dependence-based propositions are in opposition of each other. To account for the explanatory power of each theory, we offer the following competing proposition: P6b. Post-buyout, LBOs will exhibit larger boards than prior to buyout. As described in the first set of propositions, CEO duality-related managerial entrenchment causes the firm to incur agency costs, leading to performance decline and a need to restructure. In the post-buyout stage that is intended to mitigate agency costs and unlock shareholder value in the firm, LBO owners should arrange for a board leadership structure that reflects an agency-based orientation. From an agency theory perspective, buyouts in general should reflect organizational structures that attend to sources of agency costs such as CEO duality. Nevertheless, organizational decline, such as often experienced by buyout candidates, may require more formal authority in the form of CEO duality. In these particular situations, CEO duality may help to “establish a unity of command at the top, sending reassuring signals to stakeholders” (Finkelstein and D’Aveni, 1994, p. 1102) and subsequently strengthen ties with external resource providers. Because LBO managers and LBO investors have interests aligned through equity participation in the firm, non-dual leadership may only serve as an impediment to the rapid recovery of the post-buyout firm.

The following competing propositions are proffered: P7a. Post-buyout, LBOs will exhibit a non-dual board leadership structure. P7b. Post-buyout, LBOs will exhibit a dual board leadership structure. Whereas pre-buyout firms may suffer from lack of adequate monitoring by outside directors, predictions about post-buyout board independence based on agency theory suggest the addition of more outsiders who can effectively fulfill their supervisory roles. In terms of an absolute ratio, the board should tip heavily towards an almost exclusively outsider-dominated board, even to Jensen (1989) extreme suggestion of having the CEO serve as the only insider. However, to balance the inclusion of outside directors who, on the one hand, coopt necessary resources but, on the other hand, have little firm-specific knowledge, the presence of insiders may be desirable. From an agency theoretic perspective, the prediction about post-buyout board independence is unidirectional. However, resource dependence suggests only that a non-optimal configuration of insiders and outsiders in the pre-buyout phase may be adjusted post-buyout to match the firm’s environmental needs. The prediction based on resource dependence arguments, in effect, is only that board independence is expected to change. We offer the following propositions in conjunction: P8a. Post-buyout, board independence in LBOs will be larger than prior to buyout. P8b. Post-buyout, board independence in LBOs will have significantly changed from prior to buyout. Concerning board member experience and expertise, post-buyout boards are expected to “patch up” pre-buyout shortcomings by inviting directors with multiple board appointments as well as functional backgrounds that lend themselves to improved monitoring and control. Board members who serve on more boards can supply the firm with essential environmental scanning capabilities and resource contacts, as suggested by Haunschild and Beckman (1998) and Pfeffer and Salancik (1978). Additionally, the extra monitoring-related expertise allows the board to attend to agency-related problems in the firm. Thus, we propose: P9.

Post-buyout, LBOs will exhibit more board member experience than prior to buyout.

P10. Post-buyout, LBOs will exhibit more monitoring-related board member expertise than prior to buyout. Discussion and conclusion Our article is consistent with an ongoing stream of research that aims to understand whether or not the LBO, as an organizational form that improves on the defects of the widely-held public firm, creates value, and if so, how (Gottschalg, 2002; Holthausen and Larcker, 1996; Long and Ravenscraft, 1993; Lehn and Poulson, 1989). Previous studies on the LBO phenomenon have focused in large part on a particular set of changes – leverage and ownership – associated with buyout. As such, the discipline of debt and managerial equity participation continue to represent the leading justifications for why LBOs occur (e.g. Halpern et al., 1999; Muscarella and Vetsuypens, 1990; Maupin, 1987). By drawing on limited evidence from previous studies (Lorsch et al., 2004; Gertner and

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Kaplan, 1996; Singh, 1990; Baker and Wruck, 1989), we set out to explore an alternative yet complementary source of value: the board of directors. As such, our exploration focuses on the extent to which the board of directors, as the “apex of the firm’s decision control system” (Fama and Jensen, 1983a, p. 311), evolves over the course of a buyout. However, we also look beyond agency theory in an attempt to reconcile inconsistencies in earlier inquiries on buyouts and, separately, board structures. By invoking resource dependence theory, we overcome some of the scholarly weaknesses that arise from using merely one theory. As Hillman and Dalziel (2003, p. 383) rightly assert, “separate approaches provide a relatively incomplete understanding of what contributes to the provision of resources and effective monitoring” in boards. Therefore, our inclusion of board capital and to what extent it provides resources to the firm, alongside the agency inquiry, allows for a richer account of the LBO phenomenon as well as the governance by boards in general. Our study is limited to a conceptual treatment of the LBO board, although we would argue that the propositions are straightforwardly testable. Another limitation to our study concerns the heterogeneity of buyouts in the marketplace. Traditional LBOs, especially those that undergo the entire public-private-public cycle (reverse LBOs) may be most appropriate for our conceptual treatment of LBO boards since, according to Bruton et al. (2002), going-private transactions of whole companies, as in the case of R-LBOs, are generally motivated by a potential for unlocking value arising from agency cost reductions. However, several forms of buyouts exist, including buyouts of corporate units or divisions and private firm buyouts, the impetus for which are the perceived entrepreneurial opportunities (Wright et al., 2000). Future researchers may want to consider other theoretical frameworks more fitting to the exploration of board dynamics in those particular variants of LBOs. Our research is stimulated by the changing practices of the leveraged buyout business. The LBO has become a mainstay among activist investors; university endowments, pension funds and wealthy individual investors seeking to diversify their investment portfolios can choose from among over 500 buyout specialists in the US alone (Venture Economics, 2004) who focus exclusively on buyouts. To compete in an increasingly crowded environment, these buyout specialists are searching for innovative strategies and structures that seek to create investor returns. This increasingly competitive market thus begs the question: how will this class of active investor continue to generate attractive returns? In the absence of a dominating junk bond market that permitted extreme leveraging during the first boom, and given the wide-spread adoption of options to managers to provide them with “skin in the game”, practitioners are seeking to create value primarily through operating improvements and expansion rather than through financial engineering (Jin and Wang, 2002). Accordingly, for buyout firms and their investors, the success of buyouts may increasingly depend on having the right governance structure to achieve superior returns. Our conceptual investigation into governance structures of what Gertner and Kaplan (1996) deem “value-maximizing boards” has far-reaching implications for research and practice. For one, it offers a benchmark for buyout firms to compare their board characteristics by establishing best-practices linkages between pre-buyout deficiencies and post-buyout modifications. However, our study informs not only buyout participants, but managers of non-buyout firms, especially public firms. In the current post-Enron market environment, leveraged buyouts may serve as a vital point of reference. Given that buyouts continue to represent a significant force of investor

activism in domestic and global markets, we submit that the search of additional sources of value warrants further scholarly attention. References Anonymous (2004), “Private equity industry: 2004 performance outlook”, Venture Economics. Baker, G. and Smith, G. (1998), The New Financial Capitalist, Cambridge University Press, Cambridge. Baker, G. and Wruck, K. (1989), “Organizational changes and value creation in leveraged buyouts: the case of the O.M. Scott and Sons Company”, Journal of Financial Economics, Vol. 25, pp. 163-91. Baysinger, B. and Butler, H. (1985), “Corporate governance and the board of directors: performance effects of changes in board composition”, Journal of Law Economics and Organization, Vol. 1, pp. 101-24. Bethel, J. and Liebeskind, J. (1993), “The effects of ownership structure on corporate restructuring”, Strategic Management Journal, Vol. 14, pp. 15-32. Boyd, B. (1990), “Corporate linkages and organizational environment: a test of the resource dependence model”, Strategic Management Journal, Vol. 11, pp. 419-31. Boyd, B. (1995), “CEO duality and firm performance: a contingency model”, Strategic Management Journal, Vol. 16, pp. 301-12. Bruton, G.D., Keels, J.K. and Scifres, E.L. (2002), “Corporate restructuring and performance: an agency perspective on the complete buyout cycle”, Journal of Business Research, Vol. 55, pp. 709-24. Cotter, J. and Peck, S. (2001), “The structure of debt and active equity investors: the case of the buyout specialist”, Journal of Financial Economics, Vol. 59, p. 101. Daily, C. and Dalton, D. (1994), “Bankruptcy and corporate governance: the impact of board composition and structure”, Academy of Management Journal, Vol. 37, pp. 1603-18. Dalton, D., Daily, C., Ellstrand, A. and Johnson, J. (1998), “Meta-analytic reviews of board composition, leadership structure, and financial performance”, Strategic Management Journal, Vol. 19, p. 269. Dalton, D., Daily, C., Johnson, J. and Ellstrand, J. (1999), “Number of directors and financial performance: a meta-analysis”, Academy of Management Journal, Vol. 42, p. 674. Fama, E.F. (1980), “Agency problems and the theory of the firm”, Journal of Political Economy, Vol. 88, pp. 288-307. Fama, E.F. and Jensen, M.C. (1983a), “Separation of ownership and control”, Journal of Law and Economics, Vol. 26, pp. 301-26. Fama, E.F. and Jensen, M.C. (1983b), “Agency problems and residual claims”, Journal of Law and Economics, Vol. 26, pp. 327-49. Finkelstein, S. and D’Aveni, R.A. (1994), “CEO duality as a double-edged sword: how boards of directors balance entrenchment avoidance and unity of command”, Academy of Management Journal, Vol. 37, pp. 1079-2009. Fox, I. and Marcus, A. (1992), “The causes and consequences of leveraged management buyouts”, Academy of Management Review, Vol. 17, pp. 62-85. Gales, L. and Kesner, I. (1994), “An analysis of board of director size and composition in bankrupt organizations”, Journal of Business Research, Vol. 30, pp. 271-83. Gertner, R. and Kaplan, S. (1996), “The value maximizing board”, unpublished paper, University of Chicago, Chicago, IL.

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Gottschalg, O. (2002), “Why do financial buyers do it better? Agency theory meets the knowledge-based view of the firm”, paper presented at the 2005 Academy of Management Conference, August, Denver, CO. Halpern, P., Kieschnick, R. and Rotenberg, W. (1999), “On the heterogeneity of leveraged going private transactions”, The Review of Financial Studies, Vol. 2, pp. 281-309. Harris, I. and Shimizu, K. (2004), “Too busy to serve? An examination of the influence of overboarded directors”, The Journal of Management Studies, Vol. 41, p. 775. Haunschild, P. (1993), “Interorganizational imitation: the impact of interlocks on corporate acquisition activity”, Administrative Science Quarterly, Vol. 38, pp. 564-83. Haunschild, P. and Beckman, C. (1998), “When do interlocks matter? Alternative sources of information and interlock influence”, Administrative Science Quarterly, Vol. 43, pp. 815-45. He, J. (2005), “Corporate governance and firm competitive behavior: disentangling motivation and capability effects”, paper presented at 2005 Academy of Management, Honolulu, HI. Hill, C.W.L. and Snell, S.A. (1988), “External control, corporate strategy, and firm performance in research-intensive industries”, Strategic Management Journal, Vol. 6, pp. 577-90. Hillman, A. and Dalziel, T. (2003), “Boards of directors and firm performance: integrating agency and resource dependence perspectives”, Academy of Management Review, Vol. 28, p. 383. Hillman, A., Cannella, A. Jr and Paetzold, R. (2000), “The resource dependence role of corporate directors: strategic adaptation of board composition in response to environmental change”, The Journal of Management Studies, Vol. 37, p. 235. Holthausen, R. and Larcker, D. (1996), “The financial performance of reversed leverage buyouts”, Journal of Financial Economics, Vol. 42, pp. 293-332. Hoskisson, R., Johnson, R. and Moesel, D. (1994), “Corporate divestiture intensity in restructuring firms: effects of governance, strategy, and performance”, Academy of Management Journal, Vol. 37, pp. 1207-51. Jawahar, I. and McLaughlin, G. (2001), “Toward a descriptive stakeholder theory: an organizational life cycle approach”, Academy of Management Review, Vol. 26, p. 397. Jensen, M.C. (1986), “Agency costs of free cash flow, corporate finance and takeovers”, American Economic Review, Vol. 76, pp. 323-9. Jensen, M.C. (1989), “Eclipse of the public corporation”, Harvard Business Review, Vol. 67, pp. 61-74. Jin, L. and Wang, F. (2002), “Leveraged buyouts: inception, evolution, and future trends”, Perspective, Vol. 3, pp. 3-22. John, K. and Senbet, L. (1998), “Corporate governance and board effectiveness”, Journal of Banking and Finance, Vol. 22, pp. 371-404. Johnson, R., Hoskisson, R. and Hitt, M. (1993), “Board of director involvement in restructuring: the effects of board versus managerial controls and characteristics”, Strategic Management Journal, Vol. 14, pp. 33-51. Kaplan, S. (1989), “The effects of management buyouts on operating performance and value”, Journal of Financial Economics, Vol. 24, pp. 217-54. Kaplan, S. (1991), “The staying power of leveraged buyouts”, Journal of Financial Economics, Vol. 29, p. 287. Kaplan, S. (1997), “The evolution of US corporate governance: we are all Henry Kravis now”, Journal of Private Equity, Fall, pp. 7-14. Kosnik, R. (1987), “Greenmail: a study in board performance in corporate governance”, Administrative Science Quarterly, Vol. 32, pp. 163-85.

Lehn, K. and Poulson, A. (1989), “Free cash flow and shareholder gain in going private transactions”, Journal of Finance, Vol. 44, pp. 771-88. Lewis, C. (1991), “An explanation for recapitalization in corporate control contests”, Managerial and Decision Economics, Vol. 12, pp. 489-99. Lipton, M. and Lorsch, J. (1992), “A modest proposal for improved corporate governance”, Business Lawyer, Vol. 48, pp. 59-77. Long, W.F. and Ravenscraft, D.J. (1993), “LBOs, debt and R&D intensity”, Strategic Management Journal, pp. 119-35. Lorsch, J., Crane, D. and Robertson, A. (2004), “Kinetic Concepts, Inc.”, Harvard Business Case Study, October 15. Lynall, M.D., Golden, B.R. and Hillman, A. (2003), “Board composition from adolescence to maturity: a multitheoretic view”, Academy of Management Review, Vol. 28, pp. 416-31. Markides, C.C. (1992), “Consequences of corporate refocusing: ex ante evidence”, Academy of Management Journal, Vol. 35, pp. 398-412. Maupin, R. (1987), “Financial and stock market variables as predictors of management buyouts”, Strategic Management Journal, Vol. 8, pp. 319-27. Mendell, E. and Radler, J. (2006), “Mega funds drive private equity raising to new heights in second quarter of 2006”, NVCA Newsletter, July 17. Mian, S. and Rosenfeld, J. (1993), “Takeover activity and long-run performance of reverse leverage buyouts”, Financial Management, Winter, pp. 46-57. Mizruchi, M.S. (1983), “Who controls whom? An examination of the relation between management and boards of directors in large American corporations”, Academy of Management Review, Vol. 8, pp. 426-35. Muscarella, C.J. and Vetsuypens, M. (1990), “Efficiency and organizational structure: a study of reverse LBOs”, The Journal of Finance, Vol. 5, pp. 1389-413. Ocasio, W. (1994), “Political dynamics and the circulation of power: CEO succession in US industrial corporations, 1960-1990”, Administrative Science Quarterly, Vol. 39, pp. 285-312. Pearce, J.A. and Zahra, S. (1992), “Board composition from a strategic contingency perspective”, Journal of Management Studies, Vol. 29, pp. 411-38. Peck, S. (2004), “The carrot versus the stick: the role of incentive compensation and debt obligations in the success of LBOs”, American Business Review, Vol. 22, p. 12. Pfeffer, J. (1972), “Size and composition of corporate boards of directors: the organization and its environment”, Administrative Science Quarterly, Vol. 17, pp. 218-29. Pfeffer, J. and Salancik, G. (1978), The External Control of Organizations: A Resource Dependence Perspective, Harper & Row, New York, NY. Platt, J.R. (1964), “Strong inference”, Science, Vol. 46, pp. 347-53. Provan, K.G. (1980), “Board power and organizational effectiveness among human service agencies”, Academy of Management Journal, Vol. 23, pp. 221-6. Selznick, P. (1949), TVA and the Grass Roots, University of California, Berkeley, CA. Seth, A. and Easterwood, J. (1993), “Strategic redirection in large management buyouts: the evidence from post-buyout restructuring activity”, Strategic Management Journal, Vol. 14, pp. 251-74. Singh, H. (1990), “Management buyout: distinguishing characteristics and operating changes prior to public offering”, Strategic Management Journal, Vol. 11, pp. 111-29.

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Singh, H. and Harianto, F. (1989), “Management-board relationships, takeover risk, and the adoption of golden parachutes”, Academy of Management Journal, Vol. 32, pp. 7-24. Singh, J., House, R. and Tucker, D. (1986), “Organizational change and organizational mortality”, Administrative Science Quarterly, Vol. 31, pp. 587-611. Smith, A. (1990), “Corporate ownership structure and performance: the case of management buyouts”, Journal of Financial Economics, Vol. 2, pp. 143-64. Useem, M. (1984), Inner Circle: Large Corporations and the Rise of Business Political Activity in the US and UK, Oxford University Press, Oxford. Weinberg, N. and Vardi, N. (2006), “Private inequity”, Forbes, Vol. 23. Wright, M., Hoskisson, R., Busenitz, L. and Dial, J. (2000), “Privatisation and entrepreneurship: the upside of management buyouts”, Academy of Management Review, Vol. 25, pp. 591-601. Zahra, S. and Pearce, J. (1989), “Boards of directors and corporate financial performance: a review and integrative model”, Journal of Management, Vol. 15, pp. 291-334. Further reading Denis, D. (1994), “Organizational form and the consequences of highly leveraged transactions: Kroger’s recapitalization and Safeway’s LBO”, Journal of Financial Economics, Vol. 36, pp. 193-225. Johnson, J., Ellstrand, A., Dalton, C. and Dalton, D. (2004), “A fine-grained analysis of director dependence: examining board composition in detail”, Journal of Business Strategies, Vol. 21, pp. 111-33. Kester, W. and Luehrman, T. (1995), “Rehabilitating the leveraged buyout”, Harvard Business Review, Vol. 73, pp. 119-31. Kosedag, A. and Lane, W. (2002), “Is it free cash flow, tax savings, or neither? An empirical confirmation of two leading going-private explanations: the case of ReLBOs”, Journal of Business Finance and Accounting, Vol. 29, pp. 257-71. Salancik, G.R. (1977), “Commitment and the control of organizational behavior and belief”, in Staw, B.M. and Salancik, G.R. (Eds), New Directions in Organizational Behavior, St Clair Press, Chicago, IL, pp. 1-54. Corresponding author Michael R. Braun can be contacted at: [email protected]

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Entrepreneurship and organizational design: investor specialization Peter D. Casson and Tahir M. Nisar

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University of Southampton, Southampton, UK Abstract Purpose – This paper seeks to investigate the impact of venture capital firm organization (VC) on operations at portfolio companies, emphasizing particularly value added and involvement. Design/methodology/approach – Prior literature indicates the importance of organizational design on the VC firm’s engagement and monitoring practices. A survey methodology is used to examine such relationships, including the significance of human capital for the process of investor engagement. Findings – The paper finds that VC organizations with a market focus and deal specialization are much more involved in portfolio companies than the firms who diversify their portfolios. This suggests that organizational focus is an important construct for explaining the degree of support accorded to portfolio companies by venture capitalists. The research also evaluates the performance outcomes of VC firm organization. Originality/value – The research emphasizes the importance of organizational factors in the investment strategies of venture capital firms. Keywords Organizational design, Venture capital, Entrepreneurs, Entrepreneurialism, Investors Paper type Research paper

Introduction There is now a large literature in entrepreneurship theory and practice and financial economics analyzing various aspects of venture capital (VC) investment (Lockett et al., 2006; Wright and Robbie, 1998). This literature is primarily concerned with the bilateral relationship between an entrepreneur and a VC, where the VC provides monetary and non-monetary resources to turn the entrepreneur’s project idea into a viable business. However, VC funds typically invest in more than one start-up company at any given time, and engage in active portfolio management to maximize the return from their investment. This implies that VC firms develop specific capabilities and skills that play an important role in the VC-portfolio company dyad. The present study aims to examine the impact of VC firm organizational characteristics on portfolio company management, including strategy and product and process development. The assumption behind this work is that investors, in order to maximize their returns from their investment, will pay considerable attention to the way they organize their organizational structures and processes. The article thus takes an organizational perspective to analyzing VC engagement policy, and investigates the optimal conditions for the effective use of VC firm capabilities. The authors are indebted to Peter Abell, Antoine Faure-Grimaud and David Web for useful comments on an earlier draft of the paper.

Management Decision Vol. 45 No. 5, 2007 pp. 883-896 q Emerald Group Publishing Limited 0025-1747 DOI 10.1108/00251740710753693

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We specifically address the following questions: What determines the relational approach of a particular VC firm? What are the strategic and organizational aspects of managing a focused portfolio of companies? How does managing a focused portfolio affect performance? We identify three main effects of VC organization on its engagement policy. The first effect is the resource allocation effect: the VC ability to screen the start-up projects more efficiently is likely to increase the chances of entrepreneurial success (Roure and Maidique, 1986). As there are no obvious yardsticks available for screening new projects, it requires special expertise on the part of VCs to separate the wheat from the chaff. The second effect is a resource utilization effect: by offering advice and support, VCs improve operations at portfolio companies. Finally, the networking effect allows VC firms to organize external support, especially where portfolio companies lack knowledge or contacts in a particular market (Hoang and Antoncic, 2003). We argue that by adopting a particular organizational approach, a VC firm improves the likelihood of a portfolio company optimally benefiting from its resources. That is, a better fit between VC firm and portfolio company is a desirable condition for a VC to contribute fully to the start-up’s success. The paper is organised as follows: The first section develops the research framework based upon a study of relevant literature on venture capital and organization and strategic management. This is followed by our description of the data and various specifications of the variables used in empirical regressions. The next section discusses our findings and the final section provides a conclusion and highlights potential areas of future research. Literature survey The venture capital investment activity is divided into four stages (Busenitz et al., 2004). First, there is the identification of those companies that would make profitable investments. This selection process includes the collection, sorting and analysis of information. Second, having identified appropriate companies, it is necessary to structure the investment. This involves the issue of appropriate equity securities by the portfolio company, the provision of managerial incentives, and creation of effective mechanisms for the private equity firm to influence the company’s operations. Third, there is monitoring and active participation in the management of portfolio companies. This may be through board membership or other channels, and the analysis of financial and other information provided by the portfolio company (Goodstein et al., 1994). Finally, there is the disposal of investments, or exiting, and distributing cash or marketable securities to investors. There appears to be greater variability in the way in which private equity firms deal with post-investment monitoring and intervention compared to institutional investors (Busenitz et al., 2004). Some firms adopt a “hands-on” approach, becoming involved with portfolio companies, while for others the approach is “hands-off” (Baum and Silverman, 2003). The types of issues on which general partners are involved are to do with monitoring, networking and strategic issues. This reflects the special abilities that general partners possess. Contacts that general partners have with a range of companies, professionals and other financial institutions provide a network that managers can use in running and developing their companies. The knowledge that general partners have acquired through investments over time in other companies also is of use to the management of present investments in developing and implementing strategies.

VCs may also acquire specific knowledge and skills to screen investment proposals they receive for financing. One approach is to develop specific analytical frameworks for examining proposals with interesting ideas for potentially large, un-served markets, and they may put those ideas into a framework of initiatives. An “initiative” is a screening process whereby several of the partners collaborate in an embryonic area. At any time, they would have three or four initiatives that they are pursuing. These initiatives require intensive dialogue and coordination with entrepreneurs – asking for additional information about a project’s market potential as well as contacts with suppliers and customers. Many of these initiatives provide building blocks for the later development of specialization in relation to operations in a particular sector. VCs also seek out external expertise before committing themselves. In many cases, investors screen the deals by consulting the board or an external expert source; thus securing the privileged knowledge is an important step in delivering the initial support. Organization fit and VC firms Prior literature stresses the active role of VCs in adding value to their portfolio companies (Michelacci and Suarez, 2004). However, this literature examines the incentive problem between a VC and an entrepreneur in isolation from the other start-ups in the VC’s portfolio. As the VC’s networking role suggests, it is important to consider the management of a VC’s overall portfolio by focusing explicitly on the interactions between a VC and its various sets of portfolio companies. For example, after observing the outcome of an entrepreneurial initiative, the VC chooses whether to continue its involvement into the start up’s second stage, or to divest (for example, to liquidate) the project. If the VC divests one of its investments, it can partially or fully transfer its human capital and other resources from the divested start-up to the surviving one. The VC’s ability to transfer its resources from one start-up to the other, however, depends on the degree of its portfolio’s focus. This implies that, in addition to providing incentives to portfolio company management, developing VCs’ own capabilities is also important, especially when the VC can add substantial value to its portfolio companies. As mentioned, VCs add value by acquiring and delivering knowledge and skills that are often specific to their portfolio companies. One implication of adopting a more focused approach to portfolio company management is that these investments lead to specialization in the VC industry, where different VCs invest in different sets of skills. For example, some VCs specialize only in certain technologies and industries (e.g. biotechnologies), which help them to keep their investment strategy focused, whereas others diversify into different industrial sectors. VCs may specialize for a number of reasons: Amit et al. (1998) suggest that VC firms specialize in industries in order to manage issues of information asymmetries; Sapienza and Gupta (1994) argue that specialization is used to manage task uncertainty; and Dimiv and De Clercq (2006) argue that specialization enhances performance. One benefit of taking a specialized and focused approach to portfolio company management is that VCs will be able to organize support in ways that fit the implementation requirements of a portfolio company’s business strategy. In general, the fit between the organizational characteristics of a firm and its environment is viewed as a desirable state that leads to superior performance (e.g. Miles and Snow, 1994; Porter, 1996). It implies that the fit between VC organizational characteristics and portfolio

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company strategic types is also useful to the extent to which VCs adjust their support and special expertise for the benefit of their portfolio companies. For example, the activities needed to assist high technology companies require VC organizations to develop extensive network contacts and sectoral-level capabilities (e.g. Matsuno and Mentzer, 2000; Walker and Ruekert, 1987). Therefore, organizing VC advisory and networking activities in ways that meet the portfolio company’s skill requirements will be an important driver of a VC firm’s engagement policy (e.g. Walker and Ruekert, 1987). Research design As discussed, VC organization’s strategic fit is a key enabler of investor engagement. That is when an investor’s capabilities or skills match the needs of the portfolio company in which it invests, for example, when VCs specialize in a particular technology sector (e.g. bioscience or healthcare). This may be leveraged through the decentralized authority structures in the committee form that provide control over the deployment of resources and semi-formalized work routines that minimize errors in executing support services. Organizing activities in this way should facilitate a firm implementing a specialized or sectoral-based strategy to achieve superior venture capital effectiveness. At the same time, semi-formalization and decentralization allow less bureaucratic control over the new market opportunities pursued. In summary, we expect a VC firm’s effectiveness to be greater when its organizational characteristics fit the implementation requirements of portfolio company business strategies in ways that enable specific developmental goals to be achieved. The aim of this section is to develop parameters that enable us to empirically investigate those VC characteristics that create higher levels of fit and a more focused approach toward portfolio company management. As discussed below, venture capital firms can take two different forms: some operate as independent entities while banks, corporations and governments may also set up venture capital operations as an auxiliary activity. Organizational theorists have frequently noted that organizing operations in a focused way will have significant implications for the emergence of specialization and interdependency (Burt, 1992; Granovetter, 1985). This means that independent venture capitalists will acquire more specialist application in their operations while the so-called “captive” firms will generally follow the strategic priorities of their parent organizations. Hellmann et al. (2004) provide some evidence on how captive venture capital firms behave differently from their independent counterparts. Given this background, a natural conjecture for the present study is that independent VC firms will be more inclined to engage with their portfolio companies then the captives. Specialization achieved in performing an independent set of activities is likely to result in a more activist form of investment as specialist knowledge will be used to affect a particular course of portfolio company operation. Other measures of specialization we use in our study center on the nature of venture deals. The extent to which VCs focus on a single type of financing and the way they manage their deal flow will indicate the specialized nature of their operations (Norton and Tenenbaum, 1993). The first question we ask is whether a firm specializes only in venture capital, or whether it invests more broadly in other types of private equity deals, including mezzanine finance, leveraged and management buy-outs (LBOs and MBOs). There will be a higher propensity to engage if VC firms focus on venture

capital deals only. The second issue pertains to the number of deals being managed by the firm in one particular market sector. VC firms also hire specialists for screening project proposals or providing specialist advice related to individual business sectors. We measure this relationship by looking at whether one or more sector specialists are working in a VC firm. Survey data It is generally recognized that different venture capital markets are at different stages of development, with the US market more institutionalized than others (Cumming and Walz, 2004). We employed a multi-pronged data collection strategy. A survey questionnaire was sent out to all venture capital firms who were members of the British Venture Capital Association (2002). Two further criteria were applied: we only contacted firms: (i) who were actively engaged in venture capital, thus excluding private equity firms that merely trade in non-venture private equity deals such as management buy-outs (MBOs), mezzanine finance or leveraged buyouts (LBOs). For private equity firms that invest in both venture capital and non-venture private equity deals, we considered only their venture capital investments; and (ii) they were still in operations in 2005. We augmented the survey data with information from FAME, VentureExpert, and Diane. Next, we consider the representative nature of our sample, and how well it represents the population of the UK venture capital industry. To check whether the respondents span the variety of venture firms the characteristic of the UK industry, we compare the sample with the population of the UK venture capital firms. British Venture Capital Association (2002) distinguishes between three main types of private equity firms: independents, captives and semi-captives. Independents are publicly listed or private firms, funds or investment trusts which raise capital from external sources. This is in contrast to captives which are private equity firms that are either wholly owned subsidiaries or divisions of parent companies, usually financial institutions that manage funds on behalf of the parent. Finally, semi-captives are like captives in that they invest funds on behalf of the parent company, but unlike captives have also raised funds from external sources within the last five years. The investments made by these three types of UK private equity organizations in 2001 are shown in Table I. In Table I, Panel A contains information on the organizational types of the UK venture capital population. It is partitioned into three types: Independents, Captives (corporate, bank, and public venture capital firms) and Semi-captives. The independents accounted for over one-half of the investments in 2001. Panel B

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£ million Panel A Panel B (amount invested) (%) (%) Captives (organizations that invest only for a parent company) Independents (organizations that only manage funds) Semi-captives (organizations which do both) Total Source: British Venture Capital Association (2002)

397 3,136 1,219 4,752

8 66 26 100

6 71 23 100

Table I. VC composition by organization type

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provides information on these three types in our sample. As can be seen, it very closely follows the distribution of types in the population, suggesting that our results are not biased by the sample composition. This is important as prior research has shown that different types of venture firms are likely to behave differently (Sahlman, 1990).

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Data variables We first investigate VC capability in screening entrepreneurial projects. We then supplement this variable with two other governance related indicators. The frequency with which a venture capital firm interacts with the portfolio company is our second key dependent variable and can be thought of as a proxy for the effort level provided by the venture capital investor. To investigate the networking effect, we ask whether an investor helps portfolio companies in making contacts with customers and suppliers. The study also provides for a number of controls to fully gauge the impact of VC organization and other related variables in monitoring and control. Syndicating the portfolio deals is often a common practice among venture capital firms (Brander et al., 2002, Ma¨kela¨ and Maula, 2006). We therefore add two additional variables: syndicate and syndicate lead. As Gompers and Lerner (1996) suggest the size and age of a venture capital firm may be a proxy for its quality and reputation, so we control for the age and size of venture capital firms. Two other deal characteristics, industry and venture business stage, are also of interest. It is likely that companies which receive venture finance at an early stage are in a potentially better position to benefit from venture capital firm support in terms of venture networking, technical expertise and product commercialization. In addition, the study uses industry controls as the likelihood of receiving support from VC firms may be affected by the company’s industrial sector. Table II presents descriptive statistics characterizing the average venture capital firm. In addition to means the table also provides medians which are useful especially for the variables AGE and SIZE as they incur extreme values. A typical manager has 11.34 years of experience. VCs monitored portfolio companies on an ongoing basis, using a combination of methods (e.g. regular meetings with company managers, board meetings). VC firms also appointed representatives to the boards of their portfolio companies, suggesting that the firms integrated engagement into the investment process. Their engagement policy concerned three principal operations at portfolio companies: strategy and performance (e.g. new product development); corporate governance; and best management practice, such as outsourcing. The survey asked about different aspects of VC organization and partners/senior managers active as of December 2005. A definition was provided in the survey of a partner or senior manager: a partner is a person with investment decision power, i.e. somebody who can decide whether to fund or not a company. Deal specialization is a dummy variable which takes the value 1 if the venture capital firm is reported to engage only in venture capital deals; 0 otherwise. Market focus is a variable given by the inverse of the average number of companies financed in one particular market sector, per year. Sectoral specialist is a dummy variable that takes the value 1 if the venture firm has designated one or more sector specialists, zero otherwise.

Variable

Mean

Median

Min

Max

OBS

Independent VC Deal specialization Market focus Sectoral specialist Venture experience Syndicate Syndicate lead VC size VC age Early stage Interaction Screening Networking Recruiting Suppliers Customers Exit rate IPO rate M&A rate Dollar exit rate Dollar IPO rate Dollar M&A rate Medical products Biotech and pharma Software and internet Electronics Telecom Media and entertainment Financial services Industrial products Food and consumer goods Other sector

0.713 0.784 0.921 0.584 11.34 0.412 0.181 11 7.5 0.482 0.713 0.687 0.00 0.498 0.387 0.352 32.9 18.4 14.5 34.8 20.3 14.5 0.241 0.164 0.467 0.118 0.057 0.127 0.038 0.031 0.068 0.148

– – – – 14 – – 23 4 – – – – – – – 29.4 11.8 6.7 31.2 13.3 6.1 – – – – – – – – – –

0 0 0 0 0 0 0 1 1 0 0 0 2 1.27 0 0 0 0

1 1 1 1 25 1 1 63 45 1 1 1 1.19 1 1 1 100

644 654 632 632 642 374 362 644 644 534 583 583 362 563 563 562 269

0

100

211

0 0 0 0 0 0 0 0 0 0

1 1 1 1 1 1 1 1 1 1

637 637 638 637 637 637 640 637 637 640

Note: Networking is the average of standardized item scores, and thus has a zero mean

Venture experience is the average number of years of firm partners’ experience in venture capital. We construct a variety of engagement variables that encapsulate different aspects of VC firms’ interaction with their portfolio companies. Screening is a dummy variable that takes the value 1 if the venture capital firm is reported to have formal procedures for evaluating new business project proposals (e.g. examples include evaluation forms, financial forecasts). Interaction is a dummy variable that takes the value 1 if the venture capital firm is reported to interact with the company on a monthly or weekly basis; 0 if it interacts with on an annual or quarterly basis. Networking is the average of a set of three dummy variables that take the value 1 if the venture capital firm is reported to be involved in recruiting senior managers (e.g. the Chief Executive Officer (CEO), the Chief Financial officer (CFO), a vice president of marketing, or the head of R&D, or another manager) or contacting a supplier or

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Table II. Descriptive statistics

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customer on behalf of the portfolio company; 0 otherwise. Principal component analysis of these three items produces one factor with an eigenvalue greater than one that retains 61.6 per cent of the total variance. The Cronbach alpha for this scale is 0.86. Syndicate represents the percentage of the deals that have been syndicated with at least one other venture capitalist. Syndicate lead represents the percentage of the deals in which the VC is the lead syndicator. Independent VC is a dummy variable that takes the value 1 if the venture capitalist defines itself as an independent; 0 otherwise (if it belongs to one of the following categories: captive (e.g. bank, corporate or public venture capital firm), semi-captive). VC size is the amount under management of the venture capital firm at the end of the sample period, in millions of current dollars. VC age represents the age of the venture capital firm in the year 2005 (or time elapsed since the VC raised his first fund). Early stage is a dummy variable that takes the value 1 if a deal is reported as seed or start-up; 0 otherwise. Industry is set of a dummy variables that we obtain the data from our survey instrument, which gave the following choices: biotech and pharma; medical products; software and internet; financial services; industrial services; electronics; consumer services; telecom; food and consumer goods; industrial products (including energy); media and entertainment; other (specify): . Exit rate: percentage of portfolio companies exited. . IPO rate: percentage of portfolio companies sold via IPO. . M&A rate: percentage of portfolio companies sold via M&A. . Dollar exit rate: percentage of invested $ exited. . Dollar IPO rate: percentage of invested $ exited via IPO. . Dollar M&A rate: percentage of invested $ exited via M&A. Results Table III provides probit results for three sets of independent variables; screening (column 1), interaction (column 2), and networking (column 3). The results show that all organization effects are important in explaining the variation in VC engagement policy outcomes. The models’ pseudo R 2 ’s range from 0.372 to 0.548 (p , 0:001). The study uses a variety of measures to investigate the effects of organizational design and partner experience. Venture capital firms focusing on particular markets are much more involved with their companies as are those with deal specialization. Independent firms actively engage with their portfolio companies and they also assist them by providing screening and networking support. The results show that organizational design matters. Measures capturing the role of organizational focus (i.e. deal and market focus) are positively related to all three-criterion variables, although in the case of deal specialization the coefficient for networking is slightly smaller then the other equations. Specialization in the form of VC expertise in helping support the portfolio company result in how observed VC market and deal focus is correlated with its engagement practice. The source of this specialization is obviously linked to the development of VC operations in one particular sector and may also have been influenced by sector specialists as this variable is

Independent VC Deal specialization Market focus Sectoral specialist Venture experience Syndicate Syndicate lead VC size VC age Early stage Industry controls Observations X2 Model p-value Pseudo R 2

Screening

Interaction

Networking

0.258 * * * (2.55) 5.077 * * * (3.53) 1.991 * * * (6.88) 3.072 * * * (2.13) 0.242 * * * (1.17) 0.164 (0.73) 0.525 * * * (4.56) 0.109 (0.02) 0.018 (0.07) 0.312 * * * (2.24) Yes 644 327.22 0.000 0.548

1.247 * * * (8.11) 4.973 * * * (2.66) 1.944 * * * (4.72) 0.788 * * * (6.52) 2.091 * * (2.43) 0.002 (0.01) 0.443 * * * (3.82) 0.117 (0.13) 2 0.011 (0.01) 0.011 * (0.16) Yes 644 248.16 0.000 0.372

4.451 * (2.58) 1.015 * * * (3.12) 0.116 * * * (2.23) 0.263 * * (5.05) 0.593 * * * (3.89) 0.019 (0.09) 0.384 * * * (2.51) 0.082 (0.50) 0.020 (0.06) 0.596 * * (3.83) Yes 563 234.64 0.000 0.511

Notes: The table reports the estimated coefficient and the T-ratio (in parenthesis), computed using Huber-White robust standard errors. In all regressions, industry controls are included but not reported; * * *, * *, * values significant at the 1, 5 and 10 percent level are identified respectively

significant and positive in all three regressions. Similarly, prior venture capital experience has a consistently positive, large and significant effect on all the involvement variables (including project screening and networking support). The move towards a more focused and specialized engagement approach has not all been smooth sailing for many investors. Firms have had to confront organizational legacies stemming from their original multi-activity and regional approach to investing. For example, even though most of the traditional VC deal flow comes from a broad set of sources (e.g. regional offices), the set up has not always contributed to teamwork (Sahlman, 1990). To ensure that new investments make sense VCs now designate sector specialists, or domain experts, to vet proposals regardless of location. Our results suggest that the challenge for general partners, if they want to develop a key role, is to understand more about a particular market than anyone else. Market specialization means not only knowing the business issues prevalent in a particular area well but also getting to know the key people in that field. Increasingly, competitive advantage will be built on this expertise because of the nuance and contextual detail needed for screening quality projects. To this end, VCs build up specializations in areas like biosciences, retailing and media so as to capitalize on entrepreneurial opportunities in new and emerging technologies and innovation developments.

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Table III. VC organization and engagement

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Failure to observe the positive impact of VC age and size variables can be rationalized by the fact that VC firms are essentially partnership organizations where individual partners’ experience is more critical in deal making and structuring. Such an effect is magnified when VC firms consist of a small number of partners. The regressions also examine how syndication affects involvement decisions by adding two variables: one for whether a deal is syndicated, and one for whether the investor is the lead syndicator. The results show that leading a syndicate has a positive effect on the involvement variables but syndication as such is associated with lower levels of involvement. Venture capital firms taking a “hands-on” approach monitor portfolio companies both through reviewing management accounts and board minutes, and through involvement in decisions such as the purchase of major capital items, acquisitions and disposals, changes in strategic direction, appointment of directors and auditors, and changes in capital structure (Wright and Robbie, 1998; Norton and Tenenbaum, 1993). One example of this hands-on approach is the firms’ emphasis on networking. The concept refers to networks of companies bound together by mutual obligations and contacts. Entrepreneurs gain access to VC’s portfolio of companies and associations with market leaders. These relationships are the foundations for strategic alliances, partnership opportunities and the sharing of insights to help build new ventures faster, broader and with less risk. Networking also allows the development of a network of companies that helps create synergies and pooled resources for growth and development. The professional respect and regard in which VC is generally held and the influence that it enjoys with other investors are major causes of networking success. Next, we investigate the impact of various VC organization characteristics on its networking activities. To this end, we expand the networking variable into supplier contacts, customer contacts and recruiting. Table IV shows the results. As before, all the organizational factors have significantly positive effects on the various networking variables, although the variable for sectoral specialist does not explain much variation in the networking outcomes. Prior literature has observed that specialized VCs exhibit different investment behaviors than less specialized VCs (Gompers et al. (2004). Kaplan and Schoar (2005) find substantial heterogeneity in performance across VC firms, and suggest that VCs with superior skills and greater human capital will generate better results in their investments. Overall, these articles argue that VC human capital plays a key role in managing and adding value to start-ups. In turn, entrepreneurs value VC human capital, since a skilled VC can help turn their start-ups into successful commercial concerns. We also find support for the positive role of human capital; furthermore, we find that VC organization positively affects performance outcomes. Table V shows OLS results for the effects of VC firm characteristics on performance. The dependent variable for the first two regressions is denoted by EXIT, and presents the proportion of all exits done, including exits through an IPO (column 1) and a trade sale or M&A (column 2). For the third and fourth regression, EXIT2 presents the proportion of exits in terms of dollar exit rates. The models’ R 2’s range from 0.197 to 0.438 (p , 0:001). As before, VC characteristics such as market focus, deal focus and partners’ business experience were included in performance regressions. The study finds that all these variables have positive and significant effects on different measures of success

Independent VC Deal specialization Market focus Sectoral specialist Venture experience Syndicate Syndicate lead VC size VC age Early stage Industry controls Observations X2 Model p-value Pseudo R 2

Supplier contacts

Recruiting

Customer contacts

0.275 * * * (2.40) 0.490 * * * (3.35) 0.658 * (4.57) 0.163 * (0.14) 1.861 * * * (8.35) 0.141 (0.21) 0.350 * * * (2.60) 2 0.167 (1.19) 2 0.017 * * * (0.06) 0.072 (0.04) Yes 563 236.27 0.000 0.338

0.997 * * (5.18) 0.602 * * * (3.77) 1.515 * * * (4.79) 0.171 (0.17) 0.312 * * * (2.91) 0.031 (0.06) 0.545 * * (3.67) 0.158 (0.03) 20.017 * * * (0.07) 0.072 (0.15) Yes 563 374.51 0.000 0.573

1.371 * * * (7.09) 0.540 * * * (0.40) 1.304 * * * (3.18) 0.142 (0.12) 0.254 * * * (2.37) 2 0.132 (0.08) 0.608 * * (4.85) 2 0.140 (0.16) 2 0.019 * * * (0.06) 0.554 (3.77) Yes 563 248.54 0.000 0.329

Notes: The table reports the estimated coefficient and the T-ratio (in parenthesis), computed using Huber-White robust standard errors. In all regressions, industry controls are included but not reported; * * *, * *, * values significant at the 1, 5 and 10 percent level are identified respectively

used. The study also included syndicate and syndicate lead in the regressions. Contrary to our previous section’s results, these variables do not have much impact on performance outcomes, although syndicate has slightly larger coefficients than syndicate lead in two of the equations. VC age and size are also insignificant to have any impact on VC performance. The literature argues that firm size is a critical factor in driving portfolio company change and development but our results suggest that these variables do not exercise as much influence on the VC firm’s desire to induce special portfolio company behaviours. One explanation might be that VCs can normally apply controls through contractual means, for example, convertible equity securities allow VCs to directly control portfolio companies by converting their stakes into equities. Conclusion Extant literature suggests that the role of venture capitalists extends beyond that of traditional financial intermediaries like banks, and that investors can play a pivotal role in the development of the companies they finance. One of the central finding of the present study is that VC firms’ organizational focus is the key determinant of portfolio

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Table IV. VC organization and its role in providing networking support

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M&A

0.611 * * *

0.622 * * *

EXIT2 IPO2

IPO2

0.563 * * * (0.182) (0.611) (0.324) (0.163) Deal specialization 0.232 * * (0.057) 3.382 * * * (2.799) 5.311 * * * (2.569) 4.274 (2.877) Market focus 20.276 * 0.278 * 0.233 * * 0.235 * * * (20.168) (0.171) (0.053) (0.118) Sectoral specialist 20.222 20.180 2 0.218 2 0.218 (0.156) (0.035) (0.160) (0.162) Venture experience 0.260 * * 0.236 * * * 0.260 * * 0.240 * * (0.052) (0.116) (0.055) (0.115) Syndicate 0.072 0.023 0.267 * * * 0.187 * * (0.041) (0.011) (0.211) (0.122) Syndicate lead 0.001 0.005 0.003 0.022 (0.001) (0.013) (0.032) (0.054) VC size 20.167 0.084 0.124 * 0.138 (0.060) (0.008) (0.119) (0.077) VC age 0.008 0.014 0.157 0.046 (0.001) (0.003) (0.140) (0.102) Early stage 0.019 * * * 0.020 * * * 0.021 * * * 0.021 * * * (0.006) (0.007) (0.006) (0.007) Industry controls Yes Yes Yes Yes Observations 269 269 211 211 P-value of F-statistics 0.011 0.067 0.018 0.009 R2 0.438 0.326 0.348 0.197 Independent VC

894

EXIT IPO

0.561 * * *

Notes: The table reports the estimated coefficient and the T-ratio (in parenthesis), computed using Huber-White robust standard errors. In all regressions, industry controls are included but not reported; * * *, * *, * values significant at the 1, 5 and 10 percent level are identified respectively

company development and growth. A focused engagement approach provides for higher levels of fit between VC firm and portfolio company. The results further suggest that there are significant returns to investor activism, particularly when investors have considerable expertise in the areas in which they are investing. We have identified three main effects of VC firm organizational design. The VC’s focused approach improves its screening ability to fund suitable portfolio company projects. Second, a VC acquires specialized knowledge and skill to interact with its portfolio companies so as to impart useful support services and advice. As we show, this effect depends on the VC’s ability to manage its resources in a focused way. Portfolio company focus impacts both entrepreneurial and VC incentives. It is likely that VC specialization increases when the relatedness of the start-ups in its portfolio is high as it helps VC acquiring specialist knowledge and skills. On the other hand, portfolio companies benefit from the synergy and the networking effects of a focused VC approach. A more active and specialized engagement style is also found to be associated with VC firms’ networking operations. The study thus finds that organizational fit (i.e. investor capabilities to meet the specific needs of start-ups) is a key enabler of investor engagement. It finds that VC firms that are independent and firms that focus on venture capital alone become more involved with their companies.

References Amit, R., Brander, J. and Zott, C. (1998), “Why do venture capital firms exist? Theory and Canadian evidence”, Journal of Business Venturing, Vol. 13 No. 6, pp. 441-66. Baum, A.C. and Silverman, B.S. (2003), “Picking winners or building them? Alliance, intellectual, and human capital as selection criteria in venture financing and performance of biotechnology start-ups”, Journal of Business Venturing, Vol. 19 No. 3, pp. 411-36. Brander, J.A., Amit, R. and Antweiler, W. (2002), “Venture capital syndication: improved venture selection versus the value-added hypothesis”, Journal of Economics and Management Strategy, Vol. 11 No. 3, pp. 423-52. British Venture Capital Association (2002), Report on Investment Activity, BVCA, London. Burt, R.S. (1992), Structural Holes: The Social Structure of Competition, Harvard University Press, Cambridge, MA. Busenitz, L.W., Fiet, J.O. and Moesel, D.D. (2004), “Reconsidering the venture capitalists ‘value added’ proposition: an interorganizational learning perspective”, Journal of Business Venturing, Vol. 19 No. 6, pp. 787-808. Cumming, D. and Walz, U. (2004), “Private equity returns and disclosure around the world”, working paper, Center for Financial Studies, Frankfurt. Dimiv, D. and De Clercq, D. (2006), “Venture capital investment strategy and portfolio failure rate: a longitudinal study”, Entrepreneurship Theory and Practice, Vol. 30 No. 2, pp. 207-23. Gompers, P. and Lerner, J. (1996), “The use of covenants: an empirical analysis of venture partnership agreements”, Journal of Law and Economics, Vol. 39 No. 2, pp. 463-98. Gompers, P., Kovner, A., Lerner, J. and Scharfstein, D. (2004), “Venture capital investment cycles: the role of experience and specialization”, working paper, HBS, Boston, MA. Goodstein, J., Gautum, K. and Boeker, W. (1994), “The effects of board size and diversity on strategic change”, Strategic Management Journal, Vol. 15, pp. 241-50. Granovetter, M. (1985), “Economic action and social structure: the problem of embeddedness”, American Journal of Sociology, Vol. 91 No. 3, pp. 481-510. Hellmann, T., Lindsey, L. and Puri, M. (2004), “Building relationships early: banks in venture capital”, NBER WP No. 10535. Hoang, H. and Antoncic, B. (2003), “Network based research in entrepreneurship: a critical review”, Journal of Business Venturing, Vol. 18 No. 2, pp. 165-87. Kaplan, S. and Schoar, A. (2005), “Private equity returns: persistence and capital flows”, Journal of Finance, Vol. 60, pp. 1791-823. Lockett, A., Ucbasaran, D. and Butler, J. (2006), “Opening up the investor-investee dyad: syndicates, teams, and networks”, Entrepreneurship Theory and Practice, Vol. 30 No. 2, pp. 117-320. Ma¨kela¨, M. and Maula, M. (2006), “Interorganizational commitment in syndicated cross-border venture capital investments”, Entrepreneurship Theory and Practice, Vol. 30 No. 2, pp. 117-320. Matsuno, K. and Mentzer, J. (2000), “The effects of strategy type on the market orientation-performance relationship”, Journal of Marketing, Vol. 64, October, pp. 1-16. Michelacci, C. and Suarez, J. (2004), “Business creation and the stock market”, Review of Economic Studies, Vol. 71 No. 2, pp. 459-81. Miles, R. and Snow, C. (1994), Fit, Failure, and the Hall of Fame, Macmillan, New York, NY.

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Norton, E. and Tenenbaum, B.H. (1993), “The effects of venture capitalists’ characteristics on the structure of a venture capital deal”, Journal of Small Business Management, Vol. 31 No. 4, pp. 32-41. Porter, M. (1996), “What is strategy?”, Harvard Business Review, Vol. 74, November-December, pp. 61-78. Roure, J.B. and Maidique, M.A. (1986), “Linking pre-funding factors and high-technology venture success: an exploratory study”, Journal of Business Venturing, Vol. 1 No. 3, pp. 295-306. Sahlman, W.A. (1990), “The structure and governance of venture capital organizations”, Journal of Financial Economics, Vol. 27 No. 2, pp. 473-521. Sapienza, H.J. and Gupta, A.K. (1994), “Impact of agency risks and task uncertainty on venture capitalist-CEO interaction”, Academy of Management Journal, Vol. 37 No. 6, pp. 1618-33. Walker, C. and Ruekert, R. (1987), “Marketing’s role in the implementation of business strategies: a critical review and conceptual framework”, Journal of Marketing, Vol. 51, July, pp. 15-33. Wright, M. and Robbie, K. (1998), “Venture capital and private equity: a review of the literature”, Journal of Business Finance and Accounting, Vol. 25 Nos 5/6, pp. 521-70. Corresponding author Peter D. Casson can be contacted at: [email protected]

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Optimal allocation of decision rights for value-adding in venture capital Derek Eldridge

Value-adding in venture capital

897

Institute for Development Policy and Management, University of Manchester, Manchester, UK Abstract Purpose – The paper aims to evaluate decision-making processes in venture capital (VC). Design/methodology/approach – The paper develops a conceptual framework to analyse optimal allocation of decision rights in venture capital environments. How investors and investees seek mutual beneficial outcomes is also discussed. Findings – The paper finds that entrepreneurial activities are normally associated with the design and production of goods in new emerging or niche markets. Hence, coordinated choices need to be made to bundle activities such as setting up internal infrastructure to produce and serve goods, purchasing quality inputs from suppliers and establishing contacts with long-term customers. Delegation of authority by VC firms in these areas permits a new entrepreneurial initiative to be successfully managed including the coordination of various strategic decisions as a self-reinforcing bundle. Originality/value – The paper shows that investors may allocate significant decision rights to portfolio company managers because it can be more efficient and feasible to commit to such an action in some environments. A particular instance of such a delegation of decision rights is venture capital finance, which is the subject-matter of the present study. Keywords Venture capital, Decision making, Value added, Entrepreneurialism Paper type Research paper

Introduction The paper seeks to develop a conceptual framework to explain the practice of venture capital investors delegating significant decision rights to portfolio companies. It thus treats the institution of venture capital as a collection of decision variables that are coordinated in such a way that each one performs optimally in relation to other variables. That is, venture capital is about bundling together various operations which span activities from the selection of likely projects through to head-hunting, establishing supplier and customer networks and implementing strategies for the successful exit or IPO (Initial Public Offering) of funded-companies, and this paper suggests that there are important gains to be made from such coordination. Since many choice variables need to be coordinated in some specific way as, for example, team set-ups, skill acquisitions or obtaining information about some specific customers, considerable company resources may be required to obtain a coherence of direction amongst them. A venture capital firm helps realise these goals by delegating significant decision rights to portfolio company management to carry out such a myriad of project activities. The allocation of decision rights by a VC firm to a portfolio company is thus based on how various investment activities are performed in relation to each other and how best they can be organised in a set up other than the investor’s

Management Decision Vol. 45 No. 5, 2007 pp. 897-909 q Emerald Group Publishing Limited 0025-1747 DOI 10.1108/00251740710753701

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own internal organization. Optimal allocation of decision rights to a portfolio company is thus based on characterising these interactive decision situations. The paper first examines general issues involved in the allocation of decision rights in organisational environments. The way decision rights are allocated in a particular set of organizational environment, that is, venture capital is then discussed. The next section evaluates subjects and actions involved in the selection of portfolio company management whilst the final section concludes with remarks for further research in the area. The allocation of decision rights in organizational environments The allocation of decision rights in organizations has important implications for the design of hierarchical arrangements, the feasibility of different coordination mechanisms in organizing resources and the boundaries of the firm. Decision rights in organisations can be vested solely in one person, delegated to a subordinate or a team of managers, or to some independent contractor who works for the organisation. Delegation of decision rights or authority may be informal or formal, and they may be contractible in the instance when the allocation is made formally. For example, Aghion and Tirole (1997) consider the remits of formal and real authority and postulate how delegation of authority can affect the performance of managers through changes in incentives for information gathering. In their model, formal delegation of authority provides strong incentives for subordinates to search for and develop organisational projects. While Baker et al. (1999) concur with the view of Aghion and Tirole (1997) that delegation of authority is important to give managers strengthened incentives to search for and develop projects but they take the view, however, that the allocation of decision rights in organizations is not contractible, i.e. the boss can always restrict the subordinate’s actions. They posit that although informal authority is usually delegated to subordinates to initiate and develop projects, the ultimate authority resides at the top. This line of argument draws on a distinction made earlier by Fama and Jensen (1983) in the allocation of organizational decision rights. In their view, this is a four-step process involving initiation, ratification, implementation, and monitoring. Fama and Jensen’s main contention is that when nonowners hold decision rights in organizations, it results in the separation of decision control (the second and fourth of these steps) from decision management (the first and third). This distinction is also important in the model of Baker et al. (1999) as their analysis of decision-making processes rests on the implications of delegation of authority in the initiation and ratification stages. As a result, the consequences of project implementation once it is ratified do not have any direct bearing on their analytical arguments. It is important to note that these aspects have traditionally been the focus of classical agency theory. Further, their model also treats delegation of authority as an informal way of allocating decision-rights, since they claim that formal authority only resides at the top. Formal delegation of rights occurs when the boss delegates decision rights to the subordinate by making her the owner of the assets that go with the decision rights. Nevertheless, the delegation of decision rights in this way can only be between rather than within organizations. Fama and Jensen (1983) also consider that delegation of authority is associated with the implementation of projects, one of the steps in decision rights. Implementation of a project may require a wide range of decisions to be made; for example, “decision about

human resources (hiring, training, job design), decisions about production (sourcing, capital and operating expenditures), decision about competition (pricing, advertising, product design), and so on” (Baker et al., 1999, p. 57). In real organisations, many decision rights in these areas are delegated as a bundle of activities. For example, a human resource manager simultaneously deals with issues related to hiring, training and job design while strategic decisions about sourcing, pricing or advertising outlays are often made at the senior management level. Since decisions about a project vary over a wide spectrum of organizational activities, delegation of authority assumes a critical role in ensuring the feasibility of different decisions being made and the efficiency with which these decisions are implemented. However, the basis on which various types of project decisions are delegated has not hitherto been dealt with in the literature. In particular, how the delegation of a particular set of decision rights may only be feasible if other related decision rights are also made available. For example, decisions about production can only be feasible if a manager can also decide about the quality and quantity of input supplies purchased. Or decisions about technologies may also affect the marketing effort of the organisation. The linkages between a multitude of organizational choice variables and the need to bundle many of the related decision rights has profound implications for the authority relationships within and between organizations. Some of these relationships are summarized in Table I. This paper considers a particular form of delegation of authority in organizations, that is, venture capital, whereby a whole set of decision rights is delegated to portfolio company managers. Portfolio companies are run by managers who are not direct employees of VC firms but are entrusted to make a host of decisions within the remit of an agreed business plan. The allocation of decision rights to portfolio company managers is also ex ante contracted upon giving a basis to evaluate the contradictory theoretical standpoints of Fama and Jensen (1983) and Aghion and Tirole (1997). Since VC firms exercise decision control rights in many aspects of portfolio company operations (but without taking any managerial decisions), it is similar to the organizational description of Fama and Jensen in terms of the separation of decision control from decision management. On the other hand, because VC firms allocate formal authority to portfolio companies with regard to managerial operations it also meets the description of formal delegation of authority of Aghion and Tirole. Decision structure

Examples

Implications

Decisions are contractible (e.g. Aghion and Tirole)

Formal authority

Authority influences the decision-making process by changing the formal authority structures

Delegation of decision rights is Empowerment, reputation, largely informal (e.g. Baker et al.) mechanisms for employee participation (e.g. information sharing) Interdependency and complementarity determine the scope of decision rights

Venture capital, franchising, self-centred teams

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Informal organizational structures are important

Activity bundles provide the basis for the allocation of decision rights

Table I. Allocation of decision rights in organizations

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Allocation of control rights in venture capital Prior studies on the allocation of control in venture capital discuss it from the vantage point of VC corporate structure. A particular emphasis is on the allocation of control rights as determined by the conditions for raising capital. The control rights should ideally be allocated to the party, which has the greatest marginal ability to influence the returns, which in the present line of argument implies the start-up entrepreneur to be the natural controller of the company. However, the situation changes if the capital market conditions are restrictive (Lerner et al., 2003), in which case the VC firm is likely to be assigned the control rights. In relation to this contention, Lerner et al. (2003) show that venture-backed firms perform worse if conditions for raising capital are too challenging. In contrast, Kaplan and Stro¨mberg (2003) investigate a more extensive array of control rights, including cash flow rights, voting rights, liquidation rights or board rights. They suggest that the various rights are separately allocated, are interrelated, shift gradually with performance, and are contingent on the development of the company. The essence of venture capital is the allocation (subject to some agreed conditions) of significant decision rights relating to operations at portfolio companies. Unlike the informal considerations which often govern the distribution of authority in internal organizations, the relationship between a VC firm and a portfolio company is determined more explicitly, that is, many of the transactions in between them can be ex ante contracted upon. For example, the choice of location, budget approval, specific expenditure outlays (e.g. advertising), etc. are a few of the areas where both parties can come to an agreement before a transaction takes place. However, it remains unclear why VC firms delegate significant decision rights to independent operators while still retaining some controls over operations at portfolio companies and hence the need to conceptually explore the factors underpinning decisions in venture capital. Two sets of arguments have been put forward in this regard. It is argued that venture capital creates an opportunity for a firm to delegate managerial actions for which it does not have necessary capability. The second argument is about the incidence of moral hazard – a condition in which many organizations find themselves when their activities expand beyond a certain scale. More specifically, organizations exhibit circumstances in which there are weak links between managers’ compensation and their performance (Brickley, 1991). This means that managers do not bear the full costs or receive the full benefits of their actions. However, when managers of a portfolio company are compensated from the residual claims of their individual units, shirking becomes a less attractive strategy (Kaplan and Stro¨mberg, 2003). The alternative framework that is pursued here provides that venture capital is an optimal strategy where several activities need to be bundled together so as to maximise the impact of individual elements of the bundle. An initial reflection on this is that portfolio company managers offer an entrepreneurial good while making important use of technologies, which coalesce internal infrastructure with particular customer needs and with networking with upstream suppliers, and, as a result, benefit from gains which accrue from a consequent captured market share. The configuration of these activities in a measured way also delivers an outcome, which meets the quality standards associated with a new market. Investors, on their part, provide critical networking support in managing these operations at portfolio companies. Viewing the activity of venture capital in this way not only highlights how optimal delegation can be obtained in specific organizational environments but it also provides a perspective

which sees portfolio company operations as an extension of a firm’s activities, rather than as an alternative organizational arrangement as one would construe when one applies a framework such as monitoring cost explanations of firms. Venture capital contracting What attracts potential entrepreneurs to lock themselves into a specific time-period contract with a particular VC firm is not only the availability of necessary finance but also the expectation of benefits which accrue from joining VC’s network of portfolio companies. The underlying strength that motivates this expectation is the very notion of network ties. The best VC networks are based around strong portfolio company performance or business concepts such as Kleiner Perkins’ Keiretsu (Martin et al., 2007). Traditionally, an established business network provides ready market or supplier contacts to its new entrants. The relationship between a VC firm and a portfolio company is thus based on the expectation of how well one can exploit such profitable opportunities. According to popular business acumen, venture capital business is a “business marriage” between an established business (VC firm network) and the newcomer to business ownership (start-ups). The specific market arrangements, when successful and profitable, are of benefit both to the VC firm and to the portfolio company. The VC firm receives a good return for its investment when a business successfully exits, while the portfolio company benefits financially as well as in building management capability and market support. The length of a contractual period of a start-up may affect the choice variables in relation to the business plan, for example, in the quality of the new staff employed, investment in improving the operations of the portfolio company and the effectiveness with which the VC firm holds the portfolio company management to promises given (Tykvova, 2003). The relative importance of these variables may also be influenced by the duration of the venture capital contract. Where issues such as quality of service, saleability, continuity and investment are important, longer duration of the portfolio company contract will naturally provide strengthened incentives to affect choices in these particular areas. For example, when large sunk investments are involved, there is a danger of under-investment if a long-term venture capital contract (covering various rounds/stages) has not been made available to potential investors. Furthermore, in order to recoup the cost of innovation, long-term contracts may also be desirable, particularly if such innovations are of value to the entire venture capital network (Sahlman, 1990). Financing the venture companies A company goes through several distinct stages of development, including seed or initial design stage, start-up and expansion and growth. VC firms can either specialize in financing each of these individual stages or they can act as all-encompassing financiers. In practice, European VCs invest much less in seed and start-up projects and focus more on expansion projects while US VCs are not averse to investing in the expansion stage, although their major concern is usually with early stage ventures. Monitoring the venture Venture investments are generally long-term, resulting in greater business and agency risks. These risks are normally evident in the information asymmetry caused by the

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earlier stage of venture, lack of guarantees and the realisation of financial returns. As a result, many VC firms exercise greater control and follow up and usually employ four mechanisms through which they perform their monitoring role: (1) Contractual monitoring through specific shareholder agreements. (2) Contractual monitoring through differentiated shareholder rights. (3) Monitoring through board membership. (4) Monitoring through their (intense) relationships with management. As noted, business context factors at the start-up companies such as the higher entrepreneurial risks, the higher volatility of the business, the low degree of transparency and lack of public accountability motivate VC firms to try to close extensive contracts with their portfolio companies. These contracts usually entail quite an extensive array of conditions and requirements that portfolio companies will need to fulfil in periodic reviews of company performance. Expected outcomes from such shareholder contracts may be contingent on financial performance, non-financial performance, actions, dividend payments, future security offerings, or continued employment or other incentives (Tykvova, 2003). Monitoring through differentiated shareholder rights Being a financier enables a VC to obtain specific shareholder rights. Over the years, VC firms have developed complex regimes of differentiated rights. The key plank in VC monitoring is the way voting rights are differentiated from cash flow rights. Cash flow rights or voting rights may also be contingent on subsequent performance (performance vesting) or on remaining with the company (time vesting) (Kaplan and Stro¨mberg, 2003). The key idea in applying these monitoring mechanisms is the link between underperformance and the VC firm power over the portfolio company: for instance the influence of VC usually increases if the investee company is underperforming. Ultimately, the VC obtains full control if the company performs consistently poorly. On the other hand, if the company performance improves, entrepreneurs have the opportunity to increase their cash flow rights and voting rights. In general, the allocation is affected by a number of factors such as the asymmetry of information, skills, participation constraints, efforts, benefits (costs) of control, the bargaining power, or the realization of random variables. Monitoring through board membership It is a common practice in the venture capital to monitor portfolio company performance through corporate board membership as currently characterized by the boards of funded companies. As discussed, VC markets are generally subject to high uncertainty, asymmetry of information, and extensive risk, resulting in the need to continuously control the portfolio companies in which VC firms invest. One mechanism is for VC firm representatives to sit on the board of directors. There are quite a few studies, which examine the impact of VCs on board independence. For example, Baker and Gompers (2003) find that venture backing at the time of the initial public offering (IPO) has a positive impact on the fraction of independent outsiders on the board. More important, they find that the more reputable a VC, the larger is the fraction of independent outsiders.

Monitoring through interactions with management Venture capital firms interact intensively with portfolio company management in order to monitor and control their performance. This relationship depends on a number of factors and importantly Sapienza et al. (1996) suggest the time spent in the funded company relates to the time the venture is in portfolio, the industry experience of the VC and the growth path of the funded companies. They find no link between the time spent and the size of the shares owned by the VC and that information is inconsistent concerning the differences in time spent at the funded company, if the latter is performing badly. In an interesting paper, Frye (2003) provides indirect evidence on the monitoring role of VCs. She shows that after the IPO, when VCs’ monitoring declines, other corporate governance mechanisms, particularly outside monitoring (independent outside directors, outside blockholders) and contracting mechanisms (equity-based compensation, leverage) are strengthened in order to substitute for the VCs’ involvement. Gompers (1995) demonstrates how VCs’ monitoring activities depend on different characteristics of the firm. He in particular examines the factors such as increasing expected agency costs, asset intangibility, higher growth options or greater asset specificity of a firm: in all these cases the monitoring frequency rises. All these studies point towards the control exercised by VC firms. However, there are many features in the relationships, which still remain, unobservable or unverifiable. In these situations, other alternative mechanisms are used, especially incentives. Portfolio company organization With contractual arrangements in place that limit the role of a portfolio company in some key management areas, there are a host of other decision-making areas in which specified authority can be delegated to a portfolio company so that it could obtain a desirable outcome. We discuss these in terms of elements relating to internal organization, supplier relationships and customer contacts. Developing internal organization One indication of how authority is delegated in various decision-making operations can be seen from the area of support covered by a VC firm. A typical transaction when a new portfolio company is set up consists of support for establishing a new internal organizational system, including recruitment of new staff, training, and a host of professional and managerial services such as site selection, managerial assistance in equipment and operational design and local and national advertising. Important as this support is for operations at a portfolio company, the magnitude and professional nature of these activities means that a portfolio company will need to internalise these systems of production and operations. Importantly, a company’s internal organization may also help adapt its various business policies and practices to the changing demands of its market, for example, in selecting local producers and vendors, and in hiring employees it will be responsive to the particularities of local markets. It is also worth noting that producing a new good is not merely about the application of technology as a set of ubiquitous production and delivery processes dealing with multiple operational concerns is what it takes to produce a new good or service. Since there is a host of operational steps that need to be activated to obtain these objectives, a portfolio company management is urged to make a concerted effort to

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create a fit among various elements of its internal organization. For example, the successful fast delivery of fresh food to customers, a central aspect of the fast-food segment of the restaurant industry, depends on a range of factors in each restaurant. Given the perishable nature of the physical product, small buffer inventories separate the market (in the form of customers’ orders) and the production process. If the local manager does not respond to shifts in demand promptly and appropriately, product shortages or excesses occur quickly and lead either to slow service (because the product must be made) or to high level of waste (because products must be thrown out). Supplier relationships Venture capital contracts centre on the idea of specifying various milestones in respect of the business plan implementation and how they can also be useful in setting down a benchmark for evaluating portfolio company’s performance (Cuny and Talmor, 2003). The particular nature of contractual transactions relating to a portfolio company’s activities may be fully anticipated and qualified in certain instances. For example, if predicted variations in the quality of service are minimal then the task for setting specific standards for service provision will be less problematic. The opposite might be true if service variation is seen as problematic because it extends across a wide range of quality parameters. Of many of the important choice variables open to a start-up to use its authority to affect the quality outcome, the portfolio company’s own relationship with its suppliers is no less significant. A portfolio company’s relationship with input suppliers is generally governed by either of two considerations; either buying directly from the other companies in the portfolio of the VC firm – a relationship like vertical integration which also means that the authority relationship looks like a direct command structure, or obtaining supplies from independent traders, a relationship of vertical separation type. In the first case, coordination between both contractual parties is about writing a complete contract, and if such contracts consist of “exclusive” purchase, there might be a danger of inferior supplies, since a portfolio company will have little control on “acceptable levels” of quality inputs. In the second type of arrangement, parameters such as cost, quality, inventory, etc. become critical in how a portfolio company obtains a fit between these elements and other considerations pertaining to the production and delivery of its products. One crucial factor in this respect in determining a portfolio company’s behaviour is that in any arrangement it has to internalise the costs of its own sub-optimal performance vis-a`-vis its suppliers’ performance. It is also well-known that the high costs involved in writing, monitoring and executing contracts that attempt to cover all contingences may impose externalities on some contractual parties (Grossman and Hart, 1986). Although, bidders (portfolio companies) who anticipate such problems might be expected to reduce their bids accordingly, there will always be an opportunity to affect the contractual outcome when decisions regarding input supplies are coordinated with other operational decisions of the portfolio company. In particular, the willingness to coordinate with the supplier will be greater when there is a need to encourage the supplier to make complementary investment in operating equipment and infrastructure. This is not a trivial consideration in start-up companies since the very task of an entrepreneurial activity is to produce goods in hitherto unexplored markets.

Product commercialization Often portfolio companies are required to develop new markets or services for their goods, which are secured by creating an effective selling platform. This incorporates an assessment of the state of the market, competitive pricing, how its products or services suit that market, and how to generate a market need for what it has to offer. Market research into how a company’s goods fit into the market is a basis for what messages need to be communicated to the market in order to stimulate demand. Marketing may include both local and national level advertising although VCs often require that only a specified budget is spent on advertising. An increasingly common extension of this is for VCs to specify a minimum spend by the investee company on local marketing, usually as a percentage of turnover. A VC’s other portfolio companies may be able to assist the start-up with promotional materials and national effort, but in a portfolio company’s particular market area, most of the marketing work will be its own responsibility. For example, central assistance on lead generation is often possible at first, but ultimately, the crucial element would be the portfolio company’s own knowledge of its market, contacts and efforts in making use of the best medium available. Achieving this localised impact means that it must be able to understand the media and which ones to use, and choices of print techniques and distribution services. It will also be down to portfolio company management to negotiate the best deals and to get the timing and media right so that its advertising resources are not wasted. All these strategies are to some degree influenced by the way a company has coordinated its various organizational and contractual relations. VC firm and portfolio company dyads: value-adding strategies As the discussion above suggests VCs actively involve themselves in monitoring and control of their portfolio companies. As practice demonstrates, VC operations at portfolio companies can result in funded companies enjoying a sustainable competitive advantage, and translating this into higher shareholder value. This is because of superior VC information about the particulars of a market as wells as its network of support activities. Despite these advantages of VC firm participation, the way VC adds value is still not much understood. Extant literature provides two perspectives on how and when VCs add value: the way portfolio companies benefit from VC intervention and the type of VC firm characteristics that are suitable for its value-adding role. In this paper, we develop a new perspective that examines both sets of entities and look at how their complementary relationship adds value to the benefit of both investors and investees. Portfolio company development: Under this perspective, researchers have examined how VC firms influence the structure of portfolio companies, that is, the extent to which the professionalization of start-ups is driven by VC firm influences. Hellmann and Puri (2002) have provided US based evidence that suggests that the building of the organization, such as the overall human resource policies including recruitment processes, the adoption of stock option plans and the hiring of a vice president of marketing and sales are significantly influenced by the VC firms. These organizational dimensions also shed light on the extent to which start-ups achieve professionalization standards. VC firm characteristics: The other perspective on value adding activities of VC firms evaluates the VC firm characteristics itself and the roles performed by them. Sapienza et al. (1996) develop a typology of three roles, i.e. strategic, interpersonal (or supportive)

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and networking roles. They find that the most important value-added is delivered through strategic (i.e. “sounding board”, “financier”, business advisor”) and supportive (i.e. “mentor/coach”) roles. These influences are however mediated by factors such as the life cycle of the start-up, the experience of the CEO, the innovation sought by the venture and the geographical distance between the VC and the funded company (Sapienza et al., 1996). Building on these two approaches it is worth exploring how VC firm networks have access to a host of professional services, including managerial tools, which are aimed at improving the efficiency of production operations. These services are normally out of the reach of start-ups or smaller firms, thus leaving a vast market untapped in those areas where smaller firms can operate efficiently but lack resources to avail themselves of some key services. Organizational innovations such as VC networking do allow the transfer of many of the specialised services together as a comprehensive and uniform package that would help produce goods and services in new emerging or niche markets (Sahlman, 1990). Additionally, when in a relationship, a portfolio company avails itself not only of requisite finance but also of the privilege of access to a variety of networked services that typically include headhunting support, continued advice, and regular assistance in many key aspects of the start-up operation. On the other hand, a VC invests much with entrepreneurs including the provision of relationship finance as well as the maintenance of a network of portfolio companies. Both of these factors are geared towards launch and sustainability of each new start-up. In this way, the VC gains a new business opportunity as well as the potential of expanding its network cost-effectively. We therefore argue that the relationship between a VC and its portfolio companies is a complementary one. Both benefit from a set of practices that contribute to their specific goals, but require interdependency and positive feedback within the relationship. Below we discuss how VCs can contribute to the value-adding operations at portfolio companies in terms of both company selection and development. Upfront cost of venture capital For a prospective venture capital firm, it is costly to evaluate the potential of their VC business and how to go about finding promising new companies. For a VC the cost of planning, market research, self-selection (deal-selection), recruitment policies and support facilities are important factors in the selection of the right start-up in containing costs within predicted limits and in establishing a successful exit. Therefore, a VC needs appropriate management competencies to provide the necessary level and intensity of support for its network of portfolio companies. In many instances, it will have a number of companies up and running before embarking on the process of IPO (Initial Public Offering) or sales exit. Moreover, high upfront input by the VC firm, including the provision of the right expert advice to portfolio companies, will result in the need for less downstream input. By comparison, the impatient VC firm which goes for minimal upfront effort and investment in a bid to rapidly build its business in the first few years may find that its downstream problems are legion, characterised by start-ups who are inadequately trained, motivated and supported, and who cannot deliver effectively what the market expects. The result is network discord, disputes, breakaways and even collapses. If

both customers and portfolio companies are ill-served, the risk of network failure is high. Experience suggests that since venture capital is about nurturing new businesses, it is important that the VC begins from a position of strength and solidity in relation to its portfolio companies although training and support costs can be substantial.

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907 Downstream costs of venture capital Such upfront investments in venture capital means that a portfolio company gets a safer way of moving into a successful business and has access to finance and network support activities – which is why venture capital businesses stand a much better chance of survival than independent start-ups (Chan et al., 1990). When in a relationship, a VC will need to maintain healthy communication within the network, not just during launches and in the early days, but as an ongoing commitment to support. Venture-backed start-ups are critically dependent on informal communication and personal relationships for their continuity and growth. In fact, such relationships can “make or break” the partnerships. Organizations generally concentrate on formal relationships for governance and the monitoring of work performance that emphasise job design, work allocation, deployment and performance management. However, informal processes such as team organization and communication at all levels are equally important. But it is important to recognise that collaborative working creates extra challenges for staff at all levels, and thus additional support may certainly be needed when creativity and product development are the mainstays of the entrepreneurial project. In this respect, cultural differences between the partner organizations (investors and investees) can cause frustration and delays. These differences often pertain to issues such as the speed of decision-making, the degree of bureaucracy/hierarchy and attitudes to quality. It is thus required that there is clarity from the outset about what information will be shared, the standards of work expected, and how conflicts will be resolved. If these things are put in place practice suggests that the end product will invariably be the expansion and growth of the start-up company and the reward will come as the network grows on a stable basis. If such a basis prevails then portfolio companies downstream are likely to overcome problems more easily and provide network returns to facilitate the selection of more sound management, which will further develop the network. Table II summarizes some of these interrelationships. Search

Expansion

Sale

Stand-alone approach

Reliance on market for finding new investment opportunities

Independent portfolio company operations

Company product demands determine company value

Network approach

Existing networks of portfolio companies

Network provides support

VC network reputation also provides information about the company

Network approach: VC role

Act as “scout”

Act as “mentor”/ “coach”

Develop the company for IPO or sale exit

Table II. Network support for portfolio companies

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Conclusion and direction for future research The present paper argues that venture capital practice is best explained as an instrument of authority delegated to independent managers through well-defined contractual arrangements. Such mechanisms are most useful in situations in which there is a need to carry out various strategic activities as a bundle of decision-making processes so as to benefit from a complementary set of activities in hitherto unexplored markets. The activity bundles are then best carried out by portfolio companies as they can establish viable linkages between all relevant processes. It is also argued that existing explanations of venture capital are mostly speculative and that empirical evidence supporting such assertions is at best tentative (Tykvova, 2006). Furthermore, the framework that is proposed here considers venture capital a consequence of an organizational process encompassing various functions and operational parameters. Thus, an understanding of venture capital as a complementary set of systems will help evaluate the organization of activities within the specific boundaries of the firm and how authority is delegated between different layers of hierarchy to deal with common problems of resource allocation and coordination. The strong links between a VC firm and portfolio company mean that a portfolio company manager taking out a contract has a well-established business network. Through this the company can access the market information held by other portfolio companies of the VC firm as well as obtaining support from the parent organization. Start-up companies often lack enough business experience or the necessary network to succeed. Therefore, VCs act not only as financier but they also provide management support by adopting various roles. A VC can help the company find appropriate staff, suppliers, customers, or other partners. The more networked a VC is, the stronger is the likely support provided with the VC itself acquiring business and management experience as a result. This builds not only capacity in collaborating on extending the portfolio of ventures but helps establish optimal structure for the firm based on the experience of strategic, organizational, financial and other decisions involved in supporting many ventures. Further research on venture capital contracts is also warranted. The relationship between a VC and a portfolio company may not always be complementary – there may be a problem of doubly moral-hazard (Repullo and Suarez, 2004), especially in the allocation of decision rights relating to the management of the portfolio company, e.g. the purchase of input supplies, or in the investment requirements of the company to upgrade its production and delivery services. It will be interesting to examine these situations of conflict and their likely impact on venture capital. References Aghion, P. and Tirole, J. (1997), “Formal and real authority”, Journal of Political Economy, Vol. 105, pp. 1-29. Baker, G., Gibbons, R. and Murphy, K. (1999), “Informal authority in organizations”, Journal of Law, Economics and Organization, Vol. 15, pp. 56-73. Baker, M. and Gompers, P.A. (2003), “The determinants of board structure at the initial public offering”, Journal of Law and Economics, Vol. 66, pp. 569-98. Brickley, J.A. (1991), “An agency perspective on franchising”, Financial Management, Vol. 20, pp. 27-35.

Chan, Y., Siegel, D. and Thakor, A.V. (1990), “Learning, corporate control and performance requirements in venture capital contracts”, International Economic Review, Vol. 31 No. 2, pp. 365-81. Cuny, C.J. and Talmor, E. (2003), “The staging of venture capital financing: milestone vs rounds”, unpublished working paper. Fama, F. and Jensen, M. (1983), “Separation of ownership and control”, Journal of Law and Economics, Vol. XXVI, pp. 301-25. Frye, M. (2003), “The evolution of corporate governance: evidence from IPOs”, working paper, University of Central Florida, Orlando, FL. Gompers, P.A. (1995), “Optimal investment, monitoring, and staging of venture capital”, Journal of Finance, Vol. 50 No. 5, pp. 1461-89. Grossman, S. and Hart, O. (1986), “The costs and benefits of ownership: a theory of vertical and lateral integration”, Journal of Political Economy, Vol. 94, pp. 691-719. Hellmann, T. and Puri, M. (2002), “Venture capital and the professionalization of start-ups: empirical evidence”, Journal of Finance, Vol. 57 No. 1, pp. 169-97. Kaplan, S.N. and Stro¨mberg, P. (2003), “Financial contracting theory meets the real world: an empirical analysis of venture capital contracts”, Review of Economic Studies, Vol. 70 No. 2, pp. 281-315. Lerner, J., Shane, H. and Tsai, A. (2003), “Do equity financing cycles matter? Evidence from biotechnology alliances”, Journal of Financial Economics, Vol. 67, pp. 411-46. Martin, R., Casson, P.D. and Nisar, T.M. (2007), Investor engagement – Investors and Management Practice under Shareholder Value, Oxford University Press, Oxford. Repullo, R. and Suarez, J. (2004), “Venture capital finance: a security design approach”, The Review of Finance, Vol. 8 No. 1, pp. 75-108. Sahlman, W.A. (1990), “The structure and governance of venture-capital organizations”, Journal of Financial Economics, Vol. 27, pp. 473-521. Sapienza, H.J., Manigart, S. and Vermeir, W. (1996), “Venture capital governance and value added in four countries”, Journal of Business Venturing, Vol. 11, pp. 439-69. Tykvova, T. (2003), “Venture-backed IPOs: investment duration and lock-up by venture capitalists”, Finance Letters, Vol. 1, pp. 61-4. Tykvova, T. (2007), “Who chooses whom? Syndication, skills and reputation”, Review of Financial Economics. Corresponding author Derek Eldridge can be contacted at: [email protected]

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University of Southampton, Highfield, Southampton, UK, and

Peter D. Casson Roderick Martin Central European University (CEU), CEU Business School, Frankel Leo´ u´t, Budapest, Hungary Abstract Purpose – The purpose of this paper is to investigate the role of human capital in venture capital organizations. New trends in investor behaviour have emerged in recent years. There is evidence to suggest that venture capital (VC) firms involve themselves more actively in the companies in which they invest through influencing company strategy and through using their knowledge and contacts to introduce portfolio companies to networks of suppliers and customers, professionals and alternative sources of finance. Design/methodology/approach – Using survey data, the paper empirically examines the VC firms’ propensity to engage in terms of the factors that make some firms more active than the others. Findings – Specifically, the paper finds and identifies those mechanisms that are used by VC firms to develop their engagement practice, including human capital and specialized deal flow. The paper also addresses the question of the effects of VC firm engagement on performance. Originality/value – The paper makes a contribution in terms of the way human capital performs in venture capital organizations and how public policies can explicitly take into account the human dimension of the investment process. Keywords Venture capital, Human capital, Investors Paper type Literature review

Management Decision Vol. 45 No. 5, 2007 pp. 910-922 q Emerald Group Publishing Limited 0025-1747 DOI 10.1108/00251740710753710

Introduction A primary function of investors is to allocate funds, but increasingly questions are being asked about the extent to which investors perform roles that go beyond their traditional boundaries. Prior research has identified two motivations for VC firm involvement in their portfolio companies: monitoring performance and providing technical support and advice (Wright and Robbie, 1998; Gompers, 1995). The need for monitoring arises due to the classical agency problem (Jensen and Meckling, 1976). The fact that a VC typically holds a significant proportion of the share in the venture, received in exchange for its financial input, renders the VC the role of an owner, which is, nonetheless, tied to its inability to manage the venture itself. There is thus the separation of ownership and control as VC is reliant on company executives to manage it in a way that is consistent with the profit-maximization goals of investors (Berle and Means, 1932). As a special class of financial intermediation, VCs can structure their investment to minimize the potential of such agency problems. However, evidence varies on the extent to which VC firms actually engage in portfolio company monitoring and control (Macmillan et al., 1989). Some firms adopt a “hands-on” approach, becoming involved with portfolio companies, while for others the approach is “hands-off.”

It is suggested that hands on investors establish contracts with higher norms of corporate governance than hands off investors. Moreover, at higher degrees of involvement, VCs expect management to inform them better and to discuss decisions with them before hand. VCs also use a variety of methods to obtain and examine this information, including company board meetings, formal and informal information exchange, etc. (Fried and Hisrich, 1995). Using a survey-based dataset, the present study explores the characteristics of “hands-on” investors and examines the key features of this particular investment approach. Specifically, the research aims to investigate the factors that make some firms to be more active than the others. In this regard, we address the question of what constitutes an investment engagement approach: What do investors really bring to the deals? What characteristics do matter in terms of human capital? The study is thus concerned with the investors’ propensity to engage with their portfolio companies. We examine a variety of measures for active investor involvement, including the frequency of interaction with a portfolio company, the exercise of corporate governance and the support for personnel policies. The paper thus analyzes drivers of venture capital success on a micro-level basis, by identifying VC firm human capital characteristics and investigating empirically how they contribute to the success of the funded projects. The remainder of the paper is organized as follows. The next section lays out the research framework by drawing upon relevant literature on venture capital and entrepreneurship. This section also develops the hypotheses about VC firms’ propensities and forms of engagement. We then discuss our data and provide variable definitions, which is followed by our report of results. In the final section, we conclude and discuss the limitations of this study and possible directions for future research. Research framework In this section, we collect our testable hypotheses based on various strands of financial institutions and company management literature. Prior research has outlined several critical aspects of venture capital that point to the role of VC firms in the value creation process, with monitoring and networking as primary channels of support to portfolio companies (Fried and Hisrich, 1995; Wright and Robbie, 1998). From the perspectives of VC human capital and organization, we spell out more specifically these ideas below. Forms of engagement Over and above their monitoring role, VC interaction with portfolio companies is characterized by a need to provide support to portfolio companies in areas where they either lack critical knowledge or contacts within the industry, or both. Within the context of double moral hazard, Repullo and Suarez (2004) analyze the effects of VC interaction on portfolio company behaviors. Gompers (1995), Gompers and Lerner (1996) and Kaplan and Stro¨mberg (2003) focus on the level of effort provided by VC firms. In this literature, a particular concern is what VC firm engagement entails at various stages of portfolio company development. Baum and Silverman (2003) suggest that in the case of start-up companies, VC firms act as both scouts in identifying companies with potential, and coaches who assist in realizing that potential. The high returns may be secured through the selection of companies in which to invest, and/or through active post-investment involvement. Baum and Silverman suggest that the research literature

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clearly supports the view that private equity firms are both expert scouts and coaches, but also that it is unclear which of these roles is most important in adding value. Nevertheless, it is clear that they take a long-term view in their investment goals. Similar to quoted companies, VC firms and portfolio companies may also suffer from agency problems. Kaplan and Stro¨mberg (2003) examined the contracts between a number of VCs and portfolio companies with a view to identifying those features within the contracts that minimize these problems. As well as exerting control through the way in which investments are structured, VCs also exercise control on the management of portfolio companies by making funds available in stages, with the availability of additional funding being contingent on company performance or other factors. In addition, VCs frequently exert control and influence through board membership. General partners may be directors of portfolio companies and/or they may nominate outsiders as directors. In many cases private equity firms dominate the boards of portfolio companies. Like voting control, the composition of the board membership may be contingent on the performance of the portfolio company, with poor performance leading to greater representation of the private equity firm on the board. Propensity to engage The preceding discussion suggests that individual managers may be able to affect corporate policies more broadly. Recent work provides ample evidence that managerial characteristics influence corporate decision-making (Bertrand and Schoar, 2003; Malmendier and Tate, 2003). Within the context of venture capital, it takes the form of various ways in which VC firms deploy their human capital in relation to operations at portfolio companies. The knowledge that general partners acquire through venture investments over time is of particular relevance to the management of current investments. In stage funding, VC partners allocate funds intermittently, which allow them to gather experience and obtain new insights into the specific circumstances of a portfolio company business. Over time, sectoral specialization is likely to emerge resulting from VC partners’ experiences of a particular line of product. For example, business strategy analysis is often couched in terms of the opportunities (threats) available to a company in the form of complements (substitutes) (Porter, 1996). The greater the prospect of complementary products entering into the market, the more likely it is that the product’s market position will improve, and it will gain a useful competitive advantage. Similarly, the greater the threat of substitutes, the greater will be the need to fully assess and manage the threat of competition. Armed with this knowledge, a VC partner can effectively channel the entrepreneurial effort into the right direction, with both the company and the VC firm benefiting from the partner’s specialist knowledge. Failure also breeds informed decision-making at VC firms. After observing whether a start-up has been successful or not in its early stage of development, the VC chooses whether to continue its involvement into the start-ups second stage, or to divest (for example, to liquidate) the project. If the VC divests one of its investments, it can transfer (albeit imperfectly) its resources from the divested start-up to the surviving one. The VC’s ability to transfer its resources from one start-up to the other depends however on the degree of its portfolio’s focus and the relevant experience of its partner managers. On the other hand, this process also creates incentives for VCs to focus on

one particular production activity and encourages the development of VC specific human capital. Another related issue pertains to the time frame required for the maturation of a particular deal. In biotechnology sector, for example, it takes about eight to ten years for a new product to get off the ground and make a commercially viable impact. In this environment, in addition to taking the usual monitoring action, a VC partner will need to make a thorough assessment of when the portfolio company is likely to produce tangible commercial results and what strategies are available to ensure the planned exit (e.g. M&A or IPO). This will require him to closely observe the behavior of the market and seek measures that ensure divestment within the specified timeframe. VC firm performance Prior literature has observed that specialized VCs exhibit different investment behaviors than less specialized VCs (Gompers et al., 2004). Kaplan and Schoar (2005) find substantial heterogeneity in performance across VC firms, and suggest that VCs with superior skills and greater human capital will generate better results in their investments. Overall, these papers argue that VC human capital plays a key role in managing and adding value to start-ups. In turn, entrepreneurs value VC human capital, since a skilled VC can help turn their start-ups into successful commercial concerns. The motivation behind these roles stems primarily from the VC firms’ use of their contingent control rights. As the incomplete contracting literature suggests, the use of contingent control rights is likely to be a response to uncertain environments (Aghion and Tirole, 1997). However, some knowledge and expertise will be required to effectively manage market uncertainties and risk. Better screening of project ideas, support for corporate governance and introduction of customer or supplier contacts through VC networks are all intended to assist portfolio company managements in meeting the challenges of the market. The latter effect can be in the form of channeling the expert staff to projects. In line with the works of others (Hart, 1995), the study thus argues that the way a VC firm exercises its contingent control rights by organizing specific operations at portfolio companies also affects its performance. The above discussion leads us to formulate the following hypotheses for our regression analyses. H1

(Effort hypothesis): The more activist the VC firm the higher the level of interaction with a portfolio company.

H2

(Governance hypothesis): The more activist firms will have board representations at their portfolio company boards.

H3

(Networking hypothesis): Activist firms will have a greater role in the management of portfolio companies’ personnel and sourcing policies.

H4

(Performance hypothesis): Performance is positively correlated with the specialized human capital expertise of VC firms.

Research strategy We employed a multi-pronged data collection strategy. A survey questionnaire was sent out to all venture capital firms who were members of the British Venture Capital

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Association (BVCA) in 2005. Each venture capital firm was requested to submit details of the deals from which they had exited since 1998. The survey obtained information on the nature and scope of VC firm involvement in portfolio company management and several key characteristics of both types of firms (i.e. VC firm and portfolio company). We augmented the survey data with information from FAME, VentureExpert, and Diane. This information was important as it allowed us to cross-check the responses as well as fill in the missing elements, such as the amounts of venture deals with contract dates and stages involved. To capture a broad array of governance and support activities, the survey obtained a variety of engagement measures including monitoring and control. The frequency with which a venture capital firm interacts with the portfolio company is our key dependent variable and can be thought of as a proxy for the effort level provided by the venture capital investor. We then supplement this variable with two other governance related indicators. A standard measure of corporate governance is whether investors sit on the portfolio company board of directors, which underscores the importance of corporate boards in developing formal rules of engagement. To investigate the networking effect, our third dependent variable asks whether an investor helps portfolio companies in making contacts with customers and suppliers. The study also provides for a number of controls to fully gauge the impact of human capital specialization and other related variables in monitoring and control. Syndicating the portfolio deals is often a common practice among venture capital firms (Brander et al., 2002). We therefore add two additional variables: syndicate and syndicate lead. As Gompers (1995) and Gompers and Lerner (1996) suggest the size and age of a VC firm may be a proxy for its quality and reputation, so we control for VC firm age and size. Two other deal characteristics, industry and venture business stage, are also of interest. It is likely that companies that receive venture finance at an early stage are potentially in a better position to benefit from VC firm support in terms of venture networking, technical expertise and product commercialization. In addition, the study uses industry controls as the likelihood of receiving support from VC firms may be affected by the company’s industrial sector. There is limited disclosure of information relating to returns on individual VC firm investments and databanks such as Venture Economics only make funds return publicly available in aggregate form. Because of this lack of systematically available data, researchers have generally resorted to measuring VC firm performance indirectly. One performance measure frequently used by prior studies is exit via an IPO or a sale to another company (Merger & Acquisition). This choice is motivated by the fact that VC firms earn their capital gains from a small subset of portfolio companies as on average VC fund writes off 75.3 percent of its investments (Ljungqvist et al., 2005). The fraction of the firm’s portfolio companies that have been successfully exited via an IPO or M&A transaction is our main proxy for VC fund performance. Table I presents descriptive statistics characterizing the average venture capital firm. In addition to means, the Table provides medians, which are useful especially for the variables age and size as they incur extreme values. A typical manager has 6.5 years of post-high school education and 11.34 years of experience. VCs monitored portfolio companies on an ongoing basis, using a combination of methods (e.g. regular meetings with company managers, board meetings). VC firms also appointed representatives to the boards of their portfolio companies, suggesting that the firms

Variable

Mean

Median

Min

Max

OBS

Venture-experience Business-experience Directorship Science-education Sector specialist Deal focus Independent VC Syndicate Syndicate lead VC size VC age Early stage Interaction Corporate board Exit rate IPO rate M&A rate Dollar exit rate Dollar IPO rate Dollar M&A rate Medical products Biotech and pharma Software and internet Electronics Telecom Media and entertainment Financial services Industrial products Food and consumer goods Other sector

11.34 16.12 0.584 0.378 0.584 0.921 0.713 0.412 0.181 11 7.5 0.482 0.713 0.622 32.9 18.4 14.5 34.8 20.3 14.5 0.241 0.164 0.467 0.118 0.057 0.127 0.038 0.031 0.068 0.148

14 18 – – – – – – – 23 4 – – – 29.4 11.8 6.7 31.2 13.3 6.1 – – – – – – – – – –

0 0 0 0 0 0 0 0 0 1 1 0 0 0 0

25 31 1 1 1 1 1 1 1 63 45 1 1 1 100

642 624 654 622 632 632 644 374 362 644 644 534 583 621 269

0

100

211

0 0 0 0 0 0 0 0 0 0

1 1 1 1 1 1 1 1 1 1

637 637 638 637 637 637 640 637 637 640

integrated engagement into the investment process. Their engagement policy concerned three principal operations at portfolio companies: strategy and performance (e.g. new product development); corporate governance; and best management practice, such as outsourcing. Variables definition The survey asked about all partners/senior managers active as of December 2005. A definition was provided in the survey of a partner or senior manager: a partner is a person with investment decision power, i.e. somebody who can decide whether to fund or not a company. Venture-experience is the average number of years of partners’ experience in venture capital industry. Business-experience is the average number of years of partners’ general business experience. Directorship is the fraction of partners, which have one or more outside directorships.

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Table I. Descriptive statistics

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Science-education is the fraction of partners, which have an education in science or engineering. Sector specialist is a dummy variable that takes the value 1 if the venture firm has designated one or more sector specialists, 0 otherwise. Deal focus is a variable given by the inverse of the average number of companies financed in one particular market sector, per year. We construct a variety of engagement variables that encapsulate different aspects of venture capital firms’ interaction with their portfolio companies. Corporate board is a dummy variable that takes the value 1 if the venture capital firm is reported to sit or have sat on the board of directors of the company; 0 otherwise. Interaction is a dummy variable that takes the value 1 if the venture capital firm is reported to interact with the company on a monthly or weekly basis; 0 if it interacts with on an annual or quarterly basis. Syndicate represents the percentage of the deals that have been syndicated with at least one other venture capitalist. Syndicate lead represents the percentage of the deals in which the VC is the lead syndicator. Independent VC takes the value 1 if the venture capitalist defines itself as an independent venture capital firm; 0 otherwise. VC size is the amount under management of the venture capital firm at the end of the sample period, in millions of current dollars. VC age represents the age of the venture capital firm in the year 2005 (or time elapsed since the VC raised his first fund). Early stage is the percentage of early stage deals. Industry is set of a dummy variables that we obtain the data from our survey instrument, which gave the following choices: biotech and pharma; medical products; software and internet; financial services; industrial services; electronics; consumer services; telecom; food and consumer goods; industrial products (including energy); media and entertainment; other (specify): . Exit rate: percentage of portfolio companies exited. . IPO rate: percentage of portfolio companies sold via IPO. . M&A rate: percentage of portfolio companies sold via M&A. . Dollar exit rate: percentage of invested $ exited. . Dollar IPO rate: percentage of invested $ exited via IPO. . Dollar M&A rate: percentage of invested $ exited via M&A. Estimation results Three sets of estimates are reported in Table II. Column 1 provides probit results for interaction, column 2 shows results for corporate board and column 3 contains results for networking. The main effects are consistent with the predictions of our models. The models’ pseudo R 2’s range from 0.227 to 0.461 (p , 0:001). The study uses a variety of measures to investigate the effects of human capital and business and deal focus. Firms with deal focus are much more involved with their companies than the firms with a diversified interest. VC partner variables included in the regressions have strong positive effects on the interaction variable as well as the way firms provide business and networking support to their portfolio companies. This result is fully

Venture-experience Directorship Business-experience Science-education Sector specialist Deal focus Independent VC Syndicate Syndicate lead VC size VC age Early stage Industry controls Observations X2 Model p-value Pseudo R 2

Interaction

Board

Networking

0.156 * * (1.21) 0.391 * * * (2.17) 0.529 * * * (3.78) 0.861 * * * (6.69) 0.561 * * * (3.83) 0.313 * * * (2.43) 0.471 * * * (3.35) 0.162 (0.07) 0.371 * * * (2.68) 20.294 * * * (21.14) 20.001 * * * (20.01) 0.325 (1.63) Yes 644 226.41 0.000 0.461

0.631 * * * (4.21) 1.372 * * * (8.81) 0.913 * * * (5.21) 0.316 * * * (2.21) 1.216 * * (7.33) 0.685 * * * (5.87) 0.113 (0.01) 0.183 (0.14) 0.518 * * * (3.53) 20.118 * * * (20.75) 20.001 * * * (20.01) 0.271 (0.56) Yes 637 244.68 0.000 0.227

0.193 * * (1.17) 0.439 * * (3.47) 0.718 * * * (4.65) 0.635 * * * (3.82) 0.863 * (6.17) 0.641 * * (3.17) 0.363 * * * (2.88) 0.002 (0.01) 0.742 * * * (6.23) 2 0.326 * * (2 2.17) 0.004 * * (1.35) 0.221 (0.71) Yes 644 237.41 0.000 0.353

Notes: For each independent variable, the table reports the estimated coefficient and the T-ratio (in parentheses), computed using Huber-White robust standard errors. In all regressions, industry controls are included but not reported; * * *, * *, * values significant at the 1, 5 and 10 percent level are identified respectively

supported in all three regressions, thus validating our research hypotheses on the role of human capital in venture firm organizations. As with the emerging trends in modern firms (Roberts, 2005), we find a central role for human capital in investor organizations. All our human capital measures have strong positive effects, and provide explanations for the VC firms’ propensity to engage with their portfolio companies. Prior business experience has a consistently positive, large and significant effect on all the involvement variables (including networking and corporate governance support), which stylizes the fact that managers’ general business experience is a crucial ingredient for entrepreneurial success. Similarly, experience in venture business and partners with a science background are the factors that tend to drive an activist investment style, although in the case of venture experience the coefficients for interaction and networking are slightly smaller then the other equations. The skill mix of venture capital firms thus strongly influences the relationships with portfolio companies.

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Table II. Human capital and its effect on VC firm engagement practice

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Overall, these findings support the claim that human capital is one of the most valuable assets in financial intermediation (Hellmann and Puri, 2002). There is an increasing awareness at the firm level that a big part of its true value depends on intangible factors such as human knowledge and skill, rather than on physical assets such as real estate. There are many economic areas in which human capitalists typically exercise dominant control and ownership. In professional service firms, for example, the governing principle is partnership among its employees. In the case of venture capital, human capital is valuable because partners develop their knowledge and skill at the level of a specialist market, encompassing areas as diverse as deal making to product development and commercialization. Our results on VC firm propensity to engage will be better understood with the lessons learned from the previous episodes of VC highs and lows. The exuberance of investors during the last bubble episode had some severe consequences for the VC industry. It had become almost impossible to stop failing entrepreneurs as they could always argue that there were a dozen of competitors lined up to provide them with additional funding. As a result, there was far too much money chasing not necessarily too few deals, but too few partners with the adequate skills. In the VC industry, it is not the budget constraint that is binding, but the time constraint: VCs can only do so many deals. The negative externality of excessive levels of funding during the internet bubble era, created an imbalance with the level of skills available resulted in an overall reduction in the efficiency of VC investment. Extant research reinforces this impression and lends support to the view that the role of public policy, if any, is in priority to help assure the right balance on the supply side of VC finance between skills and capital (Repullo and Suarez, 2004). Literature on venture capital argues that firm size will strongly determine the extent of support given to portfolio companies (Gompers, 1995). However, the variable representing the effect of VC size shows negative correlations with all three dependent variables. Similarly, in relation to VC age there are negative estimates for two of the three equations, suggesting that VC age has no bearing on the way VC firms manage their portfolios, especially in relation to the support intensity for portfolio companies. The regressions also examine how syndication affects VC involvement by adding two variables: one for whether a deal is syndicated, and one for whether the investor is the lead syndicator. The results show that leading a syndicate has a positive effect on the engagement variables but syndication as such is associated with lower levels of involvement. Table III shows OLS results for the effects of VC firm characteristics on performance. The dependent variable for the first two regressions is denoted by EXIT, and presents the proportion of all exits done, including exits through an IPO (column 1) and a trade sale or M&A (column 2). For the third and fourth regression, EXIT2 presents the proportion of exits in terms of dollar exit rates. All the four regression estimates show interesting similarities and reveal some key results. As before, VC partner education, science background, business experience and deal focus were included in performance regressions. The study finds that all these groups of variables are important in explaining the variation in performance outcomes. The models’ R 2’s range from 0.320 to 0.466 (p , 0:001). VC partner education, science background and business experience are all-important as is VC deal focus. However, contrary to our predictions, the impact of syndicate lead is ambiguous, since it has

CONSTANT Venture-experience Directorships Business-experience Science-education Sector specialist Deal focus Independent VC Syndicate Syndicate_lead VC-size VC-age Early stage Industry controls Observations P-value of F-statistic R2

EXIT1 IPO

M&A

EXIT2 IPO2

0.691 * * *

1.351 * * *

0.825 * * *

(0.559) 0.531 * * * (0.455) 0.647 * * (0.482) 0.536 * * * (0.338) 0.271 * * * (0.153) 0.641 * * * (0.512) 0.098 (0.020) 0.253 * * 0.139) 0.001 (0.069) 20.001 (0.053) 20.002 (0.118) 2.001 (0.007) 20.001 (0.001) Yes 269 0.009 0.320

(1.016) 0.783 * * * (0.541) 0.372 * * * (0.282) 1.631 * * * (0.986) 0.631 * * * (0.581) 0.836 * * * (0.732) 0.017 * (0.033) 0.109 * (0.085) 0.002 (0.117) 0.432 * * * (0.357) 2 0.001 (0.001) 2 0.001 (0.003) 2 0.032 * * * (0.171) Yes 269 0.013 0.466

(0.698) 1.285 * * * (1.071) 0.894 * * * (0.953) 0.427 * * (0.284) 0.541 * * * (0.493) 0.533 * * * (0.479) 0.071 * * (0.012) 0.324 * * * (0.236) 0.001 (0.002) 20.002 (0.002) 20.002 (0.005) -0.006 (0.005) 20.012 * * * (0.168) Yes 211 0.011 0.381

M&A2 0.636 * * * (0.597) 0.856 * * * (0.839) 0.639 * * (0.661) 0.374 * * * (0.263) 0.681 * * (0.509) 0.473 * * * (0.310) 0.063 * * (0.071) 0.282 * * (0.138) 0.001 (0.004) 0.523 * * * (0.324) 2 0.002 (0.160) 2 0.004 (0.005) 2 0.032 (0.162) Yes 211 0.007 0.434

Notes: The standard errors and covariances are White heteroskedasticity-consistent. In all regressions, industry controls are included but not reported; * * *, * *, * values significant at the 1, 5 and 10 percent level are identified respectively

opposite effects for IPOs and M&A. It negatively impacts portfolio company exit through IPOs but its relationship with M&A is positive. There is the possibility that syndicated companies undergoing mergers or acquisitions are supported more vigorously by their syndicate leaders, which is not the case for IPOs. Overall, the results imply that VC firms’ strategy of using experienced and educated employees acts as an incentive for them to put forth higher levels of engagement effort, which results in improved firm performance. The positive relationships between employee-related variables and performance outcomes underline this particularly important connection. Similar to the results for interaction and networking variables, VC size and age are insignificant and negative in performance measurement regressions. This result is somewhat counter-intuitive as it is sometimes argued that VC firm reputation, which inevitably emerges over a period of time, is an important driver of VC firm engagement (Kaplan and Stro¨mberg, 2003). As for the early

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Table III. VC firm performance

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stage-projects, the likelihood of a successful exit is lower the more the venture capitalist invests in these types of projects, meaning that early-stage projects are riskier because of the nature of the innovation involved. Measurement issues In this section, we further probe into our main result that human capital and organizational specialization are key drivers of investment styles, and provide a number of model extension. Table III shows that human capital variables have positive effects on VC firm exit, measured as exit rate as well as dollar exit rate. It has thus been argued that VC human capital increases the odds for investment success. However, this analysis does not take into account the possibility that VC partners’ human capital, particularly science education, is valued only when it affects performance. To account for the endogenous relation between human capital and performance, we also estimate the performance effect of VC human capital with two stage least squares (2SLS). Table IV provides 2SLS results, which show that human capital indeed raises the firm

Venture-experience Directorships Business experience Science-education Sector specialist Deal focus Independent VC Syndicate Syndicate lead VC size VC age Early stage

Table IV. Endogeneity – VC firm and its performance effects

Industry controls Observations P-value of F-statistics R2

EXIT IPO

M&A

0.008 (0.513) 1.180 * * * (0.792) 0.447 * * * (0.234) 0.474 * * * (0.226) 0.832 * * * (0.529) 0.010 (0.051) 0.378 * * (0.257) 0.212 * * * (0.161) 2.955 * * * (1.175) 0.001 (0.001) 0.006 (0.004) 0.100 (0.010) Yes 1.206 0.007 0.361

0.027 * (0.930) 0.691 * * * (0.530) 0.854 * * * (0.241) 1.277 * * * (0.612) 0.460 * * (0.434) 0.191 * * (0.133) 0.216 * * * (0.114) 0.264 * * * (0.442) 0.210 * * * (0.116) 0.001 (0.001) 0.003 (0.001) 0.075 (0.085) Yes 1.345 0.011 0.544

EXIT2 IPO2

M&A2

0.024 * (0.706) 0.648 * * * (0.441) 1.031 * * * (0.420) 0.079 (0.036) 0.774 * * * (0.678) 0.318 * * * (0.212) 0.118 (0.092) 0.052 (0.085) 3.065 * * * (1.416) 0.001 * (0.001) 0.002 (0.001) 0.117 (0.035) Yes

0.010 (0.003) 0.400 * * * (0.355) 3.106 * * * (0.861) 1.083 * * * (0.961) 0.203 * * (0.734) 3.157 * * * (1.828) 0.273 * * * (0.162) 0.169 * * (0.276) 0.249 * * (0.147) 0.001 (0.073) 0.004 (0.002) 0.024 (0.028) Yes

0.009 0.393

0.013 0.338

Notes: The standard errors and covariances are White heteroskedasticity-consistent. In all regressions, industry controls are included but not reported; * * *, * *, * values significant at the 1, 5 and 10 percent level are identified respectively

performance. In fact, the results are stronger than the OLS regressions, especially the association between science education and exit via merger and acquisition. Conclusion Venture capital firms have an important role in funding young, entrepreneurial businesses, expanding older companies and, in some instances, in the restructuring of large enterprises. Prior literature indicates that VCs add value by acquiring and delivering specific knowledge and skills to their portfolio companies. One implication of this approach to portfolio company management is that these investments lead to specialization in the VC industry, where different VCs invest in different sets of skills. For example, some VCs specialize only in certain technologies and industries such as biotechnologies, which help their investment strategy focused, whereas others diversify into different industrial sectors. This implies that providing VCs with appropriate incentives to add value to their portfolio companies may often be as important as providing incentives to entrepreneurs to exert effort. The present study examines the factors that enable a VC firm to add value, especially how its human capital drives its engagement policy. The study finds that VC human capital has important role in the VC-Portfolio company dyads. The investment activity itself creates conditions for the development of VC specific human capital that allows its partners to carry out their operations with professional aplomb. The types of issues in which VCs are involved are to do with monitoring, networking and strategic concerns. Contacts that VCs have with a range of companies, professionals and other financial institutions provide a network that can be used to influence operations at portfolio companies. In addition, many VC partners have qualifications such as science degrees that instrumentalize their knowledge to the specific needs of a particular market. Given these characteristics, it is likely that a more activist engagement style will emerge to the benefit of both investors and investees. The present study focuses on venture capital for analyzing investor engagement but it would be instructive to examine the other types of investors and the factors likely to influence their propensity to engage with their portfolio companies. References Aghion, P. and Tirole, J. (1997), “Formal and real authority in organizations”, Journal of Political Economy, Vol. 105, pp. 1-29. Baum, A.C. and Silverman, B.S. (2003), “Picking winners or building them? Alliance, intellectual, and human capital as selection criteria in venture financing and performance of biotechnology start-ups”, Journal of Business Venturing, Vol. 19 No. 3, pp. 411-36. Berle, A. and Means, G. (1932), The Modern Corporation and Private Property, World Inc., New York, NY. Bertrand, M. and Schoar, A. (2003), “Managing with style: the effect of managers on firm policies”, The Quarterly Journal of Economics, Vol. 118 No. 4, pp. 1169-208. Brander, J.A., Amit, R. and Antweiler, W. (2002), “Venture capital syndication: improved venture selection versus the value-added hypothesis”, Journal of Economics and Management Strategy, Vol. 11 No. 3, pp. 423-52. Fried, V. and Hisrich, R. (1995), “The venture capitalist: a relationship investor”, California Management Review, Vol. 37 No. 2, pp. 101-13.

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Gompers, P. (1995), “Optimal investment, monitoring, and the staging of venture capital”, Journal of Finance, Vol. 50 No. 4, pp. 1461-90. Gompers, P. and Lerner, J. (1996), “The use of covenants: an empirical analysis of venture partnership agreements”, Journal of Law and Economics, Vol. 39 No. 2, pp. 463-98. Gompers, P., Kovner, A., Lerner, J. and Scharfstein, D. (2004), “Venture capital investment cycles: the role of experience and specialization”, working paper, HBS, Boston, MA. Hart, O. (1995), Firms, Contracts and Financial Structure, Oxford University Press, Oxford. Hellmann, T. and Puri, M. (2002), “Venture capital and the professionalization of start-ups: empirical evidence”, Journal of Finance, Vol. 57 No. 1, pp. 169-97. Jensen, M. and Meckling, W. (1976), “Theory of the firm: managerial behavior, agency costs and ownership structure”, Journal of Financial Economics, Vol. 3 No. 4, pp. 305-60. Kaplan, S. and Schoar, A. (2005), “Private equity returns: persistence and capital flows”, Journal of Finance, Vol. 60, pp. 1791-823. Kaplan, S.N. and Stro¨mberg, P. (2003), “Financial contracting theory meets the real world: an empirical analysis of venture capital contracts”, Review of Economic Studies, Vol. 70 No. 2, pp. 281-315. Ljungqvist, A., Richardson, M. and Wolfenzon, D. (2005), “The investment behavior of private equity fund managers”, working paper, New York University, New York, NY. Macmillan, I.C., Kulow, D.M. and Khoylian, R. (1989), “Venture capitalists’ involvement in their investments: extent and performance”, Journal of Business Venturing, Vol. 4, pp. 27-47. Malmendier, U. and Tate, G. (2003), “CEO overconfidence and corporate investment”, Stanford GSB Research Paper No. 1799. Porter, M. (1996), “What is strategy?”, Harvard Business Review, Vol. 74, November-December, pp. 61-78. Repullo, R. and Suarez, J. (2004), “Venture capital finance: a security design approach”, The Review of Finance, Vol. 8 No. 1, pp. 75-108. Roberts, J. (2005), The Modern Firm, Oxford University Press, Oxford. Wright, M. and Robbie, K. (1998), “Venture capital and private equity: a review of the literature”, Journal of Business Finance and Accounting, Vol. 25 Nos 5/6, pp. 521-70. Further reading Gompers, P. and Lerner, J. (2000), “Can corporate venture capital succeed? Organizational structure, complementarities and success”, in Morck, R. (Ed.), Concentrated Ownership, University of Chicago Press, Chicago, IL, pp. 17-50. Lerner, J. (1994), “The syndication of venture capital investments”, Financial Management, Vol. 23 No. 3, pp. 16-27. Corresponding author Peter D. Casson can be contacted at: [email protected]

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Performance effects of venture capital firm networks

Performance effects of VC firm networks

Peter Abell London School of Economics, London, UK, and

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Tahir M. Nisar University of Southampton, Southampton, UK Abstract Purpose – The purpose of this paper is to explore the networking effects of venture capital (VC) firms on portfolio companies. VCs can bring specific skills and abilities to their ongoing relationships with their portfolio companies and thus add value by influencing key portfolio company operations. High levels of engagement also translate into giving advice and support, helping with the team culture, creating strategic alliances, or exercising corporate governance. A particular mechanism through which these support services are delivered is syndication investment. Design/methodology/approach – Using network theory tools the paper investigates the effects of syndication on VC firm performance. Findings – The paper finds that networked VC firms are better placed to benefit from their investments. Originality/value – The paper sheds light on the importance of network relationships in the venture capital industry. Keywords Networking, Venture capital, Value added Paper type Research paper

Introduction Networks may be seen as an alternative to banks as intermediaries in credit markets. They may also coordinate disperse resources in factor and product markets. Networks’ role in the allocation of scarce resources has been recognized both in the past and today (Cornelli and Goldreich, 2001; Ljungqvist et al., 2005). As an organizational form a network is distinct from both a firm and a market, as they are not limited by specific contracts to some ultimate owner of property rights, nor are they engaged in a bargaining process, having to bid for resources. Networks are rather cooperative mechanisms that arrive at allocative decisions by consensus and through the pooling of relevant information. In the venture capital (VC) industry, networks abound. A central feature of venture capital is the way it allows investment firms to syndicate their investments – when two or more firms jointly undertake a new project (Lerner, 1994). Syndication inevitably creates a multitude of relationships spanning the syndicate member’s coordination and various service providers, including research anddevelopment organizations, patent lawyers, headhunters, investment bankers etc. (Gorman and Sahlman, 1989; Sahlman, 1990). The diverse sets of relationships with different agents (e.g. investors, co-investors, suppliers, customers) imply large variations in the quality and support offered to portfolio companies. It is likely that these differences in investment and engagement approach will also affect VC syndicate performance.

Management Decision Vol. 45 No. 5, 2007 pp. 923-936 q Emerald Group Publishing Limited 0025-1747 DOI 10.1108/00251740710753729

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VC firms operate in uncertain environments. The uncertainties are often linked to the risk involved in product development and commercialization. For instance, risks faced by start-up companies have their roots in both the external environment and in lack of capabilities within the organization. There may be sudden market changes and shifts in investor and consumer expectations, compelling the company to completely change the course of its strategy. Companies may also face shortage of personnel or key physical and organizational resources to carry out a new development opportunity successfully. VC literature has argued that by syndicating investments companies are able to effectively deal with all such risks and uncertainties. Prior literature on networks has primarily been concerned with identifying their existence in various financial markets. An important issue is the likely impact of this particular form of organizational structure on VC firm performance. To this end, VC network measures of how well networked a VC is will need to be developed. Recently, there has been a surge of interest in networking theory, which freely borrows its main tools of analysis from Graph theory (Hochberg et al., 2006). In the present context, we use the graph theory based measurement tools to capture the following different aspects of a VC firm’s influence: (i) the number of VCs with which it has a relationship as a proxy for information about deal flow, expertise, contacts, and pools of capital it has access to; (ii) its access to the best-connected VCs; and (iii) its ability to act as an intermediary, bringing together VCs with complementary skills or investment opportunities that lack a direct relationship. As the prevailing practice of syndication investment underlines VC firms greatly benefit from having a multitudes of relationships. Our results show that the benefits from these relationships are magnified when VC firms join hands with other well-connected VC firms. The paper is organized as follows. The next section provides a survey of the prior literature on VC firm engagement practices. This section also develops VC specific network theory measures. We then discuss our data and provide variable definitions, which is followed by our report of results. We establish empirical implications for the system of VC networked relations, including the impact of various measures of networks on VC firm performance. In the final section, we conclude and discuss the research’s implications. Literature survey The evolution of interdependencies between different organizational tasks is a manifestation of how linkages between different actors play a critical role in enterprise development. To better understand the increasingly complex relationships among organizations, which often arise, as we pointed out above, as a result of their uncertain market environments (Kenis and Knoke, 2002; Provan and Sebastian, 1998), researchers have often resorted to analysing resources and capabilities as catalysts for interorganizational relations. Such an approach is often couched as the resource-based view of the firm (Barney, 1991; Wernerfelt, 1984). Although this approach recognizes the role of unique firm history and specific nature of capabilities, it pays scant attention to network ‘complementarities’ that motivate firms’ participation in interfirm networks. It is important to note that interfirm networks can be useful in this framework as they channel valuable information about the resource advantage (e.g. key information, useful contacts, capital) that can be obtained from firm network resources.

Prior literature on syndication has generally focused on ex-anti motives of VC firms, namely how syndication may improve the selection process through improved screening, due diligence and decision-making. Following traditional finance theory, syndication is considered as a means by which VC firms secure a well-diversified portfolio, enabling the VC firm to reduce the unsystematic risk of the portfolio. There are also expectations of reciprocity and better future financial deals when VC firms are able to syndicate with other reputable firms. For a number of reasons, determining the ex-post motives of syndication, especially how investors can share their complementary skills or specific knowledge, and as a result, add value to a portfolio company is also important (Bygrave, 1988). The management of the ex-post investment may significantly affect its performance. Brander et al. (2002) compared Canadian-syndicated VC deals with stand-alone projects and found that the need to access specific resources from the ex-post management of investment, rather than for the selection of investment resulted in the syndication of projects which also enjoyed higher rate of returns than stand-alone projects. The study of such investments provides an opportunity to examine the key factors driving the VC firm performance. Network methodology Network analysis is conducted at various levels of social interaction. One can either analyse clusters (networks) of organizations and their patterns of interaction, involving a study of the complete network or focus solely upon one or more specific operations in a network (Powell, 1990; Burt, 1992; Powell et al., 1996). Within the field of business studies, one common practice is to take the firm as a unit of analysis and examine the links or ties it is able to build with actors outside the firm. This helps to understand how the firm develops and operates a network (Birley, 1985; Aldrich and Zimmer, 1986; Dubini and Aldrich, 1991; Larson, 1992). Notwithstanding the fact that counting the number of ties a firm has established provides important insights into its network size, the various dimensions of a network and/or the way they influence the development of a new business is also a key question in network analysis (Chu, 1996). For example, questions such as how socio-economic contexts in which actors operate are linked to strategic networks have not yet been fully explored. The social network model of organization formation (Granovetter, 1973, 1985; Aldrich and Zimmer, 1986; Dubini and Aldrich, 1991; Burt, 1992; Larson, 1992) views new organizations as created by entrepreneurs “embedded” (Granovetter, 1985) in a series of network relationships. Specifically, the pattern and process through which network relationships are developed and maintained are the main areas of research interest. Dubini and Aldrich (1991) define a network as “patterned relationships between individuals, groups, and organizations”. This suggests that a network consists of structure and content (Burt, 1992), where structure is the pattern by which individuals and organisations are linked, including interaction frequency and the ways in which they are connected (e.g. by contracts, equity, kinship, etc.), while content describes the resources exchanged within networks. Network size Extant literature examines the structure of organizational networks in terms of size and strength (Dubini and Aldrich, 1991). There are many ways in which network size

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is analysed. A common approach is to study the number of ties or links between an organization and outside contacts. In this respect, one can usefully distinguish between a “personal” network, i.e. “those persons with whom an entrepreneur has direct relations and an ‘extended’ network”, i.e. relationships between an organization and the external world (Dubini and Aldrich, 1991). A related distinction is between the actor’s direct “personal” links and “total” links which cover direct and indirect links – Shulman (1976) “anchorage” points within the focal organization. Shulman emphasizes the importance of both direct and indirect links as they are used as a means of accessing resource nodes. For example, Steier and Greenwood (1995) show how venture capitalists act as brokers, linking entrepreneurial ventures with such players as retail outlets, marketing consultants and other financial sponsors. In this line of research, the main unit of analysis is the number of links between an organization and its context. Irrespective of whether the links are direct or indirect, what matters is the number of links (Larson, 1992). Another strand of research emphasizes the number of links to different clusters of information and resources accessed by those resources, rather than the number of ties per se (Burt, 1992). ‘Size is a mixed blessing”. More contacts can mean more exposure to valuable information, more likely early exposure, and more referrals. But increasing network size without considering diversity can cripple the network (Burt, 1992). Burt stresses the role of diversity as a key attribute of size, implying that several single ties to multiple sources - ties to clusters of people not in communication with other clusters - than multiple ties to the same source, are more important. The number of relationships an actor in a network manages is captured by degree centrality measure. For research purposes, a network is represented by a square “adjacency” matrix, the cells of which reflect the ties among the actors in the network. For example, two VCs coinvesting in the same portfolio company can be considered as having a tie. With the number of ties increasing, the VCs would have more opportunities for exchange and so become influential, or central, in a network. We examine this by looking at whether at least one syndication relationship exists between VCs i and j. Adjacency matrices can be “directed” or “undirected”. In the case of directed matrices, we can differentiate between the originator and the receiver of a tie. Thus, we can have information about syndicates led by VC i versus those led by VC j. It allows one to distinguish between VCs who receive many ties and those who originate many ties. In the first case, VCs are invited to be syndicate members by many lead VCs, whilst, in the other case, lead VCs syndicate with many other VC members. This produces two directed measures of degree centrality. VC i’s indegree counts if at least one syndication relationship exists in which VC j is the lead investor and VC i is a syndicate member. When one counts the number of other VCs a VC firm has invited into its own syndicates (i.e. reciprocity), one has an outdegree measure. Network strength Granovetter (1973, 1985) argues that network “strength” where ties with close friends and associates who are likely to know one another, is critical for understanding the network relations. Whilst recognizing the value in weak ties as they represent diverse conduits of information, this framework focuses on “strong” ties as, for example, relations within personal networks, that allow trust and/or moral obligation to play its role as an underlying support mechanism, thus reducing the risk of opportunism and

cheating (Johanson and Mattson, 1987; Powell, 1990). Therefore, in addition to counting the number of actor relationships (i.e. degree), it would also be useful to measure their “strength” or “quality” or closeness in our setting. “Eigenvector centrality” is generally used to measure “closeness” (Bonacich, 1987), which is an actor’s total ties to other actors weighted by their respective centralities. Thus, we can measure the extent to which a VC is connected to other well-connected VCs.

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Network content In addition to structure, understanding network content is also important in the way it affects individual actors and organizations. In this respect, Tichy (1981) develops a typology of four types of resources accessed through networks: information, goods and services, expressions of affect or emotional support, and political influence. Information resources can be envisaged in terms of management expertise, and professional advice provided by accountants, lawyers and consultants. In the present context, goods and services are financial resources, as well as assets such as plants and equipment. Steier and Greenwood (1995) discuss effective support in relation to its significance for start-up companies. They also provide an example of how networks can be used for political purposes or for the mobilisation of influence. Thus, it will be useful to know those actors on whom many others must rely to make connections within the network. When a VC acts as an intermediary by bringing together VCs with complementary skills that lack a direct relationship between them, this can be captured by “betweenness” measure. It is measured by the proportion of all paths linking actors j and m that pass through actor i. Indirectly, these network measures also capture the involvement of VC firms in portfolio companies. Elango et al. (1995) identify three levels of involvement: inactive, active advice-giver, and hands-on. Involvement by the inactive group is mainly confined to attendance at board meeting. One example of “hands-on” involvement approach is the firms’ emphasis on networking among its portfolio companies. The concept refers to networks of companies bound together by mutual obligations and contacts. Entrepreneurs gain access to VC’s portfolio of companies and associations with market leaders. These relationships are the foundations for strategic alliances, partnership opportunities and the sharing of insights to help build new ventures faster, broader and with less risk (Norton and Tenenbaum, 1993). Networking also allows the development of a network of companies that helps create synergies and pooled resources for growth and development (Franke et al., 2006). The professional respect and regard in which VC is generally held and the influence that it enjoys with other investors are major sources of networking success. Empirical specifications VCs often engage in joint projects that allow them to participate in more projects, especially when they are constrained by available resources. There is empirical evidence that suggests that syndicated projects offer higher returns than projects financed by a single VC (stand-alone projects) (Brander et al., 2002). The way syndicated VCs offer improved managerial support in the form of higher reputation, and a larger variety of contacts for their portfolio firms than a single VC, accounts for the higher return. The syndication investment strategy is primarily aimed at high-risk environments, where it reduces the asymmetries of information and select the projects

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Table I. Descriptive statistics

of the highest quality (Wilson, 1968). By combining equities in an investment, either in the same investment round or, more broadly defined, at different points in time, syndicated projects mitigate investment risks. Syndication may also be advantageous when inexperienced VCs join in. Experienced VCs are likely to contribute to the project’s success with their knowledge and expertise, and thus increase the expected project value. In the process, they are also likely to help inexperienced VCs to gain valuable know-how for future deals when they invest in a project together with skilled partners. To fully investigate the effects of syndication investment, we examine directed and undirected centrality measures as discussed above (see also Hochberg et al., 2006). Entry to and exit from the network may change each VC’s centrality, thus changing the structure of the network and the relationships it supports. To keep track of these changes, we construct our adjacency matrices over trailing three-year windows. Descriptive statistics are presented in Table I. The parent of the average sample fund has normalized outdegree of 8.13 percent, indegree of 7.12 percent, and degree of 12.14 percent. This suggests a number of interesting features of syndication investment, in the UK and Continental Europe: the average VC, when acting as lead, involves a little over 8 percent of all VCs active in the market at the time, as coinvestors; has been invited to become a syndicate member by around 7 percent of all VCs; and has coinvestment relationships with a little over 12 percent of the other VCs (ignoring its and their roles in the syndicate). These relatively low degree centrality scores suggest that VC relationships are relatively exclusive and stable as they often Mean

Median

Min

Max

No.

Fund characteristics Fund size ($ million) First fund (fraction, %) Seed or early-stage fund (fraction, %) Corporate VC (fraction, %)

34.0 13.2 18.7 8.3

11.0

0.1

Fund performance Exit rate (percent of portfolio companies exited) IPO rate (percent of portfolio companies sold via IPO) M&A rate (percent of portfolio companies sold via M&A) Dollar exit rate (percent of invested $ exited) Dollar IPO rate (percent of invested $ exited via IPO) Dollar M&A rate (percent of invested $ exited via M&A)

16.7 9.2 6.3 17.1 12.3 7.2

17.0 7.8 4.7 14.6 6.8 2.4

0 0 0 0 0 0

Investment climate Average B/M ratio VC experience Partner experience Corporate board

0.273 7.5 11.34 0.622

0.258 4 14 –

0.09 1 0 0

0.873 45 25 1

624 624 624 621

Network measures Outdegree Indegree Degree Betweenness Eigenvector

8.13 7.12 12.14 0.311 4.86

6.24 5.20 10.32 0.11 2.74

0 0 0 0 0

24.2 14.2 45.17 10.87 42.53

624 624 624 624 624

2,700

624

100 100 100 100 100 100

624 624 624 624 624 624

coinvest with a small set of other VCs. There is also the existence of a special class of VCs who as a policy do not syndicate their investments. Variables definition The sample consists of 624 venture capital funds based in the UK and Continental Europe. We examine the period between 1995 and 2005. The classification into seed or early-stage funds follows Venture Economics’ fund focus variable. Corporate VCs are identified manually starting with Venture Economics’ firm type variable. We augmented the Venture Economics data with information from FAME, VentureExpert, and Diane. . Exit rate: percentage of portfolio companies exited. . IPO rate: percentage of portfolio companies sold via IPO. . M&A rate: percentage of portfolio companies sold via M&A. . Dollar exit rate: percentage of invested $ exited. . Dollar IPO rate: percentage of invested $ exited via IPO. . Dollar M&A rate: percentage of invested $ exited via M&A. B/M is the book/market ratio of public companies in the sample fund’s industry of interest. Size is the amount of committed capital reported by a VC fund. VC experience is defined as the average number of years of VC firm’s experience in venture capital industry. Partner experience is defined as the average number of years of partners’ experience in venture capital industry. Corporate board is a dummy variable that takes the value 1 if the venture capital firm is reported to sit or have sat on the board of directors of the company; 0 otherwise. Each of the following network measure is normalized by the theoretical maximum (e.g. the degree of a VC who has syndicated with every other VC in the network). Degree is defined as the number of unique VCs a firm has syndicated with (regardless of syndicate role). Indegree is defined as the number of unique VCs that have led syndicates the firm was a non-lead member of. Outdegree is defined as the number of unique VCs that have taken part as non-lead investors in syndicates led by the firm. Eigenvector is a variable that measures “closeness” in terms of how close to all other VCs a given VC is. Betweenness is defined as the number of shortest distance paths between other VCs in the network with which the VC interacts. Industry is a set of dummy variables that we obtain from our survey instrument, which gave the following choices: biotech and pharma; medical products; software and internet; financial services; industrial services; electronics; consumer services; telecom; food and consumer goods; industrial products (incl. energy); media and entertainment; other (specify).

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Benchmark analysis Earlier studies on venture capital and VC fund performance have often found the significant impact of log fund size and a set of vintage year dummies on performance (Kaplan and Schoar, 2005; Hochberg et al., 2006). Table II presents a similar type analysis. In the first column, we report results for when only size is included. In this case, we do not find any significant relationship. We then use a dummy that equals one for first-time funds in column 2. Assuming that seed, or early-stage funds invest in riskier companies and thus have relatively fewer successful exits, we also include in this column a control for such investment vehicles. Similarly, we control for corporate VCs. As expected, first-time funds perform significantly poorly. The results for the seed and early stage funds are similar, but the coefficients on corporate VCs are positive. Our subsequent analysis (column 3) includes a proxy for the investment opportunities available to funds when deploying their committed capital (using B/M ratio). In this case, we observe the impact of a more favourable investment climate at the time a fund invested its capital as significantly higher exit rates are recorded thereafter. The right of venture firms to nominate directors of portfolio companies is an important component of their control rights. The role of VC firm nominees may, however, extend beyond control. Goodstein et al. (1994) identify three functional duties of company boards:

Fund characteristics In fund size In fund size squared

(1)

(2)

(3)

0.031 (0.011) 20.003 (0.001)

0.053 * * * (0.012) 2 0.006 * * * (0.001) 2 0.067 * * * (0.017) 2 0.053 * * * (0.013) 0.048 * * (0.011)

0.042 * * * (0.011) 20.003 * * (0.002) 20.041 * * * (0.012) 20.016 * * * (0.009) 0.031 (0.016)

0.039 * * * (0.011) -0.004 * * * (0.001) 0.007 (0.012) 2 0.024 * * (0.009) 0.033 (0.016)

20.423 * * * (0.012)

2 0.276 * * * (0.019) 0.033 * * *

¼ 1 if first fund ¼ 1 if seed or early-stage fund ¼ 1 if corporate VC Investment climate Average B/M ratio VC experience

(4)

(0.015) Partner experience

Table II. Benchmark analysis (ordinary least-squares regressions)

Corporate board Adjusted R 2 Test: all coefficients ¼ 0 (F) No. of observations

18.2 41.6 * * * 621

16.1 32.5 * * * 621

19.4 47.9 * * * 621

0.031 * * * (0.010) 0.024 * * * (0.009) 24.3 33.7 * * * 621

Notes: The dependent variable is a firm’s exit rate, as defined above. Year dummies controlling for vintage year effects are included but not reported. White heteroskedasticity consistent standard errors are shown in italics;. * * *, * *, and * denote significance at the 1, 5, and 10 percent level respectively

(1) Networking activities, which are to do with forming links between the company and its external environment, and securing critical resources. (2) Monitoring activities which include dealing with internal governance issues, monitoring company performance and providing mechanisms to align the interests of management with shareholders. (3) Strategy-making activities contributing to the company’s strategic decision-making processes. Wijbenga et al. (2003) follow this framework in reviewing the role of private equity investors in the boards of portfolio companies. First, in relation to networking activities, they suggest that there is evidence that the boards of portfolio companies (on which general partners usually sit) provide an interface with other investor group members, provide industry contacts and contacts with professionals. Private equity firms also assist in obtaining alternative equity capital. Second, in relation to monitoring activities, there is evidence that the boards of portfolio companies monitor financial performance, monitor operational performance, and evaluate the portfolio company’s strategy and product market opportunities in order to develop the new venture’s strategy to changing circumstances. Finally, in relation to strategy-making activities, there is evidence that the boards of portfolio companies serve as a sounding board, assist in formulating business strategy, assist in dealing with short-term crises or problems, and recruit and/or replace managers. To investigate these matters, in column 4 our variables of interest are the venture and investment experience of the fund’s parent firm and firm’s partners. We find a significantly improved performance for funds with more experienced parents and individual partners. We find similar results for portfolio company board membership, thus emphasizing the literature’s conclusions, as discussed above. VC networks and performance In the previous section, we investigated a benchmark VC firm performance model, while controlling for fund characteristics, competition for deal flow, investment opportunities, corporate board and venture and parent firm experience. Now, we investigate the extent to which VC’s networking improve the performance of its fund. The results are largely consistent with the predictions of our framework. In Table III, we add our five network measures to the specifications shown in Table II, thus presenting estimates for four separate regression models. We find that networked VC firms are associated with significantly better fund performance in each of the specification. The results show that there are three significant network effects; indegree stands out as the most important factor in relation to its effect on network relations. This is closely followed by two other measures – eigenvector and degree. Overall, these results suggest that large benefits accrue to VC firms when they have many ties (degree). These ties have more store when VCs are invited into many syndicates (indegree), and when they involve other well-connected VCs (eigenvector). Another measure, outdegree, has a similarly relatively large effect, which implies that a VC firm’s investment in future reciprocity pays off handsomely (see also Lerner, 1994). When we examine the significance of a VC firm’s ability to act as an agent between other VCs (betweenness) we do not find a significant relationship. This reveals the fact

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¼ 1 if first fund ¼ 1 if seed or early-stage fund ¼ 1 if corporate VC Investment climate Average B/M ratio VC experience Partner experience Corporate board Network measures Degree Indegree Outdegree Eigenvector Betweenness

Table III. VC networks and performance (ordinary least-squares regressions)

Adjusted R 2 (%) Test: all coefficients ¼ 0 (F) No. of observations

(1)

(2)

(3)

(4)

0.044 * * * (0.016) 20.004 * * (0.001) 0.008 (0.013) 20.035 * * (0.011) 0.042 (0.017)

0.041 * * * (0.016) 20.005 * * (0.001) 0.008 (0.013) 20.036 * * (0.011) 0.039 (0.017)

0.042 * * * (0.016) 2 0.004 * * (0.001) 0.008 (0.013) 2 0.028 * * (0.011) 0.034 (0.017)

0.039 * * * (0.016) 2 0.004 * * (0.001) 0.011 (0.013) 2 0.036 * * (0.011) 0.032 (0.017)

20.411 * * * (0.045) 0.011 * * (0.009) 0.017 * * (0.003) 0.007 * * * (0.001)

20.414 * * * (0.045) 0.013 * * * (0.009) 0.014 * * (0.002) 0.009 * * * (0.001)

2 0.408 * * * (0.045) 0.011 * * (0.009) 0.015 * * (0.001) 0.008 * * * (0.001)

2 0.404 * * * (0.045) 0.013 * * (0.009) 0.014 * * (0.002) 0.010 * * * (0.001)

0.016 * * * (0.008) 0.019 * * * (0.002) 0.017 * * * (0.003) 0.014 * * * (0.002) 0.009 * * * (0.002) 22.5 54.2 * * * 621

0.014 * * * (0.008) 0.021 * * * (0.009) 0.016 * * * (0.003) 0.016 * * * (0.005) 0.007 * * * (0.001) 23.8 56.6 * * * 621

0.018 * * * (0.005) 0.021 * * * (0.009) 0.017 * * * (0.003) 0.016 * * * (0.005) 0.007 * * * (0.001) 21.6 53.4 * * * 621

0.016 * * * (0.008) 0.019 * * * (0.02) 0.019 * * * (0.007) 0.014 * * * (0.002) 0.007 * * * (0.001) 25.7 55.1 * * * 621

Notes: The dependent variable is a firm’s exit rate, as defined above. Year dummies controlling for vintage year effects are included but not reported. White heteroskedasticity consistent standard errors are shown in italics;. * * *, * *, and * denote significance at the 1, 5, and 10 percent level respectively

that indirect relationships (those requiring intermediation) are much less important in the way venture capital industry is organized. From these results, one can also argue that networked firms are best placed to adopt a hands-on approach to managing their portfolio companies. As discussed, VC firms taking a hands-on approach both monitor portfolio firms through, for example, reviewing management accounts and board minutes, and through involvement in decisions such as the purchase of major capital items, acquisitions and disposals, changes in strategic direction, appointment of directors and auditors, and changes in capital structure. The alternative hands-off, or passive approach, mainly involves monitoring portfolio firms, for example through management accounts. VC firms taking a hands-off approach are,

however, likely to become actively involved with the portfolio company under certain circumstances such as failure to meet agreed targets or default of payments. In our analysis, we find that the better-networked VCs generate rents by developing superior relational approaches. For example, when a VC in a network reports to the other members about the accomplishment of pre-set performance targets, both partners generate rents through exchange of knowledge valuable to one another. Frequent interactions between the parties may enhance access to each other’s knowledge base and increase the capability of processing complex knowledge. However, this analysis does not take into account the possibility that this networking approach is valued only when it affects performance. To account for the endogenous relation between VC networks and performance, we also estimate the performance effects of VC network characteristics with two stage least squares (2SLS). Table IV

Firm characteristics In firm size In firm size squared ¼ 1 if first fund ¼ 1 if seed or early-stage fund ¼ 1 if corporate VC Investment climate Average B/M ratio VC experience Partner experience Corporate board Network measures Degree Indegree Outdegree Eigenvector Betweenness Adjusted R 2 (%) Test: all coefficients ¼ 0 (F) No. of observations

(1)

(2)

(3)

(4)

0.042 * * * (0.014 20.006 * * (0.003) 0.009 (0.013) 20.028 * * (0.011) 0.023 (0.017)

0.045 * * * (0.014) 20.007 * * (0.003) 0.007 (0.013) 20.021 * (0.011) 0.021 (0.017)

0.046 * * * (0.014) 2 0.007 * * (0.003) 0.006 (0.013) 2 0.021 * (0.011) 0.022 (0.017)

0.048 * * * (0.016) 2 0.007 * * (0.003) 0.006 (0.013) 2 0.021 * (0.011) 0.023 (0.017)

20.413 * * * (0.052) 0.014 * * * (0.011) 0.004 * * * (0.001) 0.018 * * * (0.005)

20.386 * * * (0.052) 0.011 * * * (0.010) 0.005 * * * (0.001) 0.016 * * * (0.005)

2 0.374 * * * (0.052) 0.014 * * * (0.011) 0.004 * * * (0.001) 0.015 * * * (0.005)

2 0.422 * * (0.052) 0.016 * * * (0.013) 0.005 * * * (0.001) 0.018 * * * (0.005)

0.023 * * * (0.014) 0.026 * * * (0.017) 0.019 * * (0.008) 0.015 * * * (0.011) 0.011 * * * (0.002) 21.1 51.3 * * * 621

0.024 * * * (0.016) 0.025 * * * (0.011) 0.021 * * (0.008) 0.015 * * * (0.011) 0.011 * * * (0.002) 23.4 52.4 * * * 621

0.024 * * * (0.016) 0.026 * * * (0.017) 0.019 * * (0.008) 0.017 * * * (0.012) 0.011 * * * (0.002) 25.8 53.4 * * * 621

0.023 * * * (0.014) 0.025 * * * (0.011) 0.021 * * (0.008) 0.015 * * * (0.011) 0.011 * * * (0.002) 27.1 55.1 * * * 621

Notes: The dependent variable is a firm’s exit rate, as defined above. Year dummies controlling for vintage year effects are included but not reported. White heteroskedasticity consistent standard errors are shown in italics;. * * *, * *, and * denote significance at the 1, 5, and 10 percent level respectively

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Table IV. Endogeneity: the effects of VC Networks (2SLS)

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provides 2SLS results, which show that VC networks indeed raise firm performance. In fact, the results are stronger than the OLS regressions, especially the association between degree and VC performance. Conclusion Networks perform several important roles in venture capital (Dubini and Aldrich, 1991): allowing access to resources without incurring the costs of vertical integration; acting as conduits for information; and providing legitimacy to new market entrants (Burt, 1992; Larson, 1992). Given the important role of syndicates in the financing of new ventures, understanding the process by which syndicate networks are developed and managed remains a significant aspect of the entrepreneurial process. In this study, we examine the performance consequences of a particular form of organizational choice: when market transactions are characterized by strong relationships and networks. Using VCs syndicate portfolio company investments in a comprehensive sample of UK and Continental Europe based VCs over the period 1995-2005, we examine the relation between fund performance and various measures of networking among VCs. We control for various determinants of VC investment performance, and find that networked VCs realize significantly better performance. These results suggest that VC firms need to pay close attention to their relational strategies, as networking is likely to add value to firm operations. References Aldrich, H. and Zimmer, C. (1986), “Entrepreneurship through social networks”, in Sexton, D.L. and Smilor, R.W. (Eds), The Art and Science of Entrepreneurship, Ballinger, Cambridge, MA, pp. 2-23. Barney, J. (1991), “Firm resources and sustained competitive advantage”, Journal of Management, Vol. 17, pp. 99-120. Birley, S. (1985), “The role of networks in the entrepreneurial process”, Journal of Business Venturing, Vol. 1, pp. 107-17. Bonacich, P. (1987), “Power and centrality: a family of measures”, American Journal of Sociology, Vol. 92, pp. 1170-82. Brander, J., Raphael, A. and Werner, A. (2002), “Venture capital syndication: improved venture selection versus the value-added hypothesis”, Journal of Economics and Management Strategy, Vol. 11, pp. 423-52. Burt, R.S. (1992), “The social structure of competition”, in Nohria, N. and Eccles, R.G. (Eds), Networks and Organizations: Structure, Form, and Action, Harvard Business School Press, Boston, MA, pp. 57-91. Bygrave, W.D. (1988), “The structure of the investment networks of venture capital firms”, Journal of Business Venturing, Vol. 3, pp. 137-58. Chu, P. (1996), “Social network models of overseas Chinese entrepreneurship: the experience of Hong Kong and Canada”, Canadian Journal of Administrative Sciences, Vol. 13, pp. 358-65. Cornelli, F. and Goldreich, D. (2001), “Bookbuilding and strategic allocation”, Journal of Finance, Vol. 56, pp. 2337-69. Dubini, P. and Aldrich, H. (1991), “Personal and extended networks are central to the entrepreneurial process”, Journal of Business Venturing, Vol. 6, pp. 305-13.

Elango, B., Fried, V., Hisrich, R. and Polonchek, A. (1995), “How venture capital firms differ”, Journal of Business Venturing, Vol. 10, pp. 157-79. Franke, N., Gruber, M., Harhoff, D. and Henkel, J. (2006), “What you are is what you like – similarity biases in venture capitalists’ evaluations of start-up teams”, Journal of Business Venturing, Vol. 21 No. 6, pp. 802-26. Goodstein, J., Gautum, K. and Boeker, W. (1994), “The effects of board size and diversity on strategic change”, Strategic Management Journal, Vol. 15, pp. 241-50. Gorman, M. and Sahlman, W.A. (1989), “What do venture capitalists do?”, Journal of Business Venturing, Vol. 4, pp. 231-48. Granovetter, M.S. (1973), “The strength of weak ties”, American Journal of Sociology, Vol. 78, pp. 1360-80. Granovetter, M.S. (1985), “Economic action and social structure: the problem of embeddedness”, American Journal of Sociology, Vol. 91, pp. 481-510. Hochberg, Y., Ljungqvist, A. and Lu, Y. (2006), “Whom you know matters: venture capital networks and investment performance”, unpublished working paper, New York University, New York, NY. Johanson, J. and Mattson, L.G. (1987), “Interorganizational relations in industrial systems: a network approach compared with a transaction-cost approach”, International Studies of Management and Organization, Vol. 17, pp. 34-48. Kaplan, S. and Schoar, A. (2005), “Private equity returns: persistence and capital flows”, Journal of Finance, Vol. 60, pp. 1791-823. Kenis, P. and Knoke, D. (2002), “How organisational field networks shape interorganisational tie-formation rates”, Academy of Management Review, Vol. 27, pp. 275-93. Larson, A. (1992), “Network dyads in entrepreneurial settings: a study of the governance of exchange relationships”, Administrative Science Quarterly, Vol. 37, pp. 76-104. Lerner, J. (1994), “The syndication of venture capital investments”, Financial Management, Vol. 23, pp. 16-27. Ljungqvist, A., Marston, F. and Wilhelm, W.J. (2005), “Scaling the hierarchy: how and why investment banks compete for syndicate co-management appointments”, unpublished working paper, New York University, New York, NY. Norton, E. and Tenenbaum, B.H. (1993), “The effects of venture capitalists’ characteristics on the structure of a venture capital deal”, Journal of Small Business Management, Vol. 31 No. 4, pp. 32-41. Powell, W.W. (1990), “Neither market nor hierarchy: network forms of organization”, in Staw, B.M. and Cummings, L.L. (Eds), Research in Organizational Behavior, Vol. 12, JAI Press, Greenwich, CT, pp. 295-336. Powell, W.W., Koput, K.W. and Smith-Doerr, L. (1996), “Interorganizational collaboration and the locus of innovation: networks of learning in biotechnology”, Administrative Science Quarterly, Vol. 41, pp. 116-45. Provan, K.G. and Sebastian, J.G. (1998), “Networks within networks: service link overlap, organizational cliques, and network effectiveness”, Academy of Management Journal, Vol. 41, pp. 453-63. Sahlman, W.A. (1990), “The structure and governance of venture capital organizations”, Journal of Financial Economics, Vol. 27, pp. 421-73. Shulman, N. (1976), “Network analysis: a new addition to an old bag of tricks”, Acta Sociologica, Vol. 19, pp. 307-23.

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Steier, L. and Greenwood, R. (1995), “Venture capitalist relationships in the deal structuring and post-investment stages of new firm creation”, Journal of Management Studies, Vol. 32, pp. 337-57. Tichy, N.M. (1981), “Networks in organizations”, in Nystrom, P.C. and William, H. (Eds), Handbook of Organizational Design, Vol. 2, Oxford University Press, Oxford. Wernerfelt, B. (1984), “A resource-based view of the firm”, Strategic Management Journal, Vol. 5, pp. 171-80. Wijbenga, F., Postma, T., van Witteloostuijn, A. and Zwart, P. (2003), “Strategy and performance of new ventures: a contingency model of the role and influence of the venture capitalist”, Venture Capital, Vol. 5 No. 3, pp. 231-50. Wilson, R. (1968), “The theory of syndicates”, Econometrica, Vol. 36, pp. 132-99. Further reading British Venture Capital Association (2002), Report on Investment Activity, BVCA, London. Corresponding author Peter Abell can be contacted at: [email protected]

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